Document



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

FORM 10-Q
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For quarterly period ended September 30, 2016

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

For transition period __________ to __________

Commission File Number: 001-15393

HEARTLAND FINANCIAL USA, INC.
(Exact name of Registrant as specified in its charter)

Delaware
(State or other jurisdiction of incorporation or organization)

42-1405748
(I.R.S. employer identification number)

1398 Central Avenue, Dubuque, Iowa  52001
(Address of principal executive offices)(Zip Code)

(563) 589-2000
(Registrant's telephone number, including area code)

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

     Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, 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).
Yes x No o
   
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Act.
 
Large accelerated filer ¨
 
 
Accelerated Filer x
 
 
 
 
 
 
 
 
 
 
Non-accelerated filer ¨
 
 
Smaller reporting company ¨
 
 
(Do not check if a smaller reporting company)

Indicate by check mark whether the Registrant is a shell company (as defined by Rule 12b-2 of the Securities Exchange Act of 1934). Yes o No x

Indicate the number of shares outstanding of each of the classes of Registrant's common stock as of the latest practicable date:  As of November 8, 2016, the Registrant had outstanding 26,062,541 shares of common stock, $1.00 par value per share.





HEARTLAND FINANCIAL USA, INC.
Form 10-Q Quarterly Report
Table of Contents

Part I
Part II
 
 
 
 
 
101 Financial statements formatted in Extensible Business Reporting Language: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) the Consolidated Statements of Cash Flows, (v) the Consolidated Statements of Changes in Equity, and (vi) the Notes to Consolidated Financial Statements.






PART I

ITEM 1. FINANCIAL STATEMENTS

HEARTLAND FINANCIAL USA, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except per share data)
 
 
 
 
September 30, 2016 (Unaudited)
 
December 31, 2015
ASSETS
 
 
 
Cash and due from banks
$
196,234

 
$
237,841

Federal funds sold and other short-term investments
5,855

 
20,958

Cash and cash equivalents
202,089

 
258,799

Time deposits in other financial institutions
2,105

 
2,355

Securities:
 
 

Available for sale, at fair value (cost of $1,652,938 at September 30, 2016, and $1,584,703 at December 31, 2015)
1,655,696

 
1,578,434

Held to maturity, at cost (fair value of $284,948 at September 30, 2016, and $294,513 at December 31, 2015)
265,302

 
279,117

Other investments, at cost
22,082

 
21,443

Loans held for sale
78,317

 
74,783

Loans receivable:
 
 

Held to maturity
5,438,715

 
5,001,486

Allowance for loan losses
(54,653
)
 
(48,685
)
Loans receivable, net
5,384,062

 
4,952,801

Premises, furniture and equipment, net
162,207

 
146,259

Premises, furniture and equipment held for sale
3,634

 
3,889

Other real estate, net
10,740

 
11,524

Goodwill
127,699

 
97,852

Core deposit intangibles, net
23,922

 
22,019

Servicing assets, net
35,906

 
34,926

Cash surrender value on life insurance
112,060

 
110,297

Other assets
116,394

 
100,256

TOTAL ASSETS
$
8,202,215

 
$
7,694,754

LIABILITIES AND EQUITY
 
 
 
LIABILITIES:
 
 
 
Deposits:
 
 
 
Demand
$
2,238,736

 
$
1,914,141

Savings
3,753,300

 
3,367,479

Time
920,657

 
1,124,203

Total deposits
6,912,693

 
6,405,823

Short-term borrowings
214,105

 
293,898

Other borrowings
294,493

 
263,214

Accrued expenses and other liabilities
76,536

 
68,646

TOTAL LIABILITIES
7,497,827

 
7,031,581

STOCKHOLDERS' EQUITY:
 
 
 
Series C Senior Non-Cumulative Perpetual Preferred Stock (par value $1 per share; 0 shares and 81,698 shares outstanding at September 30, 2016, and December 31, 2015, respectively)

 
81,698

Series D Senior Non-Cumulative Perpetual Convertible Preferred Stock (par value $1 per share; 3,000 shares authorized and 1,078 shares issued and outstanding at September 30, 2016; 0 shares authorized, issued and outstanding at December 31, 2015)
1,357

 

Common stock (par value $1 per share; 30,000,000 shares authorized at both September 30, 2016, and December 31, 2015; issued 24,683,277 shares at September 30, 2016, and 22,435,693 shares at December 31, 2015)
24,683

 
22,436

Capital surplus
279,316

 
216,436

Retained earnings
402,179

 
348,630

Accumulated other comprehensive income (loss)
(3,079
)
 
(6,027
)
Treasury stock at cost (1,897 shares at September 30, 2016, and 0 shares at December 31, 2015)
(68
)
 

TOTAL STOCKHOLDERS' EQUITY
704,388

 
663,173

TOTAL LIABILITIES AND EQUITY
$
8,202,215

 
$
7,694,754

 
 
 
 
See accompanying notes to consolidated financial statements.
 
 
 






HEARTLAND FINANCIAL USA, INC.
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
(Dollars in thousands, except per share data)
 
 
 
 
 
 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
INTEREST INCOME:
 
 
 
 
 
 
 
Interest and fees on loans
$
70,046

 
$
58,328

 
$
208,280

 
$
167,201

Interest on securities:
 
 
 
 
 
 
 
Taxable
7,917

 
5,858

 
24,604

 
19,729

Nontaxable
3,717

 
3,077

 
10,793

 
8,867

Interest on federal funds sold
1

 
1

 
12

 
3

Interest on interest bearing deposits in other financial institutions
6

 
4

 
13

 
11

TOTAL INTEREST INCOME
81,687

 
67,268

 
243,702


195,811

INTEREST EXPENSE:
 
 
 
 
 
 
 
Interest on deposits
4,001

 
3,767

 
12,195

 
11,758

Interest on short-term borrowings
235

 
228

 
1,083

 
638

Interest on other borrowings (includes $492 and $557 of interest expense related to derivatives reclassified from accumulated other comprehensive income for the three months ended September 30, 2016 and 2015, respectively, and $1,463 and $1,680 of interest expense related to derivatives reclassified from accumulated other comprehensive income for the nine months ended September 30, 2016 and 2015, respectively)
3,770

 
3,549

 
10,918

 
12,117

TOTAL INTEREST EXPENSE
8,006

 
7,544

 
24,196


24,513

NET INTEREST INCOME
73,681

 
59,724

 
219,506


171,298

Provision for loan losses
5,328

 
3,181

 
9,513

 
10,526

NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES
68,353

 
56,543

 
209,993


160,772

NONINTEREST INCOME:
 
 
 
 
 
 
 
Service charges and fees
8,278

 
6,350

 
23,462

 
17,654

Loan servicing income
873

 
1,368

 
3,433

 
3,572

Trust fees
3,689

 
3,507

 
11,127

 
11,051

Brokerage and insurance commissions
1,006

 
869

 
2,914

 
2,872

Securities gains, net (includes $1,586 and $1,807 of net security gains reclassified from accumulated other comprehensive income for the three months ended September 30, 2016 and 2015, respectively, and $9,964 and $9,270 of net security gains reclassified from accumulated other comprehensive income for the nine months ended September 30, 2016 and 2015, respectively)
1,584

 
1,767

 
9,732

 
9,230

Net gains on sale of loans held for sale
11,459

 
9,823

 
33,794

 
38,164

Valuation allowance on commercial servicing rights
5

 

 
(41
)
 

Income on bank owned life insurance
620

 
372

 
1,733

 
1,355

Other noninterest income
1,028

 
924

 
2,992

 
2,406

TOTAL NONINTEREST INCOME
28,542

 
24,980

 
89,146


86,304

NONINTEREST EXPENSES:
 
 
 
 
 
 
 
Salaries and employee benefits
40,733

 
37,033

 
124,432

 
110,522

Occupancy
5,099

 
4,307

 
15,322

 
12,594

Furniture and equipment
2,746

 
2,121

 
7,301

 
6,403

Professional fees
5,985

 
5,251

 
20,481

 
16,544

FDIC insurance assessments
1,180

 
1,018

 
3,468

 
2,873

Advertising
1,339

 
1,327

 
4,174

 
3,841

Intangible assets amortization
1,291

 
734

 
4,483

 
2,080

Other real estate and loan collection expenses
640

 
496

 
1,871

 
1,714

(Gain)/loss on sales/valuations of assets, net
794

 
721

 
1,064

 
2,583

Other noninterest expenses
8,620

 
8,988

 
27,160

 
25,938

TOTAL NONINTEREST EXPENSES
68,427

 
61,996

 
209,756


185,092

INCOME BEFORE INCOME TAXES
28,468

 
19,527

 
89,383


61,984

Income taxes (includes $408 and $451 of income tax expense reclassified from accumulated other comprehensive income for the three months ended September 30, 2016 and 2015, respectively, and $3,171 and $2,816 of income tax expense reclassified from accumulated other comprehensive income for the nine months ended September 30, 2016 and 2015, respectively)
8,260

 
4,945

 
28,196

 
16,533

NET INCOME
20,208

 
14,582

 
61,187


45,451

Preferred dividends
(53
)
 
(205
)
 
(273
)
 
(613
)
Interest expense on convertible preferred debt
17

 

 
48

 

NET INCOME AVAILABLE TO COMMON STOCKHOLDERS
$
20,172

 
$
14,377

 
$
60,962


$
44,838

EARNINGS PER COMMON SHARE - BASIC
$
0.82

 
$
0.70

 
$
2.51

 
$
2.19

EARNINGS PER COMMON SHARE - DILUTED
$
0.81

 
$
0.69

 
$
2.48

 
$
2.16

CASH DIVIDENDS DECLARED PER COMMON SHARE
$
0.10

 
$
0.10

 
$
0.30

 
$
0.30

 
 
 
 
 
 
 
 
See accompanying notes to consolidated financial statements.
 
 
 
 
 
 
 





HEARTLAND FINANCIAL USA, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
(Dollars in thousands)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
NET INCOME
$
20,208

 
$
14,582

 
$
61,187

 
$
45,451

OTHER COMPREHENSIVE INCOME
 
 
 
 
 
 
 
Securities:
 
 
 
 
 
 
 
Net change in unrealized gain (loss) on securities
(5,696
)
 
2,202

 
18,274

 
10,916

Reclassification adjustment for net gains realized in net income
(1,586
)
 
(1,807
)
 
(9,964
)
 
(9,270
)
Net change in non-credit related other than temporary impairment

 
24

 
7

 
72

Income taxes
2,871

 
(169
)
 
(3,364
)
 
(667
)
Other comprehensive income (loss) on securities
(4,411
)
 
250

 
4,953

 
1,051

Derivatives used in cash flow hedging relationships:
 
 
 
 
 
 
 
Net change in unrealized gain (loss) on derivatives
844

 
(3,071
)
 
(4,623
)
 
(3,016
)
Reclassification adjustment for net losses on derivatives realized in net income
492

 
557

 
1,463

 
1,680

Income taxes
(517
)
 
936

 
1,155

 
488

Other comprehensive income (loss) on cash flow hedges
819

 
(1,578
)
 
(2,005
)
 
(848
)
Other comprehensive income (loss)
(3,592
)
 
(1,328
)
 
2,948

 
203

TOTAL COMPREHENSIVE INCOME
$
16,616

 
$
13,254

 
$
64,135

 
$
45,654

 
 
 
 
 
 
 
 
See accompanying notes to consolidated financial statements.
 
 
 
 
 
 
 





HEARTLAND FINANCIAL USA, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(Dollars in thousands)
 
 
Nine Months Ended September 30,
 
2016
 
2015
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net income
$
61,187

 
$
45,451

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
22,975

 
16,325

Provision for loan losses
9,513

 
10,526

Net amortization of premium on securities
24,093

 
21,339

Securities gains, net
(9,732
)
 
(9,230
)
Stock based compensation
3,073

 
2,635

Write downs and losses on repossessed assets, net
1,094

 
1,686

Loans originated for sale
(863,354
)
 
(1,087,510
)
Proceeds on sales of loans held for sale
883,758

 
1,083,285

Net gains on sale of loans held for sale
(23,938
)
 
(27,102
)
Increase (decrease) in accrued interest receivable
(1,054
)
 
170

Increase in prepaid expenses
(128
)
 
(1,021
)
Increase (decrease) in accrued interest payable
332

 
(177
)
Capitalization of servicing rights
(9,856
)
 
(11,766
)
Valuation adjustment on commercial servicing rights
41

 

Write downs and losses on sales of assets, net
(30
)
 
897

Other, net
(2,419
)
 
8,137

NET CASH PROVIDED BY OPERATING ACTIVITIES
95,555

 
53,645

CASH FLOWS FROM INVESTING ACTIVITIES:
 
 
 
Proceeds from the sale of securities available for sale
768,617

 
877,077

Proceeds from the sale of securities held to maturity
4,557

 

Proceeds from the sale of other investments
4,722

 
12,917

Proceeds from the sale of time deposits in other financial institutions

 
2,925

Proceeds from the maturity of and principal paydowns on securities available for sale
130,549

 
124,084

Proceeds from the maturity of and principal paydowns on securities held to maturity
8,271

 
1,338

Proceeds from the maturity of and principal paydowns on time deposits in other financial institutions
250

 
250

Proceeds from the maturity of and principal paydowns on other investments

 
619

Purchase of securities available for sale
(888,903
)
 
(774,657
)
Purchase of other investments
(1,875
)
 
(9,833
)
Net (increase) decrease in loans
138,725

 
(225,356
)
Purchase of bank owned life insurance policies

 
(1,100
)
Proceeds from bank owned life insurance policies
111

 

Capital expenditures
(8,318
)
 
(4,982
)
Net cash and cash equivalents received (paid) in acquisitions
8,084

 
(6,861
)
Proceeds from the sale of equipment
686

 
1,108

Proceeds on sale of OREO and other repossessed assets
3,266

 
6,328

NET CASH PROVIDED BY INVESTING ACTIVITIES
168,742

 
3,857

 
 
 
 





HEARTLAND FINANCIAL USA, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED (Unaudited)
(Dollars in thousands)
 
 
 
 
Nine Months Ended September 30,
 
2016
 
2015
CASH FLOWS FROM FINANCING ACTIVITIES:
 
 
 
Net increase in demand deposits
160,313

 
191,361

Net increase (decrease) in savings deposits
51,530

 
(73,050
)
Net decrease in time deposit accounts
(353,084
)
 
(26,326
)
Net decrease in short-term borrowings
(101,409
)
 
(25,901
)
Proceeds from short term FHLB advances
243,100

 
276,100

Repayments of short term FHLB advances
(257,250
)
 
(270,000
)
Proceeds from other borrowings
40,000

 
29,000

Repayments of other borrowings
(15,562
)
 
(134,803
)
Redemption of preferred stock
(81,698
)
 

Purchase of treasury stock
(2,293
)
 
(2,856
)
Proceeds from issuance of common stock
1,863

 
2,330

Excess tax benefits on exercised stock options
1,121

 
671

Dividends paid
(7,638
)
 
(6,794
)
NET CASH USED BY FINANCING ACTIVITIES
(321,007
)
 
(40,268
)
Net increase (decrease) in cash and cash equivalents
(56,710
)
 
17,234

Cash and cash equivalents at beginning of year
258,799

 
73,871

CASH AND CASH EQUIVALENTS AT END OF PERIOD
$
202,089

 
$
91,105

Supplemental disclosures:
 
 
 
Cash paid for income/franchise taxes
$
16,550

 
$
7,305

Cash paid for interest
$
23,864

 
$
24,690

Loans transferred to OREO
$
1,359

 
$
5,206

Purchases of securities available for sale, accrued, not paid
$

 
$
3,523

Sales of securities available for sale, accrued, not settled
$
250

 
$

Stock consideration granted for acquisition
$
57,433

 
$
53,052

 
 
 
 
See accompanying notes to consolidated financial statements.





HEARTLAND FINANCIAL USA, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (Unaudited)
(Dollars in thousands, except per share data)
 
 
Heartland Financial USA, Inc. Stockholders' Equity
 
 
Preferred
 Stock
 
Common
 Stock
 
Capital
 Surplus
 
Retained
 Earnings
 
Accumulated Other Comprehensive Income (Loss)
 
Treasury
Stock
 
Total
 Equity
Balance at January 1, 2015
$
81,698

 
$
18,511

 
$
95,816

 
$
298,764

 
$
1,528

 
$

 
$
496,317

Comprehensive income


 






45,451

 
203





45,654

Cash dividends declared:


 


 


 


 


 


 
 
Series C Preferred, $7.50 per share


 






(613
)
 






(613
)
Common, $0.30 per share


 






(6,181
)
 






(6,181
)
Purchase of 54,389 shares of common stock


 








 



(2,856
)

(2,856
)
Issuance of 2,180,585 shares of common stock


 
2,129


51,162




 



2,762


56,053

Stock based compensation


 



2,635




 






2,635

Balance at September 30, 2015
$
81,698

 
$
20,640

 
$
149,613

 
$
337,421

 
$
1,731

 
$
(94
)
 
$
591,009

Balance at January 1, 2016
$
81,698

 
$
22,436

 
$
216,436

 
$
348,630

 
$
(6,027
)
 
$

 
$
663,173

Comprehensive income
 
 
 
 
 
 
61,187

 
2,948

 


 
64,135

Cash dividends declared:
 
 
 
 
 
 
 
 


 


 
 

Series C Preferred, $2.50 per share
 
 
 

 

(168
)
 






(168
)
Series D Preferred, $35.00 per share
 
 
 
 
 
 
(105
)
 
 
 
 
 
(105
)
Common, $0.30 per share
 
 
 

 

(7,365
)
 






(7,365
)
Redemption of Series C preferred stock
(81,698
)
 
 
 
 
 
 
 
 
 
 
 
(81,698
)
Issuance of Series D preferred stock
3,777

 
 
 
 
 
 
 
 
 
 
 
3,777

Redemption of Series D preferred stock
(2,420
)
 
 
 
 
 
 
 
 
 
 
 
(2,420
)
Purchase of 49,785 shares of common stock
 
 
 

 



 



(2,293
)

(2,293
)
Issuance of 2,295,472 shares of common stock
 
 
2,247


59,807

 


 



2,225


64,279

Stock based compensation
 
 
 

3,073




 






3,073

Balance at September 30, 2016
$
1,357

 
$
24,683

 
$
279,316

 
$
402,179

 
$
(3,079
)
 
$
(68
)
 
$
704,388

 
 
 
 
 
 
 
 
 
 
 
 
 
 
See accompanying notes to consolidated financial statements.
 
 
 
 
 
 
 
 






HEARTLAND FINANCIAL USA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1: BASIS OF PRESENTATION

The interim unaudited consolidated financial statements contained herein should be read in conjunction with the audited consolidated financial statements and accompanying notes to the consolidated financial statements for the fiscal year ended December 31, 2015, included in the Form 10-K of Heartland Financial USA, Inc. ("Heartland") filed with the Securities and Exchange Commission ("SEC") on March 11, 2016. Accordingly, footnote disclosures which would substantially duplicate the disclosure contained in the audited consolidated financial statements have been omitted.

The financial information of Heartland included herein has been prepared in accordance with U.S. generally accepted accounting principles for interim financial reporting and has been prepared pursuant to the rules and regulations for reporting on Form 10-Q and Rule 10-01 of Regulation S-X. Such information reflects all adjustments (consisting of normal recurring adjustments), that are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the periods presented. The results of the interim period ended September 30, 2016, are not necessarily indicative of the results expected for the year ending December 31, 2016.

Earnings Per Share

Basic earnings per share is determined using net income available to common stockholders and weighted average common shares outstanding. Diluted earnings per share is computed by dividing net income available to common stockholders by the weighted average common shares and assumed incremental common shares issued. Amounts used in the determination of basic and diluted earnings per share for the three- and nine-month periods ended September 30, 2016 and 2015, are shown in the table below:
 
Three Months Ended September 30,
(Dollars and number of shares in thousands, except per share data)
2016
 
2015
Net income attributable to Heartland
$
20,208

 
$
14,582

Preferred dividends and discount
(53
)
 
(205
)
Interest expense on convertible preferred debt
17

 

Net income available to common stockholders
$
20,172

 
$
14,377

Weighted average common shares outstanding for basic earnings per share
24,601

 
20,620

Assumed incremental common shares issued upon exercise of stock options and non-vested restricted stock units
322

 
273

Weighted average common shares for diluted earnings per share
24,923

 
20,893

Earnings per common share — basic
$
0.82

 
$
0.70

Earnings per common share — diluted
$
0.81

 
$
0.69

Number of antidilutive common stock equivalents excluded from diluted earnings per share computation

 

 
 
 
 
 
Nine Months Ended September 30,
(Dollars and number of shares in thousands, except per share data)
2016
 
2015
Net income attributable to Heartland
$
61,187

 
$
45,451

Preferred dividends
(273
)
 
(613
)
Interest expense on convertible preferred debt
48

 

Net income available to common stockholders
$
60,962

 
$
44,838

Weighted average common shares outstanding for basic earnings per share
24,262

 
20,483

Assumed incremental common shares issued upon exercise of stock options and non-vested restricted stock units
319

 
269

Weighted average common shares for diluted earnings per share
24,581

 
20,752

Earnings per common share — basic
$
2.51

 
$
2.19

Earnings per common share — diluted
$
2.48

 
$
2.16

Number of antidilutive common stock equivalents excluded from diluted earnings per share computation

 







Stock-Based Compensation

Heartland may grant, through its Nominating and Compensation Committee (the "Compensation Committee"), non-qualified and incentive stock options, stock appreciation rights, stock awards, restricted stock, restricted stock units and cash incentive awards, under its 2012 Long-Term Incentive Plan (the "Plan"). The Plan was originally approved by stockholders in May 2012 and was amended effective March 8, 2016, to increase the number of shares of common stock authorized for issuance and make certain other changes to the Plan. As of September 30, 2016, 549,144 shares of common stock were available for issuance under future awards that may be granted under the Plan to employees and directors of, and service providers to, Heartland or its subsidiaries.

Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 718, "Compensation-Stock Compensation" requires the measurement of the cost of employee services received in exchange for an award of equity instruments based upon the fair value of the award on the grant date. The cost of the award is based upon its fair value estimated on the date of grant and recognized in the consolidated statements of income over the vesting period of the award. The fair market value of restricted stock and restricted stock units is based on the fair value of the underlying shares of common stock on the date of grant. The fair value of stock options is estimated on the date of grant using the Black-Scholes model.

The amount of tax benefit related to the exercise, vesting, and forfeiture of equity-based awards reflected in additional paid-in-capital, not taxes payable, was $1.1 million and $671,000 during the nine months ended September 30, 2016 and 2015, respectively.

Restricted Stock Units

The Plan permits the Compensation Committee to grant restricted stock units ("RSUs"). In the first quarter of 2016, the Compensation Committee granted time-based RSUs with respect to 72,644 shares of common stock, and in the first quarter of 2015, the Compensation Committee granted time-based RSUs with respect to 78,220 shares of common stock to selected officers. The time-based RSUs represent the right, without payment, to receive shares of Heartland common stock at a specified date in the future. The time-based RSUs granted in 2016 vest over three years in equal installments on the first, second and third anniversaries of the grant date. The time-based RSUs granted in 2015 vest over five years in equal installments on the third, fourth, and fifth anniversaries of the grant date. The time-based RSUs will be settled in common stock upon vesting, and will not be entitled to dividends until vested. The time-based RSUs may also vest upon death or disability, upon a change in control or upon a "qualified retirement" (as defined in the RSU agreement). The retiree is required to sign a non-solicitation and non-compete agreement as a condition to vesting.

In addition to the time-based RSUs referenced in the preceding paragraph, the Compensation Committee granted performance-based RSUs with respect to 35,516 shares of common stock in the first quarter of 2016, and 39,075 shares of common stock in the first quarter of 2015. These performance-based RSUs are earned based on satisfaction of performance targets for the fiscal years ended December 31, 2016, and December 31, 2015, respectively, and then fully vest two years after the end of the performance period. For the grants awarded in 2016, the portion of the RSUs earned based on performance vests on December 31, 2018, and for the grants awarded in 2015, the portion of the RSUs earned based on performance vests on December 31, 2017, subject to employment on the respective vesting dates. The performance-based RSUs vest to the extent that they are earned upon death or disability, upon a change in control or upon a "qualified retirement."

The Compensation Committee also granted performance-based RSUs with respect to 11,408 shares of common stock in the first quarter of 2016. These performance-based RSUs will be earned based on satisfaction of performance targets for the three-year performance period ended December 31, 2018. These performance-based RSUs will vest in 2019 after measurement of performance in relation to the performance targets.

Upon death, disability, or a "qualified retirement," all performance-based RSUs granted in 2016 remain outstanding and are earned based on actual performance at the end of each performance period. All RSUs granted on or after March 8, 2016, become fully vested upon a change in control if (1) they are not assumed by the successor corporation or (2) upon an involuntary termination of the participant's employment within two years after the change in control.

The Compensation Committee also grants RSUs under the Plan to directors as part of their compensation, to new management level employees at commencement of employment, and to other employees and service providers as incentives. During the nine months ended September 30, 2016, and September 30, 2015, 24,153 and 22,648 RSUs, respectively, were granted to directors and new employees.






A summary of the RSUs outstanding as of September 30, 2016 and 2015, and changes during the nine months ended September 30, 2016 and 2015, follows:
 
2016
 
2015
 
Shares
 
Weighted-Average Grant Date
Fair Value
 
Shares
 
Weighted-Average Grant Date
Fair Value
Outstanding at January 1
353,195

 
$
25.53

 
396,555

 
$
21.48

Granted
143,721

 
29.75

 
139,943

 
28.90

Vested
(117,898
)
 
23.44

 
(151,681
)
 
17.98

Forfeited
(11,547
)
 
27.12

 
(15,636
)
 
25.08

Outstanding at September 30
367,471

 
$
27.60

 
369,181

 
$
25.56


Total compensation costs recorded for RSUs were $3.1 million and $2.6 million for the nine-month periods ended September 30, 2016 and 2015. As of September 30, 2016, there were $3.7 million of total unrecognized compensation costs related to the Plan for RSUs that are expected to be recognized through 2019.

Options

Although the Plan provides authority to the Compensation Committee to grant stock options, no options were granted during the first nine months of 2016 and 2015. Prior to 2009, options were typically granted annually with an expiration date ten years after the date of grant. Vesting was generally over a five-year service period with equal portions of a grant becoming exercisable at three years, four years, and five years after the date of grant. A summary of the stock options outstanding as of September 30, 2016 and 2015, and changes during the nine months ended September 30, 2016 and 2015, follows:
 
2016
 
2015
 
Shares
 
Weighted-Average
Exercise Price
 
Shares
 
Weighted-Average
Exercise Price
Outstanding at January 1
125,950

 
$
24.08

 
215,851

 
$
23.85

Granted

 

 

 

Exercised
(55,250
)
 
24.82

 
(81,401
)
 
23.34

Forfeited
(1,500
)
 
21.10

 
(3,250
)
 
23.51

Outstanding at September 30
69,200

 
$
23.55

 
131,200

 
$
24.15

Options exercisable at September 30
69,200

 
$
23.55

 
131,200

 
$
24.15


At September 30, 2016, the vested options totaled 69,200 shares with a weighted average exercise price of $23.55 per share and a weighted average remaining contractual life of 0.86 years. The intrinsic value (the difference between the market price and the aggregate exercise price) for the vested options as of September 30, 2016, was $866,000. The intrinsic value for the total of all options exercised during the nine months ended September 30, 2016, was $486,000.

The exercise price of stock options granted is established by the Compensation Committee, but the exercise price for the stock options may not be less than the fair market value of the shares on the date that the option is granted or, if greater, the par value of a share of stock. Each option granted is exercisable in full at any time or from time to time, subject to vesting provisions, as determined by the Compensation Committee and as provided in the option agreement, but such time may not exceed ten years from the grant date. Cash received from options exercised was $1.4 million for the nine months ended September 30, 2016, and $1.9 million for the nine months ended September 30, 2015.

Total compensation costs recorded for options were $0 for both the nine month periods ended September 30, 2016 and 2015. There are no unrecorded compensation costs related to options at September 30, 2016. No stock options vested during the nine-month periods ended September 30, 2016 and 2015.

Subsequent Events

On October 29, 2016, Heartland entered into a definitive merger agreement providing for the acquisition of Founders Bancorp, parent company of Founders Community Bank, based in San Luis Obispo, California. The transaction is valued at approximately $29.1 million, subject to adjustment. Of the merger consideration, 70% will be in the form of shares of Heartland common stock,





and 30% will be in cash. As of September 30, 2016, Founders Community Bank had total assets of $198.5 million, which includes gross loans of $106.6 million and total deposits of $180.5 million. The closing of the acquisition is subject to customary closing conditions, including approvals by the Founders Bancorp shareholders and banking regulators, and is expected to occur in the first quarter of 2017. Simultaneous with the close, Founders Community Bank will be merged into Heartland's Premier Valley Bank subsidiary. Heartland expects the acquisition to be accretive to its earning per share during 2018.

On November 2, 2016, Heartland commenced a public offering of 1,379,690 shares of its common stock at $36.24 per share, and the offering closed on November 8, 2016. The offering resulted in net proceeds of approximately $49.7 million after deducting estimated offering expenses payable by Heartland. All of the shares of common stock included in the offering are primary shares. Heartland intends to use the net proceeds from this offering for general corporate purposes, which may include, among other things, working capital, debt repayment or financing potential acquisitions.

The interim unaudited consolidated financial statements contained herein cover results for the quarter ended September 30, 2016, and as a result, the effects of these transactions are excluded from the financial results and financial position of Heartland disclosed herein.

Effect of New Financial Accounting Standards

In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers." The amendment clarifies the principles for recognizing revenue and develops a common revenue standard. The amendment outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The core principle of the revenue model is that “an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” In applying the revenue model to contracts within its scope, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract, and (v) recognize revenue when (or as) the entity satisfies a performance obligation. The amendment applies to all contracts with customers except those that are within the scope of other topics in the FASB Codification. The standard also requires significantly expanded disclosures about revenue recognition. The amendment is effective for annual reporting periods beginning after December 15, 2017 (including interim reporting periods within those periods). Early application is not permitted. Heartland intends to adopt the accounting standard during the first quarter of 2018, as required, and is currently evaluating the impact on its results of operations, financial position, and liquidity.

In November 2014, the FASB issued ASU 2014-16, "Derivatives and Hedging (Topic 815): Determining Whether a Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share is More Akin to Debt or to Equity." The amendment clarifies how current guidance should be interpreted in evaluating the characteristics and risks of a host contract in a hybrid financial instrument issued in the form of a share. One criterion requires evaluating whether the nature of the host contract is more akin to debt or to equity and whether the economic characteristics and risks of the embedded derivative feature are "clearly and closely related" to the host contract. In making that evaluation, an issuer or investor must consider all terms and features in a hybrid financial instrument including the embedded derivative feature that is being evaluated for separate accounting or may consider all terms and features in the hybrid financial instrument except for the embedded derivative feature that is being evaluated for separate accounting. This ASU is effective for annual periods and interim periods within those annual periods beginning after December 15, 2015, with early adoption permitted. Heartland adopted this standard on January 1, 2016, and the adoption of this standard did not have a material impact on its results of operations, financial position, and liquidity.

In January 2015, the FASB issued ASU 2015-01, "Income Statement-Extraordinary and Unusual Items." The amendment eliminates from U.S. GAAP the concept of extraordinary items. Presently, an event or transaction is presumed to be an ordinary and usual activity of the reporting entity unless evidence clearly supports its classification as an extraordinary item. If an event or transaction meets the criteria for extraordinary classification, an entity is required to segregate the extraordinary item from the results of ordinary operations and show the item separately in the income statement, net of tax, after income from continuing operations. This amended guidance will prohibit separate disclosure of extraordinary items in the income statement. This amendment is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Entities may apply the amendment prospectively or retrospectively to all prior periods presented in the financial statements. Early adoption is permitted provided that the guidance is applied from the beginning of the fiscal year of adoption. Heartland adopted this standard on January 1, 2016, and the adoption of this standard did not have a material impact on the results of operations, financial position, and liquidity.






In April 2015, the FASB issued ASU 2015-05, "Intangibles-Goodwill and Other-Internal-Use Software." The amendment intends to provide guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The guidance will not change GAAP for a customer's accounting for service contracts. As a result, all software licenses within the scope of this guidance will be accounted for consistently with other licenses of intangible assets. This amendment is effective for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Entities can elect to adopt the standard either retrospectively or prospectively to all cloud computing arrangements entered into or materially modified after the adoption date. Early adoption is permitted. Heartland adopted this standard on January 1, 2016, and the adoption did not have a material impact on the results of operations, financial position, and liquidity.

In September 2015, the FASB issued ASU 2015-16, "Simplifying the Accounting for Measurement-Period Adjustments." The amendment eliminates the requirement of Topic 805, Business Combinations, to retrospectively adjust the financial statements for measurement-period adjustments that occur in periods after a business combination is consummated. Measurement-period adjustments are calculated as if they were known at the acquisition date, but are recognized in the reporting period in which they are determined. Prior period information is not revised. Additional disclosures are required about the impact on current period income statement line items of adjustments that would have been recognized in prior periods if prior period information had been revised. This amendment is effective for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted if financial statements have not been issued. Heartland adopted this standard effective September 30, 2015. The adoption of this standard did not have a material impact on the results of operations, financial position, and liquidity.

In January 2016, the FASB issued guidance ASU 2016-01, "Recognition and Measurement of Financial Assets and Financial Liabilities." The amendments in ASU 2016-01 to Subtopic 825-10, Financial Instruments, contain the following elements: (1) requires equity investments to be measured at fair value with changes in fair value recognized in net income; (2) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (3) eliminates the requirement for public entities to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet; (4) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (5) requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; (6) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or accompanying notes to the financial statements; (7) clarifies that the entity should evaluate the need for a valuation allowance on a deferred tax asset related to available for sale securities in combination with the entity's other deferred tax assets. The amendments are effective for fiscal years beginning after December 15, 2017, and for interim periods within those fiscal years. Except for the early application of the amendment noted in item (5) above, early adoption of the amendments in this update is not permitted. Heartland intends to adopt the accounting standard in 2018, as required, and is currently evaluating the potential impact of this guidance on its results of operations, financial position, and liquidity.

In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)." Topic 842 requires a lessee to recognize a lease liability and a right of use asset for each lease, with the exception of short term leases, at the commencement date of the lease and disclose key information about the leasing arrangement. Accounting requirements applied by lessors is largely unchanged. The amendment is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, and will be applied on a modified retrospective basis. Heartland intends to adopt the accounting standard in 2019, as required, and is currently evaluating the potential impact of this guidance on its results of operations, financial position, and liquidity.

In March 2016, the FASB issued ASU 2016-09, "Compensation-Stock Compensation (Topic 718)." The amendments in this ASU simplify several aspects of the accounting for share-based payments, including income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. The amendments in this ASU are effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted for any interim or annual period prior to the effective date. An entity that elects early adoption must adopt all of the amendments in the same period. Heartland intends to adopt this ASU in 2017, as required, and is currently evaluating the potential impact of this guidance on its results of operations, financial position, and liquidity.

In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses (Topic 326)." The amendments in this ASU require a financial asset (or a group of financial assets) measured at amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial





asset(s) to present the net carrying value at the amount expected to be collected on the financial asset. The amendments in this ASU indicate that an entity should not use the length of time a security has been in an unrealized loss position to avoid recording a credit loss. In addition, in determining whether a credit loss exists, the amendments in this ASU also remove the requirements to consider the historical and implied volatility of the fair value of a security and recoveries or declines in fair value after the balance sheet date. The amendment is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. An entity may adopt the amendments earlier as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Heartland intends to adopt the accounting standard in 2020, as required, and is currently evaluating the potential impact of this guidance on its results of operations, financial position, and liquidity.

In August 2016, the FASB issued ASU 2016-15, "Statement of Cash Flows (Topic 230) - Classification of Certain Cash Receipts and Cash Payments." The amendments in this update address eight specific cash flow issues with the objective of reducing the existing diversity in practice. The amendment is effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes the interim period. An entity that elects early adoption must adopt all of the amendments in the same period. The amendments in this update should be applied using a retrospective transition method to each period presented. Heartland intends to adopt this ASU in 2018, as required, and is currently evaluating the potential impact on its results of operations, financial position, and liquidity.

NOTE 2: ACQUISITIONS

CIC Bancshares, Inc.
On February 5, 2016, Heartland completed the acquisition of CIC Bancshares, Inc., parent company of Centennial Bank, headquartered in Denver, Colorado. The purchase price was approximately $76.9 million, which was paid by delivery of 2,003,235 shares of Heartland common stock and cash of $15.7 million. In addition, Heartland issued a new series of convertible preferred stock with a fair value of $3.8 million and assumed convertible notes and subordinated debt totaling approximately $7.9 million. Simultaneous with the closing of the transaction, Centennial Bank merged into Heartland's Summit Bank & Trust, with the resulting institution operating under the name, Centennial Bank and Trust. As of the close date, the transaction included, at fair value, total assets of $772.6 million, total loans of $581.5 million, and total deposits of $648.1 million. The transaction was a tax-free reorganization with respect to the stock consideration received by the stockholders of CIC Bancshares, Inc.






The assets and liabilities of CIC Bancshares, Inc. were recorded on the consolidated balance sheet at estimated fair value on the acquisition date. The following table represents, in thousands, the amounts recorded on the consolidated balance sheet as of February 5, 2016:
 
As of February 5, 2016
Fair value of consideration paid:
 
Common Stock (2,003,235 shares)
$
57,433

Preferred Stock (3,000 shares)
3,777

Cash
15,672

Total consideration paid
76,882

Fair value of assets acquired:
 
Cash and due from banks
23,756

Securities:

Securities available for sale
92,831

Other securities
3,486

Loans held to maturity
581,477

Premises, furniture and equipment, net
16,450

Other real estate, net
1,934

Other intangible assets, net
6,576

Other assets
16,276

Total assets
742,786

Fair value of liabilities assumed:
 
Deposits
648,111

Short term borrowings
35,766

Other borrowings
7,924

Other liabilities
3,951

Total liabilities assumed
695,752

Fair value of net assets acquired
47,034

Goodwill resulting from acquisition
$
29,848


Heartland recognized $29.8 million of goodwill in conjunction with the acquisition of CIC Bancshares, Inc., which is calculated as the excess of both the consideration exchanged and the liabilities assumed as compared to the fair value of identifiable assets acquired. Goodwill resulted from the expected operational synergies, enhanced market area, cross-selling opportunities and expanded business lines. See Note 6 for further information on goodwill.

Pro Forma Information (unaudited): The following pro forma information presents the results of operations for the years ended December 31, 2015, and December 31, 2014, as if the CIC Bancshares, Inc. acquisition occurred on January 1, 2014:
(Dollars in thousands, except per share data), unaudited
For the Years Ended
 
December 31, 2015
 
December 31, 2014
Net interest income
$
259,531

 
$
221,808

Net income available to common shareholders
$
59,491

 
$
41,004

Basic earnings per share
$
2.63

 
$
2.00

Diluted earnings per share
$
2.58

 
$
1.96


The above pro forma results are presented for illustrative purposes and are not intended to represent or be indicative of the actual results of operations of the merged companies that would have been achieved had the acquisition occurred at January 1, 2014, nor are they intended to represent or be indicative of future results of operations. The pro forma results do not include expected operating cost savings as a result of the acquisition. These pro forma results require significant estimates and judgments particularly with respect to valuation and accretion of income associated with the acquired loans.






Heartland incurred $551,000 of pre-tax merger related expenses in 2016 associated with the Centennial Bank acquisition. The merger expenses are reflected on the consolidated statements of income for the applicable period and are reported primarily in the categories of professional fees and other noninterest expenses.

Acquired loans were preliminarily recorded at fair value based on a discounted cash flow valuation methodology that considers, among other things, projected default rates, loss given defaults and recovery rates. No allowance for credit losses was carried over from the acquisition. The balance of nonaccrual loans on the acquisition date was $1.6 million.

Premier Valley Bank
On November 30, 2015, Heartland completed the purchase of Premier Valley Bank in Fresno, California. The purchase price was approximately $95.5 million, which was paid by delivery of 1,758,543 shares of Heartland common stock and cash of $28.5 million. The transaction included, at fair value, total assets of $692.7 million, loans of $389.8 million, and deposits of $622.7 million. Premier Valley Bank continues to operate under its current name and management team as Heartland's tenth, wholly-owned state-chartered bank. The transaction was a tax-free reorganization with respect to the stock consideration received by the stockholders of Premier Valley Bank.
 
 
Heartland recognized $41.0 million of goodwill in conjunction with the acquisition of Premier Valley Bank, which is calculated as the excess of both the consideration exchanged and the liabilities assumed as compared to the fair value of identifiable assets acquired. Goodwill resulted from the expected operational synergies, enhanced market area, cross-selling opportunities and expanded business lines. See Note 6 for further information on goodwill.
 
 
 
 
First Scottsdale Bank, N.A.
On September 11, 2015, Heartland completed the purchase of First Scottsdale Bank, N.A., in Scottsdale, Arizona, in an all cash transaction valued at approximately $17.7 million. Simultaneous with the closing of the transaction, First Scottsdale Bank, N.A., merged into Heartland's Arizona Bank & Trust subsidiary. The transaction included, at fair value, total assets of $81.2 million, loans of $54.7 million, and deposits of $65.9 million on the acquisition date.

Community Bancorporation of New Mexico, Inc.
On August 21, 2015, Heartland acquired Community Bancorporation of New Mexico, Inc., parent company of Community Bank in Santa Fe, New Mexico, in an all cash transaction valued at approximately $11.1 million. Simultaneous with the closing of the transaction, Community Bank merged into Heartland's New Mexico Bank & Trust subsidiary. The transaction included, at fair value, total assets of $166.3 million, loans of $99.5 million, and deposits of $147.4 million on the acquisition date. Also included in this transaction is one bank building with a fair value of $3.4 million that Heartland intends to sell. The bank building is part of the balance of premises, furniture and equipment held for sale on the consolidated balance sheet.

Community Banc-Corp of Sheboygan, Inc.
On January 16, 2015, Heartland completed the acquisition of Community Banc-Corp of Sheboygan, Inc., parent company of Community Bank & Trust in Sheboygan, Wisconsin. Under the terms of the merger agreement for this transaction, the aggregate purchase price was based upon 155% of the December 31, 2014, adjusted tangible book value, as defined in the merger agreement, of Community Banc-Corp of Sheboygan, Inc. The purchase price was approximately $53.1 million, which was paid by delivery of 1,970,720 shares of Heartland common stock. The transaction included, at fair value, total assets of $506.8 million, including loans of $395.0 million, and deposits of $433.9 million. Simultaneous with the close of the transaction, Community Bank & Trust merged into Heartland’s Wisconsin Bank & Trust subsidiary. The transaction was a tax-free reorganization with respect to the stock consideration received by the stockholders of Community Banc-Corp of Sheboygan, Inc.
 
 
Heartland recognized goodwill of $18.6 million in conjunction with the acquisition of Community Banc-Corp of Sheboygan, Inc., which is calculated as the excess of both the consideration exchanged and the liabilities assumed as compared to the fair value of identifiable assets acquired. See Note 6 for further information on goodwill.
 
 
 
 





NOTE 3: SECURITIES

The amortized cost, gross unrealized gains and losses, and estimated fair values of securities available for sale as of September 30, 2016, and December 31, 2015, are summarized in the table below, in thousands:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
September 30, 2016
 
 
 
 
 
 
 
U.S. government corporations and agencies
$
4,830

 
$
125

 
$

 
$
4,955

Mortgage-backed securities
1,281,459

 
14,401

 
(20,767
)
 
1,275,093

Obligations of states and political subdivisions
353,483

 
9,611

 
(987
)
 
362,107

Corporate debt securities

 

 

 

Total debt securities
1,639,772

 
24,137

 
(21,754
)
 
1,642,155

Equity securities
13,166

 
375

 

 
13,541

Total
$
1,652,938

 
$
24,512

 
$
(21,754
)
 
$
1,655,696

December 31, 2015
 
 
 
 
 
 
 
U.S. government corporations and agencies
$
25,847

 
$
22

 
$
(103
)
 
$
25,766

Mortgage-backed securities
1,254,452

 
9,134

 
(20,884
)
 
1,242,702

Obligations of states and political subdivisions
290,522

 
6,547

 
(1,087
)
 
295,982

Corporate debt securities
740

 
106

 

 
846

Total debt securities
1,571,561


15,809


(22,074
)

1,565,296

Equity securities
13,142

 
40

 
(44
)
 
13,138

Total
$
1,584,703

 
$
15,849

 
$
(22,118
)
 
$
1,578,434


At September 30, 2016, and December 31, 2015, the amortized cost of the available for sale securities is net of $0 and $237,000 of credit related other-than-temporary impairment ("OTTI"), respectively.

The amortized cost, gross unrealized gains and losses and estimated fair values of held to maturity securities as of September 30, 2016, and December 31, 2015, are summarized in the table below, in thousands:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Estimated
Fair
Value
September 30, 2016
 
 
 
 
 
 
 
Mortgage-backed securities
$

 
$

 
$

 
$

Obligations of states and political subdivisions
265,302

 
20,191

 
(545
)
 
284,948

Total
$
265,302

 
$
20,191

 
$
(545
)
 
$
284,948

December 31, 2015
 
 
 
 
 
 
 
Mortgage-backed securities
$
4,369

 
$
306

 
$

 
$
4,675

Obligations of states and political subdivisions
274,748

 
15,595

 
(505
)
 
289,838

Total
$
279,117

 
$
15,901

 
$
(505
)
 
$
294,513


At September 30, 2016, the amortized cost of the held to maturity securities is net of $0 of credit related OTTI and $0 of non-credit related OTTI. At December 31, 2015, the amortized cost of the held to maturity securities was net of $1.5 million of credit related OTTI and $40,000 of non-credit related OTTI.

Approximately 77% of Heartland's mortgage-backed securities are issuances of government-sponsored enterprises.






The amortized cost and estimated fair value of debt securities available for sale at September 30, 2016, by contractual maturity are as follows, in thousands. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without penalties.
 
Amortized Cost
 
Estimated Fair Value
Due in 1 year or less
$
1,075

 
$
1,078

Due in 1 to 5 years
22,931

 
23,277

Due in 5 to 10 years
103,104

 
105,529

Due after 10 years
231,203

 
237,178

Total debt securities
358,313

 
367,062

Mortgage-backed securities
1,281,459

 
1,275,093

Equity securities
13,166

 
13,541

Total investment securities
$
1,652,938

 
$
1,655,696


The amortized cost and estimated fair value of debt securities held to maturity at September 30, 2016, by contractual maturity are as follows, in thousands. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without penalties.
 
Amortized Cost
 
Estimated Fair Value
Due in 1 year or less
$
3,695

 
$
3,760

Due in 1 to 5 years
14,233

 
15,163

Due in 5 to 10 years
87,275

 
92,278

Due after 10 years
160,099

 
173,747

Total debt securities
265,302

 
284,948

Mortgage-backed securities

 

Total investment securities
$
265,302

 
$
284,948


As of September 30, 2016, and December 31, 2015, securities with a fair value of $792.7 million and $855.8 million, respectively, were pledged to secure public and trust deposits, short-term borrowings and for other purposes as required and permitted by law.

Gross gains and losses realized related to the sales of securities available for sale for the three- and nine-month periods ended September 30, 2016 and 2015, are summarized as follows, in thousands:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Proceeds from sales
$
146,242

 
$
351,050

 
$
768,617

 
$
877,077

Gross security gains
1,763

 
2,416

 
11,416

 
10,857

Gross security losses
177

 
609

 
1,332

 
1,587


The following tables summarize, in thousands, the amount of unrealized losses, defined as the amount by which cost or amortized cost exceeds fair value, and the related fair value of investments with unrealized losses in Heartland's securities portfolio as of September 30, 2016, and December 31, 2015. The investments were segregated into two categories: those that have been in a continuous unrealized loss position for less than 12 months and those that have been in a continuous unrealized loss position for 12 or more months. The reference point for determining how long an investment was in an unrealized loss position was September 30, 2015, and December 31, 2014, respectively. Securities for which Heartland has taken credit-related OTTI write-downs are categorized as being "less than 12 months" or "12 months or longer" in a continuous loss position based on the point in time that the fair value declined to below the cost basis and not the period of time since the credit-related OTTI write-down.





Securities available for sale
Less than 12 months
 
12 months or longer
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
September 30, 2016
 
 
 
 
 
 
 
 
 
 
 
U.S. government corporations and agencies
$

 
$

 
$

 
$

 
$

 
$

Mortgage-backed securities
575,105

 
(14,317
)
 
180,406

 
(6,450
)
 
755,511

 
(20,767
)
Obligations of states and political subdivisions
70,894

 
(986
)
 
253

 
(1
)
 
71,147

 
(987
)
Total debt securities
645,999

 
(15,303
)
 
180,659

 
(6,451
)
 
826,658

 
(21,754
)
Equity securities

 

 

 

 

 

Total temporarily impaired securities
$
645,999

 
$
(15,303
)
 
$
180,659

 
$
(6,451
)
 
$
826,658

 
$
(21,754
)
December 31, 2015
U.S. government corporations and agencies
$
22,359

 
$
(103
)
 
$

 
$

 
$
22,359

 
$
(103
)
Mortgage-backed securities
724,330

 
(15,523
)
 
139,562

 
(5,361
)
 
863,892

 
(20,884
)
Obligations of states and political subdivisions
68,482

 
(896
)
 
7,460

 
(191
)
 
75,942

 
(1,087
)
Total debt securities
815,171

 
(16,522
)
 
147,022

 
(5,552
)
 
962,193

 
(22,074
)
Equity securities
6,566

 
(44
)
 

 

 
6,566

 
(44
)
Total temporarily impaired securities
$
821,737

 
$
(16,566
)
 
$
147,022

 
$
(5,552
)
 
$
968,759

 
$
(22,118
)

Securities held to maturity
Less than 12 months
 
12 months or longer
 
Total
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
 
Fair
Value
 
Unrealized
Losses
September 30, 2016
 
 
 
 
 
 
 
 
 
 
 
Obligations of states and political subdivisions
2,639

 
(276
)
 
1,123

 
(269
)
 
3,762

 
(545
)
Total temporarily impaired securities
$
2,639

 
$
(276
)
 
$
1,123

 
$
(269
)
 
$
3,762

 
$
(545
)
December 31, 2015
Obligations of states and political subdivisions
3,646

 
(12
)
 
18,033

 
(493
)
 
21,679

 
(505
)
Total temporarily impaired securities
$
3,646

 
$
(12
)
 
$
18,033

 
$
(493
)
 
$
21,679

 
$
(505
)

Heartland reviews the investment securities portfolio on a quarterly basis to monitor its exposure to OTTI. A determination as to whether a security's decline in fair value is other-than-temporary takes into consideration numerous factors and the relative significance of any single factor can vary by security. Some factors Heartland may consider in the OTTI analysis include the length of time the security has been in an unrealized loss position, changes in security ratings, financial condition of the issuer, as well as security and industry specific economic conditions. In addition, with regard to debt securities, Heartland may also evaluate payment structure, whether there are defaulted payments or expected defaults, prepayment speeds and the value of any underlying collateral. For certain debt securities in unrealized loss positions, Heartland prepares cash flow analyses to compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security.

Heartland previously recorded $981,000 of OTTI on three private label mortgage-backed securities in March 2012. The other-than-temporary credit-related losses were $797,000 in the held to maturity category and $184,000 in the available for sale category. During 2015, Heartland recorded additional credit-related OTTI on two of the private label mortgage-backed securities that previously had OTTI credit losses. The underlying collateral on these securities experienced an increased level of defaults and a slowing of voluntary prepayments causing the present value of the forward expected cash flows, using prepayment and default vectors, to be below the amortized cost basis of the securities. Based on Heartland's evaluation, $769,000 of OTTI attributable to credit-related losses was recorded in December 2015. The credit-related OTTI was $716,000, of which $200,000 was reclassified from previous non-credit related OTTI in the held to maturity category. Credit-related OTTI was $53,000 in the available for sale category.

In the first quarter of 2016, Heartland sold the mortgage-backed securities in the held to maturity portfolio because the credit quality of the securities showed further deterioration, and it was unlikely Heartland would recover the remaining basis of the





securities prior to maturity. The significant deterioration of the credit quality of these securities was inconsistent with Heartland's original intent upon purchase and classification of these held to maturity securities. The carrying value of these securities was $4.4 million, and the associated realized gross gains were $89,000, and the realized gross losses were $439,000.

The remaining unrealized losses on Heartland's mortgage-backed securities are the result of changes in market interest rates or widening of market spreads subsequent to the initial purchase of the securities. The losses are not related to concerns regarding the underlying credit of the issuers or the underlying collateral. It is expected that the securities will not be settled at a price less than the amortized cost of the investment. Because the decline in fair value is attributable to changes in interest rates or widening market spreads and not credit quality, and because Heartland has the intent and ability to hold these investments until a market price recovery or to maturity and does not believe it will be required to sell the securities before maturity, these investments are not considered other-than-temporarily impaired.

In the third quarter of 2016, Heartland sold one obligation of states and political subdivisions from the held to maturity portfolio because the credit quality of the security showed significant deterioration, and it was unlikely Heartland would recover the remaining basis of the security prior to maturity. The significant deterioration of the credit quality of this security was inconsistent with Heartland's original intent upon purchase and classification of this held to maturity security. The carrying value of this security was $503,000, and the associated gross loss was $1,500.

The remaining unrealized losses on Heartland's obligations of states and political subdivisions are the result of changes in market interest rates or widening of market spreads subsequent to the initial purchase of the securities. Management monitors the published credit ratings of these securities and the stability of the underlying municipalities. Because the decline in fair value is attributable to changes in interest rates or widening market spreads due to insurance company downgrades and not underlying credit quality, and because Heartland has the intent and ability to hold these investments until a market price recovery or to maturity and does not believe it will be required to sell the securities before maturity, these investments are not considered other-than-temporarily impaired.

There were no gross realized gains and no gross realized losses on the sale of available for sale securities with OTTI write-downs for the period ended September 30, 2016. Additionally, there were no gross realized gains and no gross realized losses on the sale of held to maturity securities with OTTI write-downs for the period ended September 30, 2016. There were no gross realized gains or losses on the sale of available for sale or held to maturity securities with OTTI write-downs for the period ended September 30, 2015.
 
 
 
 
The following table shows the detail of OTTI write-downs on debt securities included in earnings and the related changes in other accumulated comprehensive income ("AOCI") for the same securities, in thousands:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Recorded as part of gross realized losses:
 
 
 
 
 
 
 
Credit related OTTI
$

 
$

 
$

 
$

Intent to sell OTTI

 

 

 

Total recorded as part of gross realized losses

 

 

 

Recorded directly to AOCI for non-credit related impairment:
 
 
 
 
 
 
 
  Residential mortgage backed securities

 

 

 

  Reduction of non-credit related impairment related to security sales

 

 
(120
)
 

  Accretion of non-credit related impairment

 
(24
)
 
(7
)
 
(72
)
Total changes to AOCI for non-credit related impairment

 
(24
)
 
(127
)
 
(72
)
Total OTTI losses (accretion) recorded on debt securities, net
$

 
$
(24
)
 
$
(127
)
 
$
(72
)

Included in other securities at September 30, 2016, and December 31, 2015, were shares of stock in each Federal Home Loan Bank (the "FHLB") of Des Moines, Chicago, Dallas, San Francisco and Topeka at an amortized cost of $14.9 million and $14.3 million, respectively.
 
 
 
 
 
 
 
 





NOTE 4: LOANS

Loans as of September 30, 2016, and December 31, 2015, were as follows, in thousands:
 
September 30, 2016
 
December 31, 2015
Loans receivable held to maturity:
 
 
 
Commercial
$
1,295,316

 
$
1,279,214

Commercial real estate
2,605,296

 
2,326,360

Agricultural and agricultural real estate
489,387

 
471,870

Residential real estate
625,965

 
539,555

Consumer
425,582

 
386,867

Gross loans receivable held to maturity
5,441,546

 
5,003,866

Unearned discount
(721
)
 
(488
)
Deferred loan fees
(2,110
)
 
(1,892
)
Total net loans receivable held to maturity
5,438,715

 
5,001,486

Allowance for loan losses
(54,653
)
 
(48,685
)
Loans receivable, net
$
5,384,062

 
$
4,952,801


Heartland has certain lending policies and procedures in place that are designed to provide for an acceptable level of credit risk. The board of directors reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management and the board with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies, nonperforming loans and potential problem loans. Diversification in the loan portfolio is also a means of managing risk associated with fluctuations in economic conditions.

The commercial and commercial real estate loan portfolio includes a wide range of business loans, including lines of credit for working capital and operational purposes and term loans for the acquisition of equipment and real estate. Although most loans are made on a secured basis, loans may be made on an unsecured basis where warranted by the overall financial condition of the borrower. Terms of commercial business loans generally range from one to five years. Commercial loans are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. The collateral that Heartland requires for most of these loans is based upon the discounted market value of the collateral. The primary repayment risks of commercial loans are that the cash flow of the borrowers may be unpredictable, and the collateral securing these loans may fluctuate in value. Heartland seeks to minimize these risks in a variety of ways. The underwriting analysis includes credit verification, analysis of global cash flows, appraisals and a review of the financial condition of the borrower. Personal guarantees are frequently required as a tertiary form of repayment. In addition, when underwriting loans for commercial real estate, careful consideration is given to the property's operating history, future operating projections, current and projected occupancy, location and physical condition. Heartland also utilizes government guaranteed lending through the U.S. Small Business Administration and the U.S. Department of Agriculture's Rural Development Business and Industry Program to assist customers with longer-term funding and to reduce risk.

Agricultural loans, many of which are secured by crops, machinery and real estate, are provided to finance capital improvements and farm operations as well as acquisitions of livestock and machinery. Agricultural loans present unique credit risks relating to adverse weather conditions, loss of livestock due to disease or other factors, declines in market prices for agricultural products and the impact of government regulations. The ultimate repayment of agricultural loans is dependent upon the profitable operation or management of the agricultural entity. In underwriting agricultural loans, lending personnel work closely with their customers to review budgets and cash flow projections for the ensuing crop year. These budgets and cash flow projections are monitored closely during the year and reviewed with the customers at least annually. Lending personnel also work closely with governmental agencies, including the Farm Service Agency, to help agricultural customers obtain credit enhancement products such as loan guarantees or interest assistance.

Heartland originates first-lien, adjustable-rate and fixed-rate, one-to-four-family residential real estate loans for the construction, purchase or refinancing of a single family residential property. These loans are principally collateralized by owner-occupied properties and are amortized over 10 to 30 years. Heartland typically sells longer-term, low-rate, residential mortgage loans in the secondary market with servicing rights retained. This practice allows Heartland to better manage interest rate risk and liquidity risk. The Heartland bank subsidiaries participate in lending programs sponsored by U.S. government agencies such as Veterans Administration and Federal Home Administration when justified by market conditions. As of September 30, 2016, Heartland had $1.5 million of loans secured by residential real estate property that were in the process of foreclosure.






Consumer lending includes motor vehicle, home improvement, home equity and small personal credit lines. Consumer loans typically have shorter terms, lower balances, higher yields and higher risks of default than one-to-four-family residential mortgage loans. Consumer loan collections are dependent on the borrower's continuing financial stability, and are therefore more likely to be affected by adverse personal circumstances. Risk is reduced through underwriting criteria, which include credit verification, appraisals, a review of the borrower's financial condition, and personal cash flows. A security interest, with title insurance when necessary, is taken in the underlying real estate. Heartland's consumer finance subsidiaries, Citizens Finance Co. and Citizens Finance of Illinois Co., typically lend to borrowers with past credit problems or limited credit histories, and these loans comprise approximately 19% of Heartland's total consumer loan portfolio.

Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Heartland’s policy is to discontinue the accrual of interest income on any loan when, in the opinion of management, there is a reasonable doubt as to the timely collection of the interest and principal, normally when a loan is 90 days past due. When interest accruals are deemed uncollectible, interest credited to income in the current year is reversed and interest accrued in prior years is charged to the allowance for loan losses. Nonaccrual loans are returned to an accrual status when, in the opinion of management, the financial position of the borrower indicates that there is no longer any reasonable doubt as to the timely payment of interest and principal.

Under Heartland’s credit practices, a loan is impaired when, based on current information and events, it is probable that Heartland will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loan impairment is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except where more practical, impairment is measured at the observable market price of the loan or the fair value of the collateral if the loan is collateral dependent.

The following table shows the balance in the allowance for loan losses at September 30, 2016, and December 31, 2015, and the related loan balances, disaggregated on the basis of impairment methodology, in thousands. Loans evaluated under ASC 310-10-35 include loans on nonaccrual status and troubled debt restructurings, which are individually evaluated for impairment, and other impaired loans deemed to have similar risk characteristics. All other loans are collectively evaluated for impairment under ASC 450-20. Heartland has made no significant changes to the accounting for the allowance for loan losses policy during 2016.
 
Allowance For Loan Losses
 
Gross Loans Receivable Held to Maturity
 
Ending Balance
Under ASC
310-10-35
 
Ending Balance
Under ASC
450-20
 
Total
 
Ending Balance Evaluated for Impairment
Under ASC
310-10-35
 
Ending Balance Evaluated for Impairment
Under ASC
450-20
 
 Total
September 30, 2016
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
2,077

 
$
14,814

 
$
16,891

 
$
8,002

 
$
1,287,314

 
$
1,295,316

Commercial real estate
2,661

 
21,020

 
23,681

 
56,894

 
2,548,402

 
2,605,296

Agricultural and agricultural real estate
967

 
4,039

 
5,006

 
17,155

 
472,232

 
489,387

Residential real estate
473

 
1,509

 
1,982

 
22,448

 
603,517

 
625,965

Consumer
1,364

 
5,729

 
7,093

 
5,858

 
419,724

 
425,582

Total
$
7,542

 
$
47,111

 
$
54,653

 
$
110,357

 
$
5,331,189

 
$
5,441,546

December 31, 2015
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
471

 
$
15,624

 
$
16,095

 
$
6,919

 
$
1,272,295

 
$
1,279,214

Commercial real estate
698

 
18,834

 
19,532

 
45,442

 
2,280,918

 
2,326,360

Agricultural and agricultural real estate

 
3,887

 
3,887

 
4,612

 
467,258

 
471,870

Residential real estate
393

 
1,541

 
1,934

 
17,790

 
521,765

 
539,555

Consumer
1,206

 
6,031

 
7,237

 
5,458

 
381,409

 
386,867

Total
$
2,768

 
$
45,917

 
$
48,685

 
$
80,221

 
$
4,923,645

 
$
5,003,866







The following table presents nonaccrual loans, accruing loans past due 90 days or more and troubled debt restructured loans at September 30, 2016, and December 31, 2015, in thousands.
 
September 30, 2016
 
December 31, 2015
Nonaccrual loans
$
57,344

 
$
37,874

Nonaccrual troubled debt restructured loans
455

 
1,781

Total nonaccrual loans
$
57,799

 
$
39,655

Accruing loans past due 90 days or more
$
105

 
$

Performing troubled debt restructured loans
$
10,281

 
$
11,075


The following tables provide information on troubled debt restructured loans that were modified during the three- and nine-month periods ended September 30, 2016, and September 30, 2015, dollars in thousands:
 
Three Months Ended September 30,
 
2016
 
2015
 
Number
of Loans
 
Pre-
Modification
Recorded
Investment
 
Post-
Modification
Recorded
Investment
 
Number
of Loans
 
Pre-
Modification
Recorded
Investment
 
Post-
Modification
Recorded
Investment
Commercial

 
$

 
$

 

 
$

 
$

Commercial real estate

 

 

 

 

 

Total commercial and commercial real estate

 

 

 



 

Agricultural and agricultural real estate

 

 

 

 

 

Residential real estate
5

 
651

 
651

 
1

 
55

 
55

Consumer

 

 

 

 

 

Total
5

 
$
651

 
$
651

 
1


$
55

 
$
55

 
Nine Months Ended September 30,
 
2016
 
2015
 
Number
of Loans
 
Pre-
Modification
Recorded
Investment
 
Post-
Modification
Recorded
Investment
 
Number
of Loans
 
Pre-
Modification
Recorded
Investment
 
Post-
Modification
Recorded
Investment
Commercial
1

 
$
100

 
$
100

 
1

 
$
830

 
$
830

Commercial real estate
1

 
179

 
179

 
1

 
3,992

 
3,992

Total commercial and commercial real estate
2

 
279

 
279

 
2

 
4,822

 
4,822

Agricultural and agricultural real estate

 

 

 
1

 
311

 
311

Residential real estate
5

 
651

 
651

 
1

 
55

 
55

Consumer

 

 

 

 

 

Total
7

 
$
930

 
$
930

 
4

 
$
5,188

 
$
5,188


The pre-modification and post-modification recorded investment represents amounts as of the date of loan modification. Since the modifications on these loans have been only interest rate concessions and term extensions, not principal reductions, the pre-modification and post-modification recorded investment amounts are the same. At September 30, 2016, there were no commitments to extend credit to any of the borrowers with an existing troubled debt restructuring.

The following tables present troubled debt restructured loans for which there was a payment default during the three- and nine-month periods ended September 30, 2016, and September 30, 2015, that had been modified during the twelve-month period prior to default:





 
With Payment Defaults During the Following Periods
 
Three Months Ended September 30,
 
2016
 
2015
 
Number of Loans
 
Recorded Investment
 
Number of Loans
 
Recorded Investment
Commercial

 
$

 


$

Commercial real estate

 

 
1


814

  Total commercial and commercial real estate

 

 
1

 
814

Agricultural and agricultural real estate

 

 



Residential real estate

 

 



Consumer

 

 



  Total

 
$

 
1


$
814

 
With Payment Defaults During the Following Periods
 
Nine Months Ended September 30,
 
2016
 
2015
 
Number of Loans
 
Recorded Investment
 
Number of Loans
 
Recorded Investment
Commercial
1

 
$
95




$

Commercial real estate

 


1


814

  Total commercial and commercial real estate
1

 
95

 
1

 
814

Agricultural and agricultural real estate

 





Residential real estate

 





Consumer

 





  Total
1

 
$
95

 
1

 
$
814


Heartland's internal rating system is a series of grades reflecting management's risk assessment, based on its analysis of the borrower's financial condition. The "pass" category consists of all loans that are not in the "nonpass" category, categorized into a range of loan grades that reflect increasing, though still acceptable, risk. Movement of risk through the various grade levels in the pass category is monitored for early identification of credit deterioration. The "nonpass" category consists of special mention, substandard, doubtful and loss loans. The "special mention" rating is attached to loans where the borrower exhibits negative financial trends due to borrower specific or systemic conditions that, if left uncorrected, threaten the borrower's capacity to meet its debt obligations. The borrower is believed to have sufficient financial flexibility to react to and resolve its negative financial situation. These credits are closely monitored for improvement or deterioration. The "substandard" rating is assigned to loans that are inadequately protected by the current sound net worth and paying capacity of the borrower and may be further at risk due to deterioration in the value of collateral pledged. Well-defined weaknesses jeopardize liquidation of the debt. These loans are still considered collectible; however, a distinct possibility exists that Heartland will sustain some loss if deficiencies are not corrected. Substandard loans may exhibit some or all of the following weaknesses: deteriorating trends, lack of earnings, inadequate debt service capacity, excessive debt and/or lack of liquidity. The "doubtful" rating is assigned to loans where identified weaknesses make collection or liquidation in full, on the basis of existing facts, conditions and values, highly questionable and improbable. These borrowers are usually in default, lack liquidity and capital, as well as resources necessary to remain an operating entity. Specific pending events, such as capital injections, liquidations or perfection of liens on additional collateral, may strengthen the credit, thus deferring classification of the loan as loss until the exact status can be determined. The "loss" rating is assigned to loans considered uncollectible. As of September 30, 2016, Heartland had no loans classified as doubtful and no loans classified as loss. Loans are placed on "nonaccrual" when management does not expect to collect payments of principal and interest in full or when principal or interest has been in default for a period of 90 days or more, unless the loan is both well secured and in the process of collection.






The following table presents loans by credit quality indicator at September 30, 2016, and December 31, 2015, in thousands:
 
Pass
 
Nonpass
 
Total
September 30, 2016
 
 
 
 
 
Commercial
$
1,196,389

 
$
98,927

 
$
1,295,316

Commercial real estate
2,412,518

 
192,778

 
2,605,296

  Total commercial and commercial real estate
3,608,907

 
291,705

 
3,900,612

Agricultural and agricultural real estate
422,810

 
66,577

 
489,387

Residential real estate
596,479

 
29,486

 
625,965

Consumer
415,919

 
9,663

 
425,582

  Total gross loans receivable held to maturity
$
5,044,115

 
$
397,431

 
$
5,441,546

December 31, 2015
 
 
 
 
 
Commercial
$
1,106,276

 
$
172,938

 
$
1,279,214

Commercial real estate
2,107,474

 
218,886

 
2,326,360

  Total commercial and commercial real estate
3,213,750

 
391,824

 
3,605,574

Agricultural and agricultural real estate
435,745

 
36,125

 
471,870

Residential real estate
515,195

 
24,360

 
539,555

Consumer
377,173

 
9,694

 
386,867

  Total gross loans receivable held to maturity
$
4,541,863

 
$
462,003

 
$
5,003,866


The nonpass category in the table above is comprised of approximately 53% special mention loans and 47% substandard loans as of September 30, 2016. The percent of nonpass loans on nonaccrual status as of September 30, 2016, was 15%. As of December 31, 2015, the nonpass category in the table above was comprised of approximately 68% special mention loans and 32% substandard loans. The percent of nonpass loans on nonaccrual status as of December 31, 2015, was 8%. Loans delinquent 30 to 89 days as a percent of total loans were 0.40% at September 30, 2016, compared to 0.31% at December 31, 2015. Changes in credit risk are monitored on a continuous basis and changes in risk ratings are made when identified. All impaired loans are reviewed at least annually.






The following table sets forth information regarding Heartland's accruing and nonaccrual loans at September 30, 2016, and December 31, 2015, in thousands:
 
Accruing Loans
 
 
 
 
 
30-59 Days
Past Due
 
60-89 Days
Past Due
 
90 Days or
More
Past Due
 
Total
Past Due
 
Current
 
Nonaccrual
 
Total Loans
September 30, 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
2,754

 
$
427

 
$
91

 
$
3,272

 
$
1,287,663

 
$
4,381

 
$
1,295,316

Commercial real estate
8,499

 
815

 

 
9,314

 
2,576,946

 
19,036

 
2,605,296

Total commercial and commercial real estate
11,253

 
1,242

 
91

 
12,586

 
3,864,609

 
23,417

 
3,900,612

Agricultural and agricultural real estate
93

 
1,473

 

 
1,566

 
473,708

 
14,113

 
489,387

Residential real estate
2,042

 
142

 

 
2,184

 
607,229

 
16,552

 
625,965

Consumer
4,888

 
760

 
14

 
5,662

 
416,203

 
3,717

 
425,582

Total gross loans receivable held to maturity
$
18,276

 
$
3,617

 
$
105

 
$
21,998

 
$
5,361,749

 
$
57,799

 
$
5,441,546

December 31, 2015
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
2,005

 
$
608

 
$

 
$
2,613

 
$
1,273,678

 
$
2,923

 
$
1,279,214

Commercial real estate
3,549

 
2,077

 

 
5,626

 
2,302,052

 
18,682

 
2,326,360

Total commercial and commercial real estate
5,554

 
2,685

 

 
8,239

 
3,575,730

 
21,605

 
3,605,574

Agricultural and agricultural real estate
143

 
54

 

 
197

 
470,455

 
1,218

 
471,870

Residential real estate
1,900

 
115

 

 
2,015

 
523,915

 
13,625

 
539,555

Consumer
3,964

 
933

 

 
4,897

 
378,763

 
3,207

 
386,867

Total gross loans receivable held to maturity
$
11,561

 
$
3,787

 
$

 
$
15,348

 
$
4,948,863

 
$
39,655

 
$
5,003,866







The majority of Heartland's impaired loans are those that are nonaccrual or have had their terms restructured in a troubled debt restructuring. The following tables present, by category of loan, impaired loans, the unpaid contractual loan balances at September 30, 2016, and December 31, 2015; the outstanding loan balances recorded on the consolidated balance sheets at September 30, 2016, and December 31, 2015; any related allowance recorded for those loans as of September 30, 2016, and December 31, 2015; the average outstanding loan balances recorded on the consolidated balance sheets during the three- and nine- months ended September 30, 2016, and year ended December 31, 2015; and the interest income recognized on the impaired loans during the three- and nine-month periods ended September 30, 2016, and year ended December 31, 2015, in thousands:
 
Unpaid
Contractual
Balance
 
Loan
Balance
 
Related
Allowance
Recorded
 
Quarter-
to-
Date
Avg.
Loan
Balance
 
Quarter-
to-
Date
Interest
Income
Recognized
 
Year-
to-
Date
Avg.
Loan
Balance
 
Year-
to-
Date
Interest
Income
Recognized
September 30, 2016
 
 
 
 
 
 
 
 
 
 
 
 
 
Impaired loans with a related allowance:
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
4,664

 
$
4,283

 
$
2,077

 
$
3,121

 
$
73

 
$
2,566

 
$
87

Commercial real estate
15,379

 
15,346

 
2,661

 
15,696

 
138

 
9,114

 
350

Total commercial and commercial real estate
20,043

 
19,629

 
4,738

 
18,817

 
211

 
11,680

 
437

Agricultural and agricultural real estate
3,181

 
3,181

 
967

 
1,112

 

 
390

 

Residential real estate
3,512

 
3,427

 
473

 
3,602

 
8

 
3,285

 
15

Consumer
3,277

 
3,277

 
1,364

 
3,198

 
10

 
3,251

 
25

Total impaired loans with a related allowance
$
30,013

 
$
29,514

 
$
7,542

 
$
26,729

 
$
229

 
$
18,606

 
$
477

Impaired loans without a related allowance:
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
4,632

 
$
3,719

 
$

 
$
4,413

 
$
78

 
$
7,105

 
$
339

Commercial real estate
44,750

 
41,548

 

 
37,243

 
452

 
41,645

 
1,236

Total commercial and commercial real estate
49,382

 
45,267

 

 
41,656

 
530

 
48,750

 
1,575

Agricultural and agricultural real estate
13,974

 
13,974

 

 
15,310

 
23

 
12,232

 
118

Residential real estate
19,496

 
19,021

 

 
18,660

 
136

 
17,684

 
217

Consumer
2,741

 
2,581

 

 
2,397

 
12

 
2,619

 
32

Total impaired loans without a related allowance
$
85,593

 
$
80,843

 
$

 
$
78,023

 
$
701

 
$
81,285

 
$
1,942

Total impaired loans held to maturity:
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
9,296

 
$
8,002

 
$
2,077

 
$
7,534

 
$
151

 
$
9,671

 
$
426

Commercial real estate
60,129

 
56,894

 
2,661

 
52,939

 
590

 
50,759

 
1,586

Total commercial and commercial real estate
69,425

 
64,896

 
4,738

 
60,473

 
741

 
60,430

 
2,012

Agricultural and agricultural real estate
17,155

 
17,155

 
967

 
16,422

 
23

 
12,622

 
118

Residential real estate
23,008

 
22,448

 
473

 
22,262

 
144

 
20,969

 
232

Consumer
6,018

 
5,858

 
1,364

 
5,595

 
22

 
5,870

 
57

Total impaired loans held to maturity
$
115,606

 
$
110,357

 
$
7,542

 
$
104,752

 
$
930

 
$
99,891

 
$
2,419







 
Unpaid
Contractual
Balance
 
Loan
Balance
 
Related
Allowance
Recorded
 
Year-to-
Date
Avg.
Loan
Balance
 
Year-to-
Date
Interest
Income
Recognized
December 31, 2015
 
 
 
 
 
 
 
 
 
Impaired loans with a related allowance:
 
 
 
 
 
 
 
 
 
Commercial
$
1,192

 
$
1,160

 
$
471

 
$
524

 
$
12

Commercial real estate
2,697

 
2,697

 
698

 
2,539

 
19

Total commercial and commercial real estate
3,889

 
3,857

 
1,169

 
3,063

 
31

Agricultural and agricultural real estate

 

 

 
2,823

 

Residential real estate
2,210

 
2,125

 
393

 
2,524

 
16

Consumer
3,111

 
3,111

 
1,206

 
2,877

 
33

Total impaired loans with a related allowance
$
9,210

 
$
9,093

 
$
2,768

 
$
11,287

 
$
80

Impaired loans without a related allowance:
 
 
 
 
 
 
 
 
 
Commercial
$
5,784

 
$
5,759

 
$

 
$
7,511

 
$
515

Commercial real estate
46,099

 
42,745

 

 
38,444

 
1,395

Total commercial and commercial real estate
51,883

 
48,504

 

 
45,955

 
1,910

Agricultural and agricultural real estate
4,612

 
4,612

 

 
2,287

 
175

Residential real estate
15,802

 
15,665

 

 
10,186

 
145

Consumer
2,347

 
2,347

 

 
2,403

 
38

Total impaired loans without a related allowance
$
74,644

 
$
71,128

 
$

 
$
60,831

 
$
2,268

Total impaired loans held to maturity:
 
 
 
 
 
 
 
 
 
Commercial
$
6,976

 
$
6,919

 
$
471

 
$
8,035

 
$
527

Commercial real estate
48,796

 
45,442

 
698

 
40,983

 
1,414

Total commercial and commercial real estate
55,772

 
52,361

 
1,169

 
49,018

 
1,941

Agricultural and agricultural real estate
4,612

 
4,612

 

 
5,110

 
175

Residential real estate
18,012

 
17,790

 
393

 
12,710

 
161

Consumer
5,458

 
5,458

 
1,206

 
5,280

 
71

Total impaired loans held to maturity
$
83,854

 
$
80,221

 
$
2,768

 
$
72,118

 
$
2,348


On February 5, 2016, Heartland acquired CIC Bancshares, Inc., parent company of Centennial Bank, in Denver, Colorado. As of February 5, 2016, Centennial Bank had loans of $594.9 million, and the estimated fair value of the loans acquired was $581.5 million.

On November 30, 2015, Heartland acquired Premier Valley Bank in Fresno, California. As of November 30, 2015, Premier Valley Bank had loans of $400.5 million, and the estimated fair value of the loans acquired was $389.8 million.

On September 11, 2015, Heartland acquired First Scottsdale Bank, N.A. in Scottsdale, Arizona. As of September 11, 2015, First Scottsdale Bank, N.A. had loans of $56.5 million, and the estimated fair value of the loans acquired was $54.7 million.

On August 21, 2015, Heartland acquired Community Bancorporation of New Mexico, Inc., parent company of Community Bank of Santa Fe, New Mexico. As of August 21, 2015, Community Bank had loans of $103.7 million, and the estimated fair value of the loans acquired was $99.5 million.

On January 16, 2015, Heartland acquired Community Banc-Corp of Sheboygan, Inc., parent company of Community Bank & Trust in Sheboygan, Wisconsin. As of January 16, 2015, Community Bank & Trust had loans of $413.4 million, and the estimated fair value of the loans acquired was $395.0 million.

The acquisitions of Community Banc-Corp of Sheboygan, Inc., Community Bancorporation of New Mexico, Inc., First Scottsdale Bank, N.A., Premier Valley Bank and CIC Bancshares, Inc. were accounted for under the acquisition method of accounting in accordance with ASC 805, “Business Combinations.” Purchased loans acquired in a business combination are recorded at estimated fair value on their purchase date, but the purchaser cannot carry over the related allowance for loan losses. Purchased loans are accounted for under ASC 310-30, “Loans and Debt Securities with Deteriorated Credit Quality,” when the loans have evidence of credit deterioration since origination, and when at the date of the acquisition, it is probable that Heartland will not collect all





contractually required principal and interest payments. Evidence of credit quality deterioration at the purchase date includes statistics such as past due and nonaccrual status. Generally, acquired loans that meet Heartland’s definition for nonaccrual status fall within the scope of ASC 310-30. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the nonaccretable difference which is included in the carrying value of the loans. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior charges, or a reclassification of the difference from nonaccretable to accretable with a positive impact on future interest income. Further, any excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable yield and is recognized into interest income over the remaining life of the loan when there is a reasonable expectation about the amount and timing of such cash flows.

The carrying amount of the acquired loans at September 30, 2016, and December 31, 2015, consisted of purchased impaired and nonimpaired loans as summarized in the following table, in thousands:
 
September 30, 2016
 
December 31, 2015
 
Impaired
Purchased
Loans
 
Non Impaired
Purchased
Loans
 
Total
Purchased
Loans
 
Impaired
Purchased
Loans
 
Non Impaired
Purchased
Loans
 
Total
Purchased
Loans
Commercial
$
2,371

 
$
119,811

 
$
122,182

 
$

 
$
159,393

 
$
159,393

Commercial real estate
4,119

 
688,587

 
692,706

 
7,716

 
494,010

 
501,726

Agricultural and agricultural real estate

 
174

 
174

 

 
2,985

 
2,985

Residential real estate
185

 
175,812

 
175,997

 

 
85,549

 
85,549

Consumer loans

 
49,515

 
49,515

 

 
33,644

 
33,644

Total Loans
$
6,675

 
$
1,033,899

 
$
1,040,574

 
$
7,716

 
$
775,581

 
$
783,297


Changes in accretable yield on acquired loans with evidence of credit deterioration at the date of acquisition for the three- and nine-month periods ended September 30, 2016, and September 30, 2015, were as follows, in thousands:
Balance at June 30, 2016
$
168

Original yield discount, net, at date of acquisition

Accretion
(379
)
Reclassification from nonaccretable difference(1)
331

Balance at September 30, 2016
$
120

 
 
Balance at December 31, 2015
$
557

Original yield discount, net, at date of acquisitions
19

Accretion
(845
)
Reclassification from nonaccretable difference(1)
389

Balance at September 30, 2016
$
120

 
 
(1) Represents increases in estimated cash flows expected to be received, primarily due to lower estimated credit losses.






Balance at June 30, 2015
$
398

Original yield discount, net, at date of acquisitions
68

Accretion
(202
)
Reclassification from nonaccretable difference(1)
34

Balance at September 30, 2015
$
298

 
 
Balance at December 31, 2014
$

Original yield discount, net, at date of acquisitions
420

Accretion
(318
)
Reclassification from nonaccretable difference(1)
196

Balance at September 30, 2015
$
298

 
 
(1) Represents increases in estimated cash flows expected to be received, primarily due to lower estimated credit losses.

On the acquisition dates, the preliminary estimate of the contractually required payments receivable for all loans with evidence of credit deterioration since origination was $21.0 million, and the estimated fair value of the loans was $13.1 million. At September 30, 2016, a majority of these loans were valued based upon the liquidation value of the underlying collateral, because the expected cash flows are primarily based on the liquidation of underlying collateral, and the timing and amount of the cash flows could not be reasonably estimated. At September 30, 2016, there was an allowance for loan losses of $549,000 related to these ASC 310-30 loans.

On the acquisition dates, the preliminary estimate of the contractually required payments receivable for all nonimpaired loans acquired in the acquisitions was $1.55 billion, and the estimated fair value of the loans was $1.51 billion.

NOTE 5: ALLOWANCE FOR LOAN LOSSES

Changes in the allowance for loan losses for the three- and nine-month periods ended September 30, 2016, and September 30, 2015, were as follows, in thousands:
 
Commercial
 
Commercial
Real Estate
 
Agricultural
 
Residential
Real Estate
 
Consumer
 
Total
Balance at June 30, 2016
$
15,525

 
$
22,968

 
$
4,100

 
$
2,065

 
$
7,098

 
$
51,756

Charge-offs
(240
)
 
(814
)
 

 
(106
)
 
(2,123
)
 
(3,283
)
Recoveries
119

 
467

 
2

 
1

 
263

 
852

Provision
1,487

 
1,060

 
904

 
22

 
1,855

 
5,328

Balance at September 30, 2016
$
16,891

 
$
23,681

 
$
5,006

 
$
1,982

 
$
7,093

 
$
54,653

 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
Commercial
Real Estate
 
Agricultural
 
Residential
Real Estate
 
Consumer
 
Total
Balance at December 31, 2015
$
16,095

 
$
19,532

 
$
3,887

 
$
1,934

 
$
7,237

 
$
48,685

Charge-offs
(587
)
 
(2,229
)
 

 
(248
)
 
(4,775
)
 
(7,839
)
Recoveries
438

 
3,056

 
9

 
25

 
766

 
4,294

Provision
945

 
3,322

 
1,110

 
271

 
3,865

 
9,513

Balance at September 30, 2016
$
16,891

 
$
23,681

 
$
5,006

 
$
1,982

 
$
7,093

 
$
54,653






 
Commercial
 
Commercial
Real Estate
 
Agricultural
 
Residential
Real Estate
 
Consumer
 
Total
Balance at June 30, 2015
$
13,064

 
$
17,608

 
$
3,676

 
$
4,099

 
$
7,167

 
$
45,614

Charge-offs
(869
)
 
(376
)
 

 
(13
)
 
(1,181
)
 
(2,439
)
Recoveries
87

 
357

 
5

 
71

 
229

 
749

Provision
1,628

 
497

 
258

 
(311
)
 
1,109

 
3,181

Balance at September 30, 2015
$
13,910

 
$
18,086

 
$
3,939

 
$
3,846

 
$
7,324

 
$
47,105

 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
Commercial
Real Estate
 
Agricultural
 
Residential
Real Estate
 
Consumer
 
Total
Balance at December 31, 2014
$
11,909

 
$
15,898

 
$
3,295

 
$
3,741

 
$
6,606

 
$
41,449

Charge-offs
(1,825
)
 
(1,080
)
 
(551
)
 
(126
)
 
(3,595
)
 
(7,177
)
Recoveries
518

 
853

 
29

 
178

 
729

 
2,307

Provision
3,308

 
2,415

 
1,166

 
53

 
3,584

 
10,526

Balance at September 30, 2015
$
13,910

 
$
18,086

 
$
3,939

 
$
3,846

 
$
7,324

 
$
47,105


Management allocates the allowance for loan losses by pools of risk within each loan portfolio. The allocation of the allowance for loan losses by loan portfolio is made for analytical purposes and is not necessarily indicative of the trend of future loan losses in any particular category. The total allowance for loan losses is available to absorb losses from any segment of the loan portfolio.

NOTE 6: GOODWILL, CORE DEPOSIT PREMIUM AND OTHER INTANGIBLE ASSETS

Heartland had goodwill of $127.7 million at September 30, 2016, and $97.9 million at December 31, 2015. Heartland conducts its annual internal assessment of the goodwill both collectively and at its subsidiaries as of September 30. There was no goodwill impairment as of the most recent assessment.

Heartland recorded $29.8 million of goodwill in connection with the acquisition of CIC Bancshares, Inc., parent company of Centennial Bank, based in Denver, Colorado on February 5, 2016. The goodwill associated with this transaction is not deductible for tax purposes. As part of this acquisition, Heartland recognized core deposit intangibles of $6.4 million that are expected to be amortized over a period of 10 years on an accelerated basis. The core deposit intangibles associated with this transaction are not deductible for tax purposes. In addition, Heartland recognized commercial servicing rights of $190,000.

Heartland recorded $41.0 million of goodwill in connection with the acquisition of Premier Valley Bank, based in Fresno, California on November 30, 2015. The goodwill associated with this transaction is not deductible for tax purposes. As part of this acquisition, Heartland recognized core deposit intangibles of $8.0 million that are expected to be amortized over a period of 10 years on an accelerated basis. The core deposit intangibles associated with this transaction are not deductible for tax purposes. In addition, Heartland recognized commercial servicing rights of $616,000.

Heartland recorded $2.5 million of goodwill in connection with the acquisition of First Scottsdale Bank, N.A., based in Scottsdale, Arizona on September 11, 2015. The goodwill associated with this transaction is not deductible for tax purposes. As part of this acquisition, Heartland also recognized core deposit intangibles of $357,000 that are expected to be amortized over a period of 10 years on an accelerated basis. The core deposit intangibles associated with this transaction are not deductible for tax purposes.

Heartland recorded $213,000 of goodwill in connection with the acquisition of Community Bancorporation of New Mexico, Inc., parent company of Community Bank, based in Santa Fe, New Mexico, on August 21, 2015. The goodwill associated with this transaction is not deductible for tax purposes. As part of this acquisition, Heartland also recognized core deposit intangibles of $1.7 million that are expected to be amortized over a period of 10 years on an accelerated basis. The core deposit intangibles associated with this transaction are not deductible for tax purposes.

Heartland recorded $18.6 million of goodwill in connection with the acquisition of Community Banc-Corp of Sheboygan, Inc., the parent company of Community Bank & Trust, based in Sheboygan, Wisconsin on January 16, 2015. The goodwill associated with this transaction is not deductible for tax purposes. As part of this acquisition, Heartland recognized core deposit intangibles of $6.0 million that are expected to be amortized over a period of 10 years on an accelerated basis. The core deposit intangibles associated with this transaction are not deductible for tax purposes. In addition, Heartland recognized commercial servicing rights of $4.3 million.






Goodwill related to the CIC Bancshares, Inc., Premier Valley Bank, First Scottsdale Bank, N.A., Community Bancorporation of New Mexico, Inc. and Community Banc-Corp of Sheboygan, Inc., resulted from expected operational synergies, increased market presence, cross-selling opportunities, and expanded business lines.

Other intangible assets consist of core deposit intangibles, mortgage servicing rights, customer relationship intangible, and commercial servicing rights. The gross carrying amount of other intangible assets and the associated accumulated amortization at September 30, 2016, and December 31, 2015, are presented in the table below, in thousands:
 
September 30, 2016
 
December 31, 2015
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
 
Gross
Carrying
Amount
 
Accumulated
Amortization
 
Net
Carrying
Amount
Amortizing intangible assets:
 
 
 
 
 
 
 
 
 
 
 
Core deposit intangibles
$
43,504

 
$
19,913

 
$
23,591

 
$
37,118

 
$
15,460

 
$
21,658

Mortgage servicing rights
49,494

 
17,652

 
31,842

 
45,744

 
15,430

 
30,314

Customer relationship intangible
1,177

 
846

 
331

 
1,177

 
815

 
362

Commercial servicing rights
6,409

 
2,345

 
4,064

 
5,685

 
1,074

 
4,611

Total
$
100,584

 
$
40,756

 
$
59,828

 
$
89,724

 
$
32,779

 
$
56,945


The following table shows the estimated future amortization expense for amortizable intangible assets, in thousands:
 
Core
Deposit
Intangibles
 
Mortgage
Servicing
Rights
 
Customer
Relationship
Intangible
 
Commercial
Servicing
Rights
 
 
 
Total
Three months ending December 31, 2016
$
1,206

 
$
2,968

 
$
10

 
$
232

 
$
4,416

Year ending December 31,
 
 
 
 
 
 
 
 
 
2017
4,409

 
7,219

 
40

 
908

 
12,576

2018
3,900

 
6,187

 
39

 
836

 
10,962

2019
3,418

 
5,156

 
38

 
657

 
9,269

2020
2,975

 
4,125

 
37

 
482

 
7,619

2021
2,457

 
3,094

 
35

 
489

 
6,075

Thereafter
5,226

 
3,093

 
132

 
460

 
8,911

Total
$
23,591

 
$
31,842

 
$
331

 
$
4,064

 
$
59,828


Projections of amortization expense for mortgage servicing rights are based on existing asset balances and the existing interest rate environment as of September 30, 2016. Heartland's actual experience may be significantly different depending upon changes in mortgage interest rates and market conditions. Mortgage loans serviced for others were $4.26 billion and $4.06 billion as of September 30, 2016, and December 31, 2015, respectively. Custodial escrow balances maintained in connection with the mortgage loan servicing portfolio were approximately $28.3 million and $19.2 million as of September 30, 2016, and December 31, 2015, respectively. The fair value of Heartland's mortgage servicing rights was estimated at $38.1 million at September 30, 2016, and $40.9 million at December 31, 2015.

Heartland's mortgage servicing rights portfolio is comprised of loans serviced for the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and the Government National Mortgage Association. The servicing rights portfolio is separated into 15- and 30-year tranches, and the servicing rights portfolio is an asset of one of Heartland's subsidiaries.

The fair value of mortgage servicing rights is calculated based upon a discounted cash flow analysis. Cash flow assumptions, including prepayment speeds, servicing costs and escrow earnings are considered in the calculation. The average constant prepayment rate was 13.13% and 10.65% for the September 30, 2016, and December 31, 2015, valuations, respectively. The discount rate was 9.26% and 9.25% for the September 30, 2016, and December 31, 2015, valuations, respectively. The average capitalization rate for the first nine months of 2016 ranged from 88 to 141 basis points compared to the range of 65 to 138 basis points for 2015. Fees collected for the servicing of mortgage loans for others were $3.1 million and $2.6 million for the quarter ended September 30, 2016, and September 30, 2015, respectively and $9.0 million and $7.8 million for the nine months ended September 30, 2016, and September 30, 2015, respectively.






The following table summarizes, in thousands, the changes in capitalized mortgage servicing rights for the nine months ended September 30, 2016, and September 30, 2015:
 
2016
 
2015
Balance at January 1,
$
30,314

 
$
24,984

Originations
9,323

 
11,062

Amortization
(7,795
)
 
(6,446
)
Balance at September 30,
$
31,842

 
$
29,600

Fair value of mortgage servicing rights
$
38,127

 
$
40,166

Mortgage servicing rights, net to servicing portfolio
0.75
%
 
0.75
%

Heartland's commercial servicing rights portfolio was initially acquired with the Community Banc-Corp of Sheboygan, Inc. transaction that closed on January 16, 2015. Heartland also acquired commercial servicing rights portfolios with the Premier Valley Bank transaction that closed on November 30, 2015, and the CIC Bancshares, Inc. transaction that closed on February 5, 2016. The commercial servicing portfolio is comprised of loans guaranteed by the Small Business Administration and United States Department of Agriculture that have been sold with servicing retained by Heartland, which totaled $175.6 million. The commercial servicing rights portfolio is separated into two tranches, loans with a term of less than 20 years and loans with a term of more than 20 years, at each subsidiary. Fees collected for the servicing of commercial loans for others were $230,000 and $78,000 for the quarter ended September 30, 2016, and September 30, 2015, respectively and $685,000 and $438,000 for the nine months ended September 30, 2016, and September 30, 2015, respectively.

The fair value of each commercial servicing rights portfolio is calculated based upon a discounted cash flow analysis. Cash flow assumptions, including prepayment speeds and servicing costs, are considered in the calculation. The range of average constant prepayment rates for the portfolio valuations for the first nine months of 2016 was 6.65% to 7.63% compared to 7.33% to 8.10% as of December 31, 2015. The discount rate range was 12.07% to 13.59% for the September 30, 2016, valuations compared to 12.35% to 13.49% for the December 31, 2015, valuations. The capitalization rate for 2016 ranged from 310 to 445 basis points compared to 180 to 445 basis points for 2015. The total fair value of Heartland's commercial servicing rights was estimated at $4.4 million as of September 30, 2016.

The following table summarizes, in thousands, the changes in capitalized commercial servicing rights for the nine months ended September 30, 2016, and September 30, 2015:
 
2016
 
2015
Balance at January 1,
$
4,611

 
$

Purchased commercial servicing rights
190

 
4,255

Originations
533

 
704

Amortization
(1,229
)
 
(802
)
Valuation allowance on commercial servicing rights
(41
)
 

Balance at September 30,
$
4,064

 
$
4,157

Fair value of commercial servicing rights
$
4,397

 
$
4,412

Commercial servicing rights, net to servicing portfolio
2.38
%
 
2.33
%

Mortgage and commercial servicing rights are initially recorded at fair value in net gains on sale of loans held for sale when they are acquired through loan sales. Fair value is based on market prices for comparable servicing contracts, when available, or based on a valuation model that calculates the present value of estimated future net servicing income.

Mortgage and commercial servicing rights are subsequently measured using the amortization method, which requires the asset to be amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans. Servicing rights are evaluated for impairment at each Heartland subsidiary based upon the fair value of the assets as compared to the carrying amount. Impairment is recognized through a valuation allowance for specific tranches to the extent that fair value is less than carrying amount at each Heartland subsidiary. At September 30, 2016, no valuation allowance was required on commercial servicing rights less than 20 years and a $41,000 valuation allowance was required on commercial servicing rights greater than 20 years. At December 31, 2015, no valuation allowance was required for any of Heartland's servicing rights.






The following table summarizes, in thousands, the book value, the fair value of each tranche of the commercial servicing rights and any recorded valuation allowance at each respective subsidiary at September 30, 2016, and December 31, 2015:
September 30, 2016
Book Value-
Less than
20 Years
 
Fair Value-
Less than
20 Years
 
Impairment-
Less than
20 Years
 
Book Value-
More than
20 Years
 
Fair Value-
More than
20 Years
 
Impairment-
More than
20 Years
Centennial Bank and Trust
$
25

 
$
27

 
$

 
$
118

 
$
121

 
$

Premier Valley Bank
171

 
188

 

 
373

 
332

 
41

Wisconsin Bank & Trust
916

 
1,031

 

 
2,502

 
2,698

 

Total
$
1,112

 
$
1,246

 
$

 
$
2,993

 
$
3,151

 
$
41

December 31, 2015
 
 
 
 
 
 
 
 
 
 
 
Centennial Bank and Trust
$

 
$

 
$

 
$

 
$

 
$

Premier Valley Bank
189

 
200

 

 
417

 
432

 

Wisconsin Bank & Trust
1,048

 
1,097

 

 
2,957

 
3,173

 

Total
$
1,237

 
$
1,297

 
$

 
$
3,374

 
$
3,605

 
$


NOTE 7: DERIVATIVE FINANCIAL INSTRUMENTS

Heartland uses derivative financial instruments as part of its interest rate risk management strategy. As part of the strategy, Heartland considers the use of interest rate swaps, caps, floors, collars, and certain interest rate lock commitments and forward sales of securities related to mortgage banking activities. Heartland's current strategy includes the use of interest rate swaps, interest rate lock commitments and forward sales of mortgage securities. In addition, Heartland is facilitating back-to-back loan swaps to assist customers in managing interest rate risk. Heartland's objectives are to add stability to its net interest margin and to manage its exposure to movements in interest rates. The contract or notional amount of a derivative is used to determine, along with the other terms of the derivative, the amounts to be exchanged between the counterparties. Heartland is exposed to credit risk in the event of nonperformance by counterparties to financial instruments. Heartland minimizes this risk by entering into derivative contracts with counterparties that meet Heartland’s credit standards, and the contracts contain collateral provisions protecting the at-risk party. Heartland has not experienced any losses from nonperformance by these counterparties. Heartland monitors counterparty risk in accordance with the provisions of ASC 815.

In addition, interest rate-related derivative instruments generally contain language outlining collateral pledging requirements for each counterparty. Collateral must be posted when the market value exceeds certain threshold limits which are determined by credit ratings of each counterparty. Heartland was required to pledge $7.6 million and $5.3 million of cash as collateral at September 30, 2016, and December 31, 2015, respectively. Heartland's counterparties were required to pledge $0 at September 30, 2016, and $79,000 at December 31, 2015, respectively.

Heartland's derivative and hedging instruments are recorded at fair value on the consolidated balance sheets. See Note 8, “Fair Value,” for additional fair value information and disclosures.

Cash Flow Hedges
Heartland has variable rate funding which creates exposure to variability in interest payments due to changes in interest rates. To manage the interest rate risk related to the variability of interest payments, Heartland has entered into various interest rate swap agreements. Amounts reported in accumulated other comprehensive income (loss) related to derivatives will be reclassified to interest expense as interest payments are received or made on Heartland's variable-rate liabilities. For the nine months ended September 30, 2016, the change in net unrealized losses on cash flow hedges reflects changes in the fair value of the swaps and reclassification from accumulated other comprehensive income to interest expense totaling $1.5 million. For the next twelve months, Heartland estimates that cash payments and reclassification from accumulated other comprehensive income to interest expense will total $2.0 million.

Heartland executed an interest rate swap transaction on April 5, 2011, with an effective date of April 20, 2011, to effectively convert $15.0 million of variable rate amortizing debt to fixed rate debt. For accounting purposes, this swap transaction was designated as a cash flow hedge of the changes in cash flows attributable to changes in one-month LIBOR, the benchmark interest rate being hedged. This interest rate swap transaction expired on April 20, 2016.

Heartland entered into five forward starting interest rate swap transactions to effectively convert Heartland Financial Statutory Trust IV, V, and VII, which total $65.0 million, as well as Morrill Statutory Trust I and II, which total $20.0 million, from variable rate subordinated debentures to fixed rate debt. For accounting purposes, these five swap transactions are designated as cash flow





hedges of the changes in LIBOR, the benchmark interest rate being hedged, associated with the interest payments made on $85.0 million of Heartland's subordinated debentures that reset quarterly on a specified reset date. At inception, Heartland asserted that the underlying principal balance would remain outstanding throughout the hedge transaction, making it probable that sufficient LIBOR-based interest payments would exist through the maturity date of the swaps.

During the first quarter of 2015, Heartland entered into two additional forward starting interest rate swaps. The first forward starting interest rate swap transaction relates to Heartland's $20.0 million Statutory Trust VI, which will convert from a fixed interest rate subordinated debenture to a variable interest rate subordinated debenture. The effective date of the interest rate swap transaction is June 15, 2017, and Heartland Statutory Trust VI will effectively remain at a fixed interest rate. The forward-starting swap transaction expires on June 15, 2024. The second forward starting interest rate swap is effective on March 1, 2017, and will replace the current interest rate swap related to Heartland Statutory Trust VII upon its expiration on March 1, 2017.

Heartland entered into an interest rate swap transaction on May 10, 2016, to effectively convert $40.0 million of amortizing term debt from variable rate debt to fixed rate debt. For accounting purposes, this swap is designated as a cash flow hedge of the changes in LIBOR, the benchmark interest rate being hedged, associated with the interest payments on the amortizing term debt that resets monthly on a specified reset date. The swap expires on May 10, 2021.

The table below identifies the balance sheet category and fair values of Heartland's derivative instruments designated as cash flow hedges at September 30, 2016, and December 31, 2015, in thousands:
 
Notional
Amount
 
Fair
Value
 
Balance
Sheet
Category
 
Receive
Rate
 
Weighted
Average
Pay Rate
 
Maturity
September 30, 2016
 
 
 
 
 
 
 
 
 
 
 
Interest rate swap
$

 
$

 
Other liabilities
 
%
 
%
 
04/20/2016
Interest rate swap
25,000

 
(1,263
)
 
Other liabilities
 
0.857
%
 
2.255
%
 
03/17/2021
Interest rate swap
20,000

 
(236
)
 
Other liabilities
 
0.842
%
 
3.220
%
 
03/01/2017
Interest rate swap
20,000

 
(1,626
)
 
Other liabilities
 
0.657
%
 
3.355
%
 
01/07/2020
Interest rate swap
10,000

 
(163
)
 
Other liabilities
 
0.857
%
 
1.674
%
 
03/26/2019
Interest rate swap
10,000

 
(160
)
 
Other liabilities
 
0.857
%
 
1.658
%
 
03/18/2019
Interest rate swap
38,667

 
(352
)
 
Other liabilities
 
3.018
%
 
3.674
%
 
05/10/2021
Interest rate swap(1)
20,000

 
(1,391
)
 
Other liabilities
 
%
 
2.390
%
 
06/15/2024
Interest rate swap(2)
20,000

 
(1,409
)
 
Other liabilities
 
%
 
2.352
%
 
03/01/2024
December 31, 2015
 
 
 
 
 
 
 
 
 
 
 
Interest rate swap
$
8,947

 
$
(57
)
 
Other liabilities
 
3.152
%
 
5.140
%
 
04/20/2016
Interest rate swap
25,000

 
(713
)
 
Other liabilities
 
0.526
%
 
2.255
%
 
03/17/2021
Interest rate swap
20,000

 
(600
)
 
Other liabilities
 
0.414
%
 
3.220
%
 
03/01/2017
Interest rate swap
20,000

 
(1,582
)
 
Other liabilities
 
0.323
%
 
3.355
%
 
01/07/2020
Interest rate swap
10,000

 
(83
)
 
Other liabilities
 
0.603
%
 
1.674
%
 
03/26/2019
Interest rate swap
10,000

 
(83
)
 
Other liabilities
 
0.526
%
 
1.658
%
 
03/18/2019
Interest rate swap(1)
20,000

 
(146
)
 
Other liabilities
 
%
 
2.390
%
 
06/15/2024
Interest rate swap(2)
20,000

 
(176
)
 
Other liabilities
 
%
 
2.352
%
 
03/01/2024
 
(1) This swap is a forward starting swap with a weighted average pay rate of 2.390% beginning on June 15, 2017. No interest payments are required related to this swap until September 15, 2017.
(2) This swap is a forward starting swap with a weighted average pay rate of 2.352% beginning on March 1, 2017. No interest payments are required on this swap until June 1, 2017.






The table below identifies the gains and losses recognized on Heartland's derivative instruments designated as cash flow hedges for the three- and nine-month periods ended September 30, 2016, and September 30, 2015, in thousands:
 
Effective Portion
 
Ineffective Portion
 
Recognized in OCI
 
Reclassified from AOCI into Income
 
Recognized in Income on Derivatives
 
Amount of
Gain (Loss)
 
Category
 
Amount of
Gain (Loss)
 
Category
 
Amount of
Gain (Loss)
Three Months Ended September 30, 2016
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
1,336

 
Interest expense
 
$
(492
)
 
Other income
 
$

Nine Months Ended September 30, 2016
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
(3,160
)
 
Interest expense
 
$
(1,463
)
 
Other income
 
$

Three Months Ended September 30, 2015
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
(2,514
)
 
Interest expense
 
$
(557
)
 
Other income
 
$

Nine Months Ended September 30, 2015
 
 
 
 
 
 
 
 
 
Interest rate swaps
$
(1,336
)
 
Interest expense
 
$
(1,680
)
 
Other income
 
$


Fair Value Hedge
Heartland uses interest rate swaps to convert certain long term fixed rate loans to floating rates to hedge interest rate risk exposure. Heartland uses hedge accounting in accordance with ASC 815, with the unrealized gains and losses, representing the change in fair value of the derivative and the change in fair value of the risk being hedged on the related loan, being recorded in the consolidated statements of income. The ineffective portions of the unrealized gains or losses, if any, are recorded in interest income and interest expense in the consolidated statements of income. Heartland uses statistical regression to assess hedge effectiveness, both at the inception of the hedge as well as on a continual basis. The regression analysis involves regressing the periodic change in fair value of the hedging instrument against the periodic changes in the fair value of the asset being hedged due to changes in the hedge risk.

During the second quarter of 2015, Heartland entered into an interest rate swap, paying a fixed interest rate of 3.40% to the counterparty and receiving a variable interest rate from the same counterparty based on one month LIBOR plus .88% calculated on a notional amount of $13.8 million. In the fourth quarter of 2015, Heartland acquired undesignated interest rate swaps with the Premier Valley Bank transaction. These swaps were classified as undesignated interest rate swaps at December 31, 2015. During the first quarter of 2016, Heartland was able to designate some of these interest rate swaps with long term fixed rate loans and now classifies these interest rate swaps as fair value hedges and uses hedge accounting in accordance with ASC 815. Heartland was required to pledge $6.7 million of cash and securities as collateral as of September 30, 2016.

The table below identifies the notional amount, fair value and balance sheet category of Heartland's fair value hedges at September 30, 2016, and December 31, 2015, in thousands:
 
Notional Amount
 
Fair Value
 
Balance Sheet Category
September 30, 2016
 
 
 
 
 
Fair value hedges
$
41,007

 
$
(4,467
)
 
Other liabilities
December 31, 2015
 
 
 
 
 
Fair value hedges
$
13,805

 
$
(621
)
 
Other liabilities





The table below identifies the gains and losses recognized on Heartland's fair value hedges for the three- and nine-month periods ended September 30, 2016, and September 30, 2015, in thousands:
 
 
Amount of Gain (Loss)
 
Income Statement Category
Three Months Ended September 30, 2016
 
 
 
 
Fair value hedges
 
$
(225
)
 
Interest income
Nine Months Ended September 30, 2016
 
 
 
 
Fair value hedges
 
$
(2,335
)
 
Interest income
Three Months Ended September 30, 2015
 
 
 
 
Fair value hedges
 
$

 
Interest income
Nine Months Ended September 30, 2015
 
 
 
 
Fair value hedges
 
$

 
Interest income

Embedded Derivatives
Heartland acquired fixed rate loans with embedded derivatives in the Premier Valley Bank transaction during the fourth quarter of 2015. The loans contain terms that affect the cash flows or value of the loan similar to a derivative instrument, and therefore are considered to contain an embedded derivative. The embedded derivatives are bifurcated from the loans because the terms of the derivative instrument are not clearly and closely related to the loans. The embedded derivatives are recorded at fair value on the consolidated balance sheets as a part of other assets, and changes in the fair value are a component of noninterest income. The table below identifies the notional amount, fair value and balance sheet category of Heartland's embedded derivatives at September 30, 2016, and December 31, 2015, in thousands:
 
Notional
Amount
 
Fair
Value
 
Balance
Sheet
Category
 
Income
Statement
Category
 
Quarter-to-Date
Gain (Loss)
Recognized
 
Year-to-Date
Gain (Loss)
Recognized
September 30, 2016
 
 
 
 
 
 
 
 
 
 
 
Embedded derivatives
$
14,668

 
$
1,817

 
Other assets
 
Other noninterest income
 
$
(173
)
 
$
243

December 31, 2015
 
 
 
 
 
 
 
 
 
 
 
Embedded derivatives
$
15,020

 
$
1,574

 
Other assets
 
Other noninterest income
 
$

 
$


In conjunction with the CIC Bancshares, Inc., transaction on February 5, 2016, Heartland acquired convertible subordinated debt. The subordinated debt has a face value of $2.0 million, and the embedded conversion option allows the holder to convert the debt to common equity in any increment. The conversion option is bifurcated from the debt because the terms of the conversion option are not clearly and closely related to the terms of the debt. The total number of shares to be issued upon conversion is 73,394.

During the third quarter of 2016, $1.4 million of the debt was converted to 52,917 shares of common equity. As of September 30, 2016, the remaining shares to be issued upon conversion total 20,477. The embedded conversion option is reported at fair value on the consolidated balance sheets using the Black-Scholes model. The following table identifies, in thousands, the notional amount, fair value, balance sheet category and income statement category for the change in fair value of the embedded conversion option as of September 30, 2016:
 
Notional
Amount
 
Fair
Value
 
Balance
Sheet
Category
 
Income
Statement
Category
 
Quarter-
to-Date
Gain (Loss)
Recognized
 
Year-
to-Date
Gain (Loss)
Recognized
September 30, 2016
 
 
 
 
 
 
 
 
 
 
 
Embedded conversion option
$
558

 
$
(184
)
 
Other liabilities
 
Other noninterest income
 
$
435

 
$
138







Back-To-Back Loan Swaps
During 2015, Heartland began entering into interest rate swap loan relationships with customers to meet their financing needs. Upon entering into these loan swaps, Heartland enters into offsetting positions with counterparties in order to minimize interest rate risk. These back-to-back loan swaps qualify as free standing financial derivatives with the fair values reported in other assets and other liabilities on the consolidated balance sheets. Heartland was required to post $3.6 million and $0 as of September 30, 2016, and December 31, 2015, respectively, as collateral related to these back-to-back swaps. Any gains and losses on these back-to-back swaps are recorded in noninterest income on the consolidated statements of income, and for the three and nine months ended September 30, 2016 and September 30, 2015, no gain or loss was recognized. The table below identifies the balance sheet category and fair values of Heartland's derivative instruments designated as loan swaps at September 30, 2016, and December 31, 2015, in thousands:
 
 
Notional
Amount
 
Fair
Value
 
Balance Sheet
Category
 
Weighted
Average
Receive
Rate
 
Weighted
Average
Pay
Rate
September 30, 2016
 
 
 
 
 
 
 
 
 
 
Receive fixed-pay floating interest rate swap
 
$
52,930

 
$
3,411

 
Other assets
 
4.82
%
 
3.34
%
Pay fixed-receive floating interest rate swap
 
52,930

 
(3,411
)
 
Other liabilities
 
3.34
%
 
4.82
%
December 31, 2015
 
 
 
 
 
 
 
 
 
 
Receive fixed-pay floating interest rate swap
 
$
15,782

 
$
663

 
Other assets
 
5.08
%
 
3.07
%
Pay fixed-receive floating interest rate swap
 
15,782

 
(663
)
 
Other liabilities
 
3.07
%
 
5.08
%

Other Free Standing Derivatives
Heartland has entered into interest rate lock commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans and mortgage backed securities that are considered derivative instruments. Heartland enters into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of future changes in interest rates on the commitments to fund the loans as well as on residential mortgage loans available for sale. The fair value of these commitments is recorded on the consolidated balance sheets, with the changes in fair value recorded in the consolidated statements of income as a component of gains on sale of loans held for sale. These derivative contracts are designated as free standing derivative contracts and are not designated against specific assets and liabilities on the consolidated balance sheets or forecasted transactions and therefore do not qualify for hedge accounting treatment. Heartland was required to pledge $768,000 and $0 at September 30, 2016, and December 31, 2015, respectively, as collateral for these forward commitments.

Heartland acquired undesignated interest rate swaps with the Premier Valley Bank transaction in the fourth quarter of 2015. These swaps were entered into primarily for the benefit of customers seeking to manage their interest rate risk and are not designated against specific assets or liabilities on the consolidated balance sheet or forecasted transactions and therefore do not qualify for hedge accounting in accordance with ASC 815. These swaps are carried at fair value on the consolidated balance sheets as a component of other liabilities, with changes in the fair value recorded as a component of other noninterest income.

The table below identifies the balance sheet category and fair values of Heartland's other free standing derivative instruments not designated as hedging instruments at September 30, 2016, and December 31, 2015, in thousands:
 
Balance Sheet
Category
 
Notional
Amount
 
Fair
Value
September 30, 2016
 
 
 
 
 
Interest rate lock commitments (mortgage)
Other assets
 
$
139,704

 
$
6,239

Forward commitments
Other assets
 
112,500

 
209

Forward commitments
Other liabilities
 
285,248

 
(1,312
)
Undesignated interest rate swaps
Other liabilities
 
22,620

 
(1,944
)
December 31, 2015
 
 


 


Interest rate lock commitments (mortgage)
Other assets
 
$
99,665

 
$
3,168

Forward commitments
Other assets
 
118,378

 
523

Forward commitments
Other liabilities
 
136,709

 
(315
)
Undesignated interest rate swaps
Other liabilities
 
50,975

 
(3,677
)






The table below identifies the income statement category of the gains and losses recognized in income on Heartland's other free standing derivative instruments not designated as hedging instruments for the three- and nine-month periods ended September 30, 2016, and September 30, 2015, in thousands:
 
Income Statement Category
 
Gain (Loss) Recognized
Three Months Ended September 30, 2016
 
 
 
Interest rate lock commitments (mortgage)
Gains on sale of loans held for sale
 
$
(1,344
)
Forward commitments
Gains on sale of loans held for sale
 
931

Undesignated interest rate swaps
Other noninterest income
 
269

Nine Months Ended September 30, 2016
 
 
 
Interest rate lock commitments (mortgage)
Gains on sale of loans held for sale
 
$
4,464

Forward commitments
Gains on sale of loans held for sale
 
(1,311
)
Undesignated interest rate swaps
Other noninterest income
 
(101
)
Three Months Ended September 30, 2015
 
 
 
Interest rate lock commitments (mortgage)
Gains on sale of loans held for sale
 
$
(361
)
Forward commitments
Gains on sale of loans held for sale
 
(4,237
)
Nine Months Ended September 30, 2015
 
 
 
Interest rate lock commitments (mortgage)
Gains on sale of loans held for sale
 
$
3,471

Forward commitments
Gains on sale of loans held for sale
 
(662
)

NOTE 8: FAIR VALUE

Heartland utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available for sale, trading securities and derivatives are recorded in the consolidated balance sheets at fair value on a recurring basis. Additionally, from time to time, Heartland may be required to record at fair value other assets on a nonrecurring basis such as loans held for sale, loans held to maturity and certain other assets including, but not limited to, mortgage servicing rights, commercial servicing rights and other real estate owned. These nonrecurring fair value adjustments typically involve application of the lower of cost or fair value accounting or write-downs of individual assets.

Fair Value Hierarchy

Under ASC 820, assets and liabilities are grouped at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

Level 1 — Valuation is based upon quoted prices for identical instruments in active markets.

Level 2 — Valuation is based upon quoted prices for similar instruments in active markets, or similar instruments in markets that are not active, and model-based valuation techniques for all significant assumptions are observable in the market.

Level 3 — Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value on a recurring or non-recurring basis.

Assets

Securities Available for Sale and Held to Maturity
Securities available for sale are recorded at fair value on a recurring basis. Securities held to maturity are generally recorded at cost and are recorded at fair value only to the extent a decline in fair value is determined to be other-than-temporary. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security's credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded





on an active exchange, such as the New York Stock Exchange, as well as U.S. Treasury securities. Level 2 securities include U.S. government and agency securities, mortgage-backed securities and private collateralized mortgage obligations, municipal bonds and corporate debt securities. Level 3 securities consist primarily of Z-TRANCHE mortgage-backed securities and corporate debt securities. On a quarterly basis, a secondary independent pricing service is used for a sample of securities to validate the pricing from Heartland's primary pricing service.

Loans Held for Sale
Loans held for sale are carried at the lower of cost or fair value on an aggregate basis. The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, Heartland classifies loans held for sale subjected to nonrecurring fair value adjustments as Level 2.

Loans Held to Maturity
Heartland does not record loans held to maturity at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC 310. The fair value of impaired loans is measured using one of the following impairment methods: 1) the present value of expected future cash flows discounted at the loan's effective interest rate or 2) the observable market price of the loan or 3) the fair value of the collateral if the loan is collateral dependent. In accordance with ASC 820, impaired loans measured at fair value are classified as nonrecurring Level 3 in the fair value hierarchy.

Premises, Furniture and Equipment Held for Sale
Heartland values premises, furniture and equipment held for sale based on third-party appraisals less estimated disposal costs. Heartland considers third party appraisals, as well as independent fair value assessments from Realtors or persons involved in selling bank premises, furniture and equipment, in determining the fair value of particular properties. Accordingly, the valuation of premises, furniture and equipment held for sale is subject to significant external and internal judgment. Heartland periodically reviews premises, furniture and equipment held for sale to determine if the fair value of the property, less disposal costs, has declined below its recorded book value and records any adjustments accordingly. Premises, furniture and equipment held for sale are classified as nonrecurring Level 3 in the fair value hierarchy.

Mortgage Servicing Rights
Mortgage servicing rights assets represent the value associated with servicing residential real estate loans that have been sold to outside investors with servicing retained. Heartland uses the amortization method (i.e., the lower of amortized cost or estimated fair value measured on a nonrecurring basis), not fair value measurement accounting, to determine the carrying value of its mortgage servicing rights. The fair value for servicing assets is determined through discounted cash flow analysis and utilizes discount rates, prepayment speeds and delinquency rate assumptions as inputs. All of these assumptions require a significant degree of management estimation and judgment. Mortgage servicing rights are subject to impairment testing. The carrying values of these rights are reviewed quarterly for impairment based upon the calculation of fair value as performed by an outside third party. For purposes of measuring impairment, the rights are stratified into certain risk characteristics including note type and note term. If the valuation model reflects a fair value less than the carrying value, mortgage servicing rights are adjusted to fair value through a valuation allowance. Heartland classifies mortgage servicing rights as nonrecurring with Level 3 measurement inputs.

Commercial Servicing Rights
Commercial servicing rights assets represent the value associated with servicing commercial loans guaranteed by the Small Business Administration and the United States Department of Agriculture that have been sold with servicing retained by Heartland. Heartland uses the amortization method (i.e., the lower of amortized cost or estimated fair value measured on a nonrecurring basis), not fair value measurement accounting, to determine the carrying value of its commercial servicing rights. The fair value for servicing assets is determined through market prices for comparable servicing contracts, when available, or through a valuation model that calculates the present value of estimated future net servicing income. Inputs utilized include discount rates, prepayment speeds and delinquency rate assumptions as inputs. All of these assumptions require a significant degree of management estimation and judgment. Commercial servicing rights are subject to impairment testing, and the carrying values of these rights are reviewed quarterly for impairment based upon the calculation of fair value as performed by an outside third party. If the valuation model reflects a fair value less than the carrying value, commercial servicing rights are adjusted to fair value through a valuation allowance. Heartland classifies commercial servicing rights as nonrecurring with Level 3 measurement inputs.

Derivative Financial Instruments
Heartland's current interest rate risk strategy includes interest rate swaps. The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. To comply with the provisions of ASC 820, Heartland incorporates credit





valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty's nonperformance risk in the fair value measurements. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, Heartland has considered the impact of netting any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees.

Although Heartland has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. However, as of September 30, 2016, and December 31, 2015, Heartland has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, Heartland has determined that its derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.

Interest rate lock commitments
Heartland uses an internal valuation model that relies on internally developed inputs to estimate the fair value of its interest rate lock commitments which is based on unobservable inputs that reflect management's assumptions and specific information about each borrower. Interest rate lock commitments are classified in Level 3 of the fair value hierarchy.

Forward commitments
The fair value of forward commitments are estimated using an internal valuation model, which includes current trade pricing for similar financial instruments in active markets that Heartland has the ability to access and are classified in Level 2 of the fair value hierarchy.

Other Real Estate Owned
Other real estate owned ("OREO") represents property acquired through foreclosures and settlements of loans. Property acquired is carried at the fair value of the property at the time of acquisition (representing the property's cost basis), plus any acquisition costs, or the estimated fair value of the property, less disposal costs. Heartland considers third party appraisals, as well as independent fair value assessments from realtors or persons involved in selling OREO, in determining the fair value of particular properties. Accordingly, the valuation of OREO is subject to significant external and internal judgment. Heartland periodically reviews OREO to determine if the fair value of the property, less disposal costs, has declined below its recorded book value and records any adjustments accordingly. OREO is classified as nonrecurring Level 3 of the fair value hierarchy.






The table below presents Heartland's assets and liabilities that are measured at fair value on a recurring basis as of September 30, 2016, and December 31, 2015, in thousands, aggregated by the level in the fair value hierarchy within which those measurements fall:
 
Total Fair Value
 
Level 1
 
Level 2
 
Level 3
September 30, 2016
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Securities available for sale
 
 
 
 
 
 
 
U.S. government corporations and agencies
$
4,955

 
$
530

 
$
4,425

 
$

Mortgage-backed securities
1,275,093

 

 
1,273,196

 
1,897

Obligations of states and political subdivisions
362,107

 

 
362,107

 

Corporate debt securities

 

 

 

Equity securities
13,541

 

 
13,541

 

Derivative financial instruments(1)
5,228

 

 
5,228

 

Interest rate lock commitments
6,239

 

 

 
6,239

Forward commitments
209

 

 
209

 

Total assets at fair value
$
1,667,372

 
$
530

 
$
1,658,706

 
$
8,136

Liabilities
 
 
 
 
 
 
 
Derivative financial instruments(2)
$
16,606

 
$

 
$
16,606

 
$

Forward commitments
1,312

 

 
1,312

 

Total liabilities at fair value
$
17,918

 
$

 
$
17,918

 
$

December 31, 2015
 
 
 
 
 
 
 
Assets
 
 
 
 
 
 
 
Securities available for sale
 
 
 
 
 
 
 
U.S. government corporations and agencies
$
25,766

 
$
519

 
$
25,247

 
$

Mortgage-backed securities
1,242,702

 

 
1,240,663

 
2,039

Obligations of states and political subdivisions
295,982

 

 
295,982

 

Corporate debt securities
846

 

 

 
846

Equity securities
13,138

 

 
13,138

 

Derivative financial instruments(1)
2,237

 

 
2,237

 

Interest rate lock commitments
3,168

 

 

 
3,168

Forward commitments
523

 

 
523

 

Total assets at fair value
$
1,584,362

 
$
519

 
$
1,577,790

 
$
6,053

Liabilities
 
 
 
 
 
 
 
Derivative financial instruments(2)
$
8,401

 
$

 
$
8,401

 
$

Forward commitments
315

 

 
315

 

Total liabilities at fair value
$
8,716

 
$

 
$
8,716

 
$

 
 
 
 
 
 
 
 
(1) Includes embedded derivatives and loan swaps
(2) Includes cash flow hedges, fair value hedges, loan swaps, embedded conversion options and free standing derivative instruments






The tables below present Heartland's assets that are measured at fair value on a nonrecurring basis, in thousands:
 
Fair Value Measurements at September 30, 2016
 
Total
 
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
 Inputs
(Level 3)
 
Year-to-
Date
Losses
Collateral dependent impaired loans:
 
 
 
 
 
 
 
 
 
Commercial
$
2,366

 
$

 
$

 
$
2,366

 
$
190

Commercial real estate
14,707

 

 

 
14,707

 
3,895

Agricultural and agricultural real estate
2,213

 

 

 
2,213

 

Residential real estate
3,200

 

 

 
3,200

 

Consumer
1,913

 

 

 
1,913

 

Total collateral dependent impaired loans
$
24,399

 
$

 
$

 
$
24,399

 
$
4,085

Other real estate owned
$
10,740

 
$

 
$

 
$
10,740

 
$
1,094

Premises, furniture and equipment held for sale
$
3,634

 

 
$

 
$
3,634

 
$
255

Commercial servicing rights
$
332

 
$

 
$

 
$
332

 
$
41


 
Fair Value Measurements at December 31, 2015
 
Total
 
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
 Inputs
(Level 3)
 
Year-to-
Date
Losses
Collateral dependent impaired loans:
 
 
 
 
 
 
 
 
 
Commercial
$
597

 
$

 
$

 
$
597

 
$
82

Commercial real estate
1,522

 

 

 
1,522

 
86

Agricultural and agricultural real estate

 

 

 

 

Residential real estate
2,330

 

 

 
2,330

 
104

Consumer
1,905

 

 

 
1,905

 

Total collateral dependent impaired loans
$
6,354

 
$

 
$

 
$
6,354

 
$
272

Other real estate owned
$
11,524

 
$

 
$

 
$
11,524

 
$
5,520

Premises, furniture and equipment held for sale
$
3,889

 
$

 
$

 
$
3,889

 
$

Commercial servicing rights
$

 
$

 
$

 
$

 
$






The following tables present additional quantitative information about assets measured at fair value and for which Heartland has utilized Level 3 inputs to determine fair value, in thousands:
 
Fair Value at 9/30/16
 
Valuation
Technique
 
Unobservable
Input
 
Range
(Weighted Average)
Z-TRANCHE Securities
$
1,897

 
Discounted cash flows
 
Pretax discount rate
 
7.50 - 9.50%
 
 
 
 
 
Actual defaults
 
17.09 - 35.91% (30.93%)
 
 
 
 
 
Actual deferrals
 
8.22 - 22.82% (13.62%)
Corporate debt securities

 
Discounted cash flows
 
Bank analysis
 
(1) 
Interest rate lock commitments
6,239

 
Discounted cash flows
 
Closing ratio
 
(2) 
Premises, furniture and equipment held for sale
3,634

 
Modified appraised value
 
Third party appraisal
 
(3) 
 
 
 
 
 
Appraisal discount
 
(3) 
Commercial servicing rights
332

 
Discounted cash
flows
 
Third party valuation
 
(4) 
Other real estate owned
10,740

 
Modified appraised value
 
Third party appraisal
 
(3) 
 
 
 
 
 
Appraisal discount
 
(3) 
Collateral dependent impaired loans:
 
 
 
 
 
 
 
Commercial
2,366

 
Modified appraised value
 
Third party appraisal
 
(3) 
 
 
 
 
 
Appraisal discount
 
(3) 
Commercial real estate
14,707

 
Modified appraised value
 
Third party appraisal
 
(3) 
 
 
 
 
 
Appraisal discount
 
(3) 
Agricultural and agricultural real estate
2,213

 
Modified appraised value
 
Third party appraisal
 
(3) 
 
 
 
 
 
Appraisal discount
 
(3) 
Residential real estate
3,200

 
Modified appraised value
 
Third party appraisal
 
(3) 
 
 
 
 
 
Appraisal discount
 
(3) 
Consumer
1,913

 
Modified appraised value
 
Third party valuation
 
(3) 
 
 
 
 
 
Valuation discount
 
(3) 
 
 
 
 
 
 
 
 
(1) The unobservable input is the bank analysis market using Moody's Global Bank Rating Methodology. The analysis takes into consideration various performance metrics as well as yield on the debt securities and credit risk analysis.
(2) The significant unobservable input used in the fair value measurement is the closing ratio, which represents the percentage of loans currently in a lock position which management estimates will ultimately close. The closing ratio calculation takes into consideration historical data and loan-level data; therefore providing a range would not be meaningful. The weighted average closing ratio at September 30, 2016, was 87%.
(3) Third party appraisals are obtained as to the value of the underlying asset, but disclosure of this information would not provide meaningful information, as the range will vary widely from loan to loan. Types of discounts considered included age of the appraisal, local market conditions, current condition of the property, and estimated sales costs. These discounts will also vary from loan to loan, thus providing range would not be meaningful.
(4) The significant unobservable input used in the fair value measurement are the value indices, which are weighted-average spreads to LIBOR based on maturity groups.






 
Fair Value at 12/31/15
 
Valuation
Technique
 
Unobservable
Input
 
Range
(Weighted Average)
Z-TRANCHE Securities
$
2,039

 
Discounted cash flows
 
Pretax discount rate
 
7.50 - 9.50%
 
 
 
 
 
Actual defaults
 
22.20 - 33.55% (30.60%)
 
 
 
 
 
Actual deferrals
 
  10.75 - 21.82% (13.36%)
Corporate debt securities
846

 
Discounted cash flows
 
Bank analysis
 
(1) 
Interest rate lock commitments
3,168

 
Discounted cash flows
 
Closing ratio
 
(2) 
Premises, furniture and equipment held for sale
3,889

 
Modified appraised value
 
Third party appraisal
 
(3) 
Commercial servicing rights

 
Discounted cash
flows
 
Third party valuation
 
(4) 
Other real estate owned
11,524

 
Modified appraised value
 
Disposal costs
 
(3) 
 
 
 
 
 
Third party appraisal
 
(3) 
 
 
 
 
 
Appraisal discount
 
(3) 
Collateral dependent impaired loans:
 
 
 
 
 
 
 
Commercial
597

 
Modified appraised value
 
Third party appraisal
 
(3) 
 
 
 
 
 
Appraisal discount
 
(3) 
Commercial real estate
1,522

 
Modified appraised value
 
Third party appraisal
 
(3) 
 
 
 
 
 
Appraisal discount
 
(3) 
Agricultural and agricultural real estate

 
Modified appraised value
 
Third party appraisal
 
(3) 
 
 
 
 
 
Appraisal discount
 
(3) 
Residential real estate
2,330

 
Modified appraised value
 
Third party appraisal
 
(3) 
 
 
 
 
 
Appraisal discount
 
(3) 
Consumer
1,905

 
Modified appraised value
 
Third party valuation
 
(3) 
 
 
 
 
 
Valuation discount
 
(3) 
 
 
 
 
 
 
 
 
(1) The unobservable input is the bank analysis market using Moody's Global Bank Rating Methodology. The analysis takes into consideration various performance metrics as well as yield on the debt securities and credit risk analysis.
(2) The significant unobservable input used in the fair value measurement is the closing ratio, which represents the percentage of loans currently in a lock position which management estimates will ultimately close. The closing ratio calculation takes into consideration historical data and loan-level data; therefore providing a range would not be meaningful. The weighted average closing ratio at December 31, 2015, was 86%.
(3) Third party appraisals are obtained as to the value of the underlying asset, but disclosure of this information would not provide meaningful information, as the range will vary widely from loan to loan. Types of discounts considered included age of the appraisal, local market conditions, current condition of the property, and estimated sales costs. These discounts will also vary from loan to loan, thus providing range would not be meaningful.
(4) The significant unobservable input used in the fair value measurement are the value indices, which are weighted-average spreads to LIBOR based on maturity groups.






The changes in fair value of the Z-TRANCHE, a Level 3 asset, that is measured on a recurring basis are summarized in the following table, in thousands:
 
For the Nine Months Ended September 30, 2016
 
For the Year Ended December 31, 2015
Balance at January 1,
$
2,039

 
$
4,947

Total gains (losses):
 
 


  Included in earnings

 
(3,038
)
  Included in other comprehensive income
(142
)
 
982

Purchases, sales and settlements:
 
 

  Purchases

 
6

  Sales

 
(736
)
  Settlements

 
(122
)
Balance at period end
$
1,897

 
$
2,039


The changes in fair value of the corporate debt securities, Level 3 assets, that are measured on a recurring basis is summarized in the following table, in thousands:
 
For the Nine Months Ended September 30, 2016
 
For the Year Ended December 31, 2015
Balance at January 1,
$
846

 
$

Total gains (losses):


 


  Included in earnings
56

 

  Included in other comprehensive income
(106
)
 
106

Purchases, acquired, sales and settlements:
 
 

  Purchases

 

  Acquired

 
740

  Sales
(796
)
 

  Settlements

 

Balance at period end
$

 
$
846


The changes in fair value of the interest rate lock commitments, which are Level 3 financial instruments and are measured on a recurring basis, are summarized in the following table, in thousands:
 
For the Nine Months Ended September 30, 2016
 
For the Year Ended December 31, 2015
Balance at January 1,
$
3,168

 
$
2,496

Total gains (losses) included in earnings
4,464

 
288

Issuances
1,540

 
5,428

Settlements
(2,933
)
 
(5,044
)
Balance at period end
$
6,239

 
$
3,168


Gains included in gains (losses) on sale of loans held for sale attributable to interest rate lock commitments held at September 30, 2016, and December 31, 2015, were $6.2 million and $3.2 million, respectively.

The tables below summarize the estimated fair value of Heartland's financial instruments as defined by ASC 825 as of September 30, 2016, and December 31, 2015, in thousands. The carrying amounts in the following tables are recorded in the consolidated balance sheets under the indicated captions. In accordance with ASC 825, the assets and liabilities that are not financial instruments are not included in the disclosure, such as the value of the mortgage servicing rights, premises, furniture and equipment, premises, furniture and equipment held for sale, goodwill and other intangibles and other liabilities.

Heartland does not believe that the estimated information presented herein is representative of the earnings power or value of Heartland. The following analysis, which is inherently limited in depicting fair value, also does not consider any value associated with either existing customer relationships or the ability of Heartland to create value through loan origination, deposit gathering or fee generating activities. Many of the estimates presented herein are based upon the use of highly subjective information and





assumptions and, accordingly, the results may not be precise. Management believes that fair value estimates may not be comparable between financial institutions due to the wide range of permitted valuation techniques and numerous estimates which must be made. Furthermore, because the disclosed fair value amounts were estimated as of the balance sheet date, the amounts actually realized or paid upon maturity or settlement of the various financial instruments could be significantly different.
 
 
 
 
 
Fair Value Measurements at
September 30, 2016
 
Carrying
Amount
 
Estimated
Fair
Value
 
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
 Inputs
(Level 3)
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
202,089

 
$
202,089

 
$
202,089

 
$

 
$

Time deposits in other financial institutions
2,105

 
2,105

 
2,105

 

 

Securities:
 
 
 
 
 
 
 
 
 
Available for sale
1,655,696

 
1,655,696

 
530

 
1,653,269

 
1,897

Held to maturity
265,302

 
284,948

 

 
284,948

 

Other investments
22,082

 
22,082

 

 
21,847

 
235

Loans held for sale
78,317

 
78,317

 

 
78,317

 

Loans, net:
 
 
 
 
 
 
 
 
 
Commercial
1,277,691

 
1,271,961

 

 
1,269,595

 
2,366

Commercial real estate
2,580,136

 
2,584,885

 

 
2,570,178

 
14,707

Agricultural and agricultural real estate
485,071

 
487,861

 

 
485,648

 
2,213

Residential real estate
622,684

 
618,770

 

 
615,570

 
3,200

Consumer
418,480

 
422,770

 

 
420,857

 
1,913

Total Loans, net
5,384,062

 
5,386,247

 

 
5,361,848

 
24,399

Derivative financial instruments(1)
5,228

 
5,228

 

 
5,228

 

Interest rate lock commitments
6,239

 
6,239

 

 

 
6,239

Forward commitments
209

 
209

 

 
209

 

Financial liabilities:
 
 
 
 
 
 
 
 
 
Deposits
 
 
 
 
 
 
 
 
 
Demand deposits
2,238,736

 
2,238,736

 

 
2,238,736

 

Savings deposits
3,753,300

 
3,753,300

 

 
3,753,300

 

Time deposits
920,657

 
920,657

 

 
920,657

 

Short term borrowings
214,105

 
214,105

 

 
214,105

 

Other borrowings
294,493

 
297,018

 

 
297,018

 

Derivative financial instruments(2)
16,606

 
16,606

 

 
16,606

 

Forward commitments
1,312

 
1,312

 

 
1,312

 

 
(1) Includes embedded derivatives and loan swaps
(2) Includes cash flow hedges, fair value hedges, loan swaps, embedded conversion options and free standing derivative instruments






 
 
 
 
 
Fair Value Measurements at
December 31, 2015
 
Carrying
Amount
 
Estimated
Fair
Value
 
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
 
Significant Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
 Inputs
(Level 3)
Financial assets:
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
258,799

 
$
258,799

 
$
258,799

 
$

 
$

Time deposits in other financial institutions
2,355

 
2,355

 
2,355

 

 

Securities:
 
 
 
 
 
 
 
 
 
Available for sale
1,578,434

 
1,578,434

 
519

 
1,575,030

 
2,885

Held to maturity
279,117

 
294,513

 

 
294,513

 

Other investments
21,443

 
21,443

 

 
21,208

 
235

Loans held for sale
74,783

 
74,783

 

 
74,783

 

Loans, net:
 
 
 
 
 
 
 
 
 
Commercial
1,262,612

 
1,257,355

 

 
1,256,758

 
597

Commercial real estate
2,305,908

 
2,304,716

 

 
2,303,194

 
1,522

Agricultural and agricultural real estate
468,533

 
469,485

 

 
469,485

 

Residential real estate
536,190

 
531,931

 

 
529,601

 
2,330

Consumer
379,558

 
382,579

 

 
380,674

 
1,905

Total Loans, net
4,952,801

 
4,946,066

 

 
4,939,712

 
6,354

Derivative financial instruments(1)
2,237

 
2,237

 

 
2,237

 

Interest rate lock commitments
3,168

 
3,168

 

 

 
3,168

Forward commitments
523

 
523

 

 
523

 

Financial liabilities:
 
 
 
 
 
 
 
 
 
Deposits
 
 
 
 
 
 
 
 
 
Demand deposits
1,914,141

 
1,914,141

 

 
1,914,141

 

Savings deposits
3,367,479

 
3,367,479

 

 
3,367,479

 

Time deposits
1,124,203

 
1,124,203

 

 
1,124,203

 

Short term borrowings
293,898

 
293,898

 

 
293,898

 

Other borrowings
263,214

 
281,271

 

 
281,271

 

Derivative financial instruments(2)
8,401

 
8,401

 

 
8,401

 

Forward commitments
315

 
315

 

 
315

 

 
(1) Includes embedded derivatives and loan swaps
(2) Includes cash flow hedges, fair value hedges, loan swaps, embedded conversion options and free standing derivative instruments

Cash and Cash Equivalents — The carrying amount is a reasonable estimate of fair value due to the short-term nature of these instruments.

Time Deposits in Other Financial Institutions — The carrying amount is a reasonable estimate of fair value due to the short-term nature of these instruments.

Securities — For securities either held to maturity, available for sale or trading, fair value equals quoted market price if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. For Level 3 securities, Heartland utilizes independent pricing provided by third party vendors or brokers.






Other Investments — Fair value measurement of other investments, which consists primarily of FHLB stock, are based on their redeemable value, which is at cost due to the restrictions placed on their transferability. The market for these securities is restricted to the issuer of the stock and subject to impairment evaluation.

Loans — The fair value of loans is estimated using an entrance price concept by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. The fair value of impaired loans is measured using the fair value of the underlying collateral. The fair value of loans held for sale is estimated using quoted market prices.

Interest Rate Lock Commitments — The fair value of interest rate lock commitments is estimated using an internal valuation model, which includes grouping the interest rate lock commitments by interest rate and terms, applying an estimated closing ratio based on historical experience, and then multiplying by quoted investor prices determined to be reasonably applicable to the loan commitment groups based on interest rate, terms, and rate lock expiration dates of the loan commitment group.

Forward Commitments — The fair value of these instruments is estimated using an internal valuation model, which includes current trade pricing for similar financial instruments.

Derivative Financial Instruments — The fair value of all derivatives is estimated based on the amount that Heartland would pay or would be paid to terminate the contract or agreement, using current rates and prices, and, when appropriate, the current creditworthiness of the counter-party.

Deposits — The fair value of demand deposits, savings accounts and certain money market 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.

Short-term and Other Borrowings Rates currently available to Heartland for debt with similar terms and remaining maturities are used to estimate fair value of existing debt.

Commitments to Extend Credit, Unused Lines of Credit and Standby Letters of Credit — Based upon management's analysis of the off balance sheet financial instruments, there are no significant unrealized gains or losses associated with these financial instruments based upon review of the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties.

NOTE 9: SEGMENT REPORTING

Heartland has identified two operating segments for purposes of financial reporting: community and other banking, and retail mortgage banking. These segments were determined based on the products and services provided or the type of customers served and are consistent with the information used by Heartland's key decision makers to make operating decisions and to assess Heartland's performance. The following tables present financial information from Heartland's operating segments for the three- and nine-month periods ended September 30, 2016, and September 30, 2015, in thousands.

 
Three Months Ended September 30,
 
2016
 
2015
 
Community
and Other
Banking
 
Retail
Mortgage
Banking
 
Total
 
Community
and Other
Banking
 
Retail
Mortgage
Banking
 
Total
Net interest income
$
72,694

 
$
987

 
$
73,681

 
$
58,123

 
$
1,601

 
$
59,724

Provision for loan losses
5,328

 

 
5,328

 
3,181

 

 
3,181

Total noninterest income
17,337

 
11,205

 
28,542

 
16,015

 
8,965

 
24,980

Total noninterest expense
57,988

 
10,439

 
68,427

 
49,168

 
12,828

 
61,996

Income (loss) before taxes
$
26,715

 
$
1,753

 
$
28,468

 
$
21,789

 
$
(2,262
)
 
$
19,527

Average Loans, for the period
$
5,464,304

 
$
73,784

 
$
5,538,088

 
$
4,563,221

 
$
90,958

 
$
4,654,179

Segment Assets, at period end
$
8,084,810

 
$
117,405

 
$
8,202,215

 
$
6,676,526

 
$
129,358

 
$
6,805,884







 
Nine Months Ended September 30,
 
2016
 
2015
 
Community
and Other
Banking
 
Retail
Mortgage
Banking
 
Total
 
Community
and Other
Banking
 
Retail
Mortgage
Banking
 
Total
Net interest income
$
216,172

 
$
3,334

 
$
219,506

 
$
167,000

 
$
4,298

 
$
171,298

Provision for loan losses
9,513

 

 
9,513

 
10,526

 

 
10,526

Total noninterest income
55,773

 
33,373

 
89,146

 
48,679

 
37,625

 
86,304

Total noninterest expense
177,421

 
32,335

 
209,756

 
145,614

 
39,478

 
185,092

Income before taxes
$
85,011

 
$
4,372

 
$
89,383

 
$
59,539

 
$
2,445

 
$
61,984

Average Loans, for the period
$
5,422,843

 
$
70,344

 
$
5,493,187

 
$
4,365,908

 
$
91,807

 
$
4,457,715

Segment Assets, at period end
$
8,084,810

 
$
117,405

 
$
8,202,215

 
$
6,676,526

 
$
129,358

 
$
6,805,884







ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SAFE HARBOR STATEMENT

This document (including any information incorporated herein by reference) contains, and future oral and written statements of Heartland 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 Heartland. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of Heartland'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. Although Heartland has made these statements based on management's experience and best estimate of future events, there may be events or factors that management has not anticipated, and the accuracy and achievement of such forward-looking statements and estimates are subject to a number of risks, including those identified in our Annual Report on Form 10-K for the year ended December 31, 2015. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and Heartland undertakes no obligation to update any statement in light of new information or future events.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, income and expenses. These estimates are based upon historical experience and on various other assumptions that management believes are reasonable under the circumstances. Among other things, the estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The estimates and judgments that management believes have the most effect on Heartland's reported financial position and results of operations are described as critical accounting policies in Heartland's Annual Report on Form 10-K for the year ended December 31, 2015. There have been no significant changes in the critical accounting policies or the assumptions and judgments utilized in applying these policies since the year ended December 31, 2015.

OVERVIEW

Heartland's results of operations depend primarily on net interest income, which is the difference between interest income from interest earning assets and interest expense on interest bearing liabilities. Noninterest income, which includes service charges and fees, loan servicing income, trust income, brokerage and insurance commissions, securities gains, gains on sale of loans held for sale, and valuation adjustment on commercial servicing rights also affects Heartland's results of operations. Heartland's principal operating expenses, aside from interest expense, consist of the provision for loan losses, salaries and employee benefits, occupancy and equipment costs, professional fees, FDIC insurance premiums, advertising and other real estate and loan collection expenses.

Net income available to common stockholders for the quarter ended September 30, 2016, was $20.2 million, or $0.81 per diluted common share, compared to $14.4 million, or $0.69 per diluted common share, for the quarter ended September 30, 2015. Return on average common equity was 11.64% and return on average assets was 0.98% for the third quarter of 2016, compared to 11.40% and 0.85%, respectively, for the same quarter in 2015.

Net income available to common stockholders for the first nine months of 2016 was $61.0 million, or $2.48 per diluted common share, compared to $44.8 million, or $2.16 per diluted common share, for the first nine months of 2015. Return on average common equity was 12.28% and return on average assets was 1.00% for the first nine months of 2016, compared to 12.38% and 0.91%, respectively, for the same period in 2015.

Acquisitions were a significant contributing factor to improved net income during 2016. Heartland's earning assets during the third quarter of 2016 were $7.38 billion in comparison with $6.16 billion during the third quarter of 2015, a $1.22 billion or 20% increase. During the first nine months of 2016, average earning assets were $7.37 billion in comparison with $6.03 billion during the first nine months of 2015, a $1.34 billion or 22% increase. This growth resulted in an increase of $14.0 million or 23% in net interest income for the third quarter of 2016 compared to the third quarter of 2015 and an increase of $48.2 million or 28% for the first nine months of 2016 compared to the first nine months of 2015. The effect of these increases was partially offset by a $6.4 million or 10% increase in noninterest expense for the quarterly comparative periods and a $24.7 million or 13% increase for the nine-month comparative periods.






On February 5, 2016, Heartland completed the acquisition of CIC Bancshares, Inc., parent company of Centennial Bank, headquartered in Denver, Colorado, in a transaction valued at approximately $76.9 million. Of this amount, approximately $15.7 million was paid in cash and the remainder of the consideration was provided by the issuance of 2,003,235 shares of Heartland common stock and 3,000 shares of newly issued Heartland Series D preferred stock. In addition, Heartland assumed convertible notes and subordinated debt totaling approximately $7.9 million. Simultaneous with closing of the transaction, Centennial Bank merged into Heartland’s Summit Bank & Trust subsidiary, with the resulting institution operating under the name Centennial Bank and Trust. As of the closing date, CIC Bancshares, Inc. had, at fair value, total assets of $772.6 million, total loans of $581.5 million and total deposits of $648.1 million. The systems conversion for this transaction was completed during the second quarter of 2016.

On March 15, 2016, Heartland redeemed all of the 81,698 shares of its Series C Preferred Stock issued to the U.S. Treasury as part of the Small Business Lending Fund program. The aggregate redemption price was approximately $81.9 million, including dividends accrued but unpaid through the redemption date, and was paid with available funds. The redemption terminated Heartland's participation in the Small Business Lending Fund program.

Total assets of Heartland were $8.20 billion at September 30, 2016, an increase of $507.5 million or 7% since year-end 2015. Included in this growth, at fair value, were $772.6 million of assets acquired in the CIC Bancshares, Inc. transaction. Securities represented 24% of total assets at both September 30, 2016, and December 31, 2015.

Total loans held to maturity were $5.44 billion at September 30, 2016, compared to $5.00 billion at year-end 2015, an increase of $437.2 million or 9%. This increase includes $581.5 million of total loans held to maturity, at fair value, acquired in the CIC Bancshares, Inc. transaction.

Total deposits were $6.91 billion as of September 30, 2016, compared to $6.41 billion at year-end 2015, an increase of $506.9 million or 8%. This increase includes $648.1 million of deposits, at fair value, acquired in the CIC Bancshares, Inc. transaction. Demand deposits totaled $2.24 billion at September 30, 2016, an increase of $324.6 million or 17% since year-end 2015, with $164.3 million of the increase attributable to the CIC Bancshares, Inc. transaction.

Common stockholders' equity was $703.0 million at September 30, 2016, compared to $581.5 million at year-end 2015. Book value per common share was $28.48 at September 30, 2016, compared to $25.92 at year-end 2015. Heartland's unrealized loss on securities available for sale and derivative instruments, net of applicable taxes, was $3.1 million at September 30, 2016, compared to a $6.0 million unrealized loss, net of applicable taxes, at December 31, 2015.

RECENT DEVELOPMENTS

On October 29, 2016, Heartland entered into a definitive merger agreement for the acquisition of Founders Bancorp, parent company of Founders Community Bank, based in San Luis Obispo, California. The transaction is valued at approximately $29.1 million, subject to adjustment. Of the merger consideration, 70% will be in the form of shares of Heartland common stock, and 30% will be in cash. As of September 30, 2016, Founders Community Bank had total assets of $198.5 million, which includes gross loans of $106.6 million and total deposits of $180.5 million. The closing of the acquisition is subject to customary closing conditions, including approvals by the Founders Bancorp shareholders and banking regulators, and is expected to occur in the first quarter of 2017. Simultaneous with the close, Founders Community Bank will be merged into Heartland's Premier Valley Bank subsidiary. Heartland expects the acquisition to be accretive to its earning per share during 2018.

On November 2, 2016, Heartland commenced a public offering of 1,379,690 shares of its common stock at $36.24 per share, and the offering closed on November 8, 2016. The offering resulted in net proceeds of approximately $49.7 million after deducting estimated offering expenses payable by Heartland. All of the shares of common stock included in the offering are primary shares. Heartland intends to use the net proceeds from this offering for general corporate purposes, which may include, among other things, working capital, debt repayment or financing potential acquisitions.






RESULTS OF OPERATIONS

Net Interest Income

Net interest margin, expressed as a percentage of average earning assets, was 3.97% (4.14% on a fully taxable equivalent basis) during the third quarter of 2016, compared to 3.85% (4.01% on a fully taxable equivalent basis) during the third quarter of 2015. Net interest margin, expressed as a percentage of average earning assets, was 3.98% (4.15% on a fully taxable equivalent basis) during the first nine months of 2016, compared to 3.80% (3.96% on a fully taxable equivalent basis) during the first nine months of 2015. Heartland's success in maintaining net interest margin at or near the 4.00% level has been the result of continuous loan and deposit pricing discipline and management's ability to shift dollars from the securities portfolio into the loan portfolio. Also contributing to the improved net interest margin during the most recent quarters has been the amortization of purchase accounting discounts associated with the three acquisitions completed by Heartland during the last half of 2015 and the CIC Bancshares, Inc. acquisition completed during the first quarter of 2016. See "Analysis of Average Balances, Tax-Equivalent Yields and Rates" for a description of our use of net interest income on a fully taxable equivalent basis, which is not defined by GAAP, and a reconciliation of annualized net interest margin on a fully taxable equivalent basis to GAAP.

Interest income for the third quarter of 2016 was $81.7 million, an increase of $14.4 million or 21%, compared to the $67.3 million recorded in the third quarter of 2015. The tax-equivalent adjustments for income taxes saved on the interest earned on nontaxable securities and loans were $3.2 million for the third quarter of 2016 and $2.6 million for the third quarter of 2015. With these adjustments, interest income on a tax-equivalent basis was $84.9 million for the third quarter of 2016, an increase of $15.1 million or 22%, compared to $69.9 million for the third quarter of 2015. For the first nine months of 2016, interest income increased $47.9 million or 24% to $243.7 million from $195.8 million for the first nine months of 2015. The tax-equivalent adjustments for income taxes saved on the interest earned on nontaxable securities and loans were $9.4 million and $7.4 million for the first nine months of 2016 and 2015, respectively. With these adjustments, interest income on a tax-equivalent basis was $253.1 million during the first nine months of 2016 compared to $203.2 million during the first nine months of 2015, an increase of $49.9 million or 25%. The increases in interest income during 2016 were primarily due to increases in average earning assets, which totaled $7.38 billion during the third quarter of 2016 compared to $6.16 billion during the third quarter of 2015, a $1.22 billion or 20% increase. For the first nine months of 2016, average earning assets were $7.37 billion compared to $6.03 billion during the first nine months of 2015, an increase of $1.34 billion or 22%. A majority of the growth in average earning assets during both comparable periods was attributable to the acquisitions completed during the last half of 2015, in addition to the CIC Bancshares, Inc. acquisition completed during the first quarter of 2016.

Interest expense for the third quarter of 2016 was $8.0 million, an increase of $462,000 or 6% from $7.5 million in the third quarter of 2015. Interest expense for the first nine months of 2016 was $24.2 million compared to $24.5 million for the first nine months of 2015, a decrease of $317,000 or 1%. Average interest bearing liabilities increased $733.1 million or 16% for the quarter ended September 30, 2016, as compared to the same quarter in 2015, while the average interest rate paid on Heartland's interest bearing deposits and borrowings declined 6 basis points from 0.67% in the third quarter of 2015 to 0.61% in the third quarter of 2016. Average interest bearing liabilities increased $839.5 million or 19% for the first nine months of 2016 as compared to the first nine months in 2015, while the average interest rate paid on Heartland's interest bearing deposits and borrowings declined 13 basis points from 0.74% in the first nine months of 2015 to 0.61% in the first nine months of 2016. The average interest rate paid on savings deposits was 0.22% during both the third quarter of 2016 and the third quarter of 2015, and the average interest rate paid on time deposits was 0.79% during the third quarter of 2016 compared to 0.91% during the third quarter of 2015. For the first nine months of 2016, the average interest rate paid on savings deposits was 0.22% compared to 0.23% during the first nine months of 2015, and the average interest rate paid on time deposits was 0.80% during the first nine months of 2016 compared to 0.99% during the first nine months of 2015.

Net interest income increased $14.0 million or 23% to $73.7 million in the third quarter of 2016 from $59.7 million in the third quarter of 2015. After the tax-equivalent adjustment discussed above, net interest income on a tax-equivalent basis totaled $76.9 million during the third quarter of 2016, an increase of $14.6 million or 23% from $62.3 million during the third quarter of 2015. For the first nine months of 2016, net interest income increased $48.2 million or 28% to $219.5 million from the $171.3 million recorded in the first nine months of 2015. After the tax-equivalent adjustment discussed above, net interest income on a tax-equivalent basis totaled $228.9 million during the first nine months of 2016, an increase of $50.2 million or 28% from the $178.7 million recorded during the nine months of 2015. Net interest income in dollars has increased steadily for each of the last sixteen quarters.

Heartland attempts to manage its balance sheet to minimize the effect that a change in interest rates has on its net interest margin. Heartland plans to continue to work toward increasing its earning assets and improving its funding mix through targeted acquisitions and organic growth strategies, which management believes will result in additional net interest income. Heartland believes its net interest income simulations reflect a well-balanced and manageable interest rate position. Approximately 39% of Heartland's





commercial and agricultural loan portfolios consist of floating rate loans that reprice based upon changes in the national prime or LIBOR interest rate. Since nearly 38% of these floating rate loans have interest rate floors that are currently in effect, an upward movement in the national prime interest rate or LIBOR would not have an immediate positive effect on Heartland's interest income. Item 3 of Part I of this Form 10-Q report contains additional information about the results of Heartland's most recent net interest income simulations. Note 7 to the quarterly consolidated financial statements contains a detailed discussion of the derivative instruments Heartland has utilized to manage its interest rate risk.

The following table sets forth certain information relating to Heartland's average consolidated balance sheets and reflects the yield on average earning assets and the cost of average interest bearing liabilities for the periods indicated, in thousands. Dividing income or expense by the average balance of assets or liabilities derives such yields and costs. Average balances are derived from daily balances, and nonaccrual loans and loans held for sale are included in each respective loan category. Assets with tax favorable treatment are evaluated on a tax-equivalent basis assuming a federal income tax rate of 35%. Tax favorable assets generally have lower contractual pre-tax yields than fully taxable assets. A tax-equivalent yield is calculated by adding the tax savings to the interest earned on tax favorable assets and dividing this amount by the average balance of the tax favorable assets.






ANALYSIS OF AVERAGE BALANCES, TAX-EQUIVALENT YIELDS AND RATES(1)
For the Quarters Ended September 30, 2016 and 2015
 
2016
 
2015
 
Average
Balance
 
Interest
 
Rate
 
Average
Balance
 
Interest
 
Rate
Earning Assets
 
 
 
 
 
 
 
 
 
 
 
Securities:
 
 
 
 
 
 
 
 
 
 
 
Taxable
$
1,415,446

 
$
7,917

 
2.23
%
 
$
1,192,259

 
$
5,858

 
1.95
%
Nontaxable(1)
473,152

 
5,719

 
4.81

 
348,760

 
4,733

 
5.38

Total securities
1,888,598

 
13,636

 
2.87

 
1,541,019

 
10,591

 
2.73

Interest bearing deposits
7,026

 
6

 
0.34

 
11,567

 
4

 
0.14

Federal funds sold
1,409

 
1

 
0.28

 
1,032

 
1

 
0.38

Loans:(2)
 
 
 
 
 
 
 
 
 
 
 
Commercial and commercial real estate(1)
3,908,623

 
48,334

 
4.92

 
3,252,610

 
38,802

 
4.73

Residential mortgage
717,374

 
7,248

 
4.02

 
570,117

 
5,848

 
4.07

Agricultural and agricultural real estate(1)
486,008

 
5,719

 
4.68

 
461,144

 
5,525

 
4.75

Consumer
426,083

 
8,256

 
7.71

 
370,308

 
7,384

 
7.91

Fees on loans

 
1,708

 

 

 
1,701

 

Less: allowance for loan losses
(52,261
)
 

 

 
(46,302
)
 

 

Net loans
5,485,827

 
71,265

 
5.17

 
4,607,877

 
59,260

 
5.10

Total earning assets
7,382,860

 
84,908

 
4.58
%
 
6,161,495

 
69,856

 
4.50
%
Nonearning Assets
789,823

 
 
 
 
 
564,701

 
 
 
 
Total Assets
$
8,172,683

 
 
 
 
 
$
6,726,196

 
 
 
 
Interest Bearing Liabilities
 
 
 
 
 
 
 
 
 
 
 
Savings
$
3,697,426

 
$
2,066

 
0.22
%
 
$
2,870,847

 
$
1,565

 
0.22
%
Time, $100,000 and over
399,498

 
813

 
0.81

 
337,163

 
741

 
0.87

Other time deposits
570,445

 
1,122

 
0.78

 
622,110

 
1,461

 
0.93

Short-term borrowings
258,783

 
235

 
0.36

 
362,094

 
228

 
0.25

Other borrowings
298,020

 
3,770

 
5.03

 
298,875

 
3,549

 
4.71

Total interest bearing liabilities
5,224,172

 
8,006

 
0.61
%
 
4,491,089

 
7,544

 
0.67
%
Noninterest Bearing Liabilities
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing deposits
2,171,965

 
 
 
 
 
1,593,298

 
 
 
 
Accrued interest and other liabilities
84,142

 
 
 
 
 
59,712

 
 
 
 
Total noninterest bearing liabilities
2,256,107

 
 
 
 
 
1,653,010

 
 
 
 
Stockholders' Equity
692,404

 
 
 
 
 
582,097

 
 
 
 
Total Liabilities and Stockholders' Equity
$
8,172,683

 
 
 
 
 
$
6,726,196

 
 
 
 
Net interest income, fully taxable equivalent (non-GAAP)(1)
 
 
$
76,902

 
 
 
 
 
$
62,312

 
 
Net interest spread(1)
 
 
 
 
3.97
%
 
 
 
 
 
3.83
%
Net interest income, fully taxable equivalent (non-GAAP) to total earning assets(3)
 
 
 
 
4.14
%
 
 
 
 
 
4.01
%
Interest bearing liabilities to earning assets
70.76
%
 
 
 
 
 
72.89
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Reconciliation of Annualized Net Interest Margin, Fully Taxable Equivalent (non-GAAP)(3)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income, fully taxable equivalent (non-GAAP)
 
 
$
76,902

 
 
 
 
 
$
62,312

 
 
Adjustments for taxable equivalent interest(1)
 
 
(3,221
)
 
 
 
 
 
(2,588
)
 
 
Net interest income (GAAP)
 
 
$
73,681

 
 
 
 
 
$
59,724

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Average Earning Assets
$
7,382,860

 
 
 
 
 
$
6,161,495

 
 
 
 
Annualized net interest margin (GAAP)
 
 
 
 
3.97
%
 
 
 
 
 
3.85
%
Annualized net interest margin, fully taxable equivalent (non-GAAP)
 
 
 
 
4.14
%
 
 
 
 
 
4.01
%
 
 
 
 
 
 
 
 
 
 
 
 
(1) Computed on a taxable equivalent basis using an effective tax rate of 35%
(2) Nonaccrual loans are included in the average loans outstanding.
(3) Annualized net interest margin, fully taxable equivalent is a non-GAAP measure, which adjusts net interest income for the tax-favored status of certain loans and securities. Management believes this measure enhances the comparability of net interest income arising from taxable and tax-exempt sources. This measure should not be considered a substitute for operating results determined in accordance with GAAP.





ANALYSIS OF AVERAGE BALANCES, TAX-EQUIVALENT YIELDS AND RATES(1)
For the Nine Months Ended September 30, 2016 and 2015
 
2016
 
2015
 
Average
Balance
 
Interest
 
Rate
 
Average
Balance
 
Interest
 
Rate
Earning Assets
 
 
 
 
 
 
 
 
 
 
 
Securities:
 
 
 
 
 
 
 
 
 
 
 
Taxable
$
1,464,080

 
$
24,604

 
2.24
%
 
$
1,266,546

 
$
19,729

 
2.08
%
Nontaxable(1)
440,275

 
16,605

 
5.04

 
335,104

 
13,641

 
5.44

Total securities
1,904,355

 
41,209

 
2.89

 
1,601,650

 
33,370

 
2.79

Interest bearing deposits
9,785

 
13

 
0.18

 
10,541

 
11

 
0.14

Federal funds sold
12,509

 
12

 
0.13

 
4,562

 
3

 
0.09

Loans:(2)
 
 
 
 
 
 
 
 
 
 
 
Commercial and commercial real estate(1)
3,840,060

 
141,977

 
4.94

 
3,133,525

 
112,343

 
4.79

Residential mortgage
751,694

 
23,133

 
4.11

 
529,412

 
16,146

 
4.08

Agricultural and agricultural real estate(1)
478,564

 
16,952

 
4.73

 
436,050

 
15,835

 
4.86

Consumer
422,869

 
24,452

 
7.72

 
358,728

 
21,476

 
8.00

Fees on loans
 
 
5,362

 

 
 
 
4,016

 

Less: allowance for loan losses
(50,980
)
 

 

 
(43,856
)
 

 

Net loans
5,442,207

 
211,876

 
5.20

 
4,413,859

 
169,816

 
5.14

Total earning assets
7,368,856

 
253,110

 
4.59
%
 
6,030,612

 
203,200

 
4.50
%
Nonearning Assets
767,636

 
 
 
 
 
572,473

 
 
 
 
Total Assets
$
8,136,492

 
 
 
 
 
$
6,603,085

 
 
 
 
Interest Bearing Liabilities
 
 
 
 
 
 
 
 
 
 
 
Savings
$
3,651,370

 
$
5,988

 
0.22
%
 
$
2,851,506

 
$
5,002

 
0.23
%
Time, $100,000 and over
439,609

 
2,417

 
0.73

 
343,369

 
2,373

 
0.92

Other time deposits
599,745

 
3,790

 
0.84

 
570,446

 
4,383

 
1.03

Short-term borrowings
314,367

 
1,083

 
0.46

 
343,537

 
638

 
0.25

Other borrowings
281,617

 
10,918

 
5.18

 
338,307

 
12,117

 
4.79

Total interest bearing liabilities
5,286,708

 
24,196

 
0.61
%
 
4,447,165

 
24,513

 
0.74
%
Noninterest Bearing Liabilities
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing deposits
2,084,379

 
 
 
 
 
1,531,450

 
 
 
 
Accrued interest and other liabilities
78,093

 
 
 
 
 
58,354

 
 
 
 
Total noninterest bearing liabilities
2,162,472

 
 
 
 
 
1,589,804

 
 
 
 
Stockholders' Equity
687,312

 
 
 
 
 
566,116

 
 
 
 
Total Liabilities and Stockholders' Equity
$
8,136,492

 
 
 
 
 
$
6,603,085

 
 
 
 
Net interest income, fully taxable equivalent (non-GAAP)(1)
 
 
$
228,914

 
 
 
 
 
$
178,687

 
 
Net interest spread(1)
 
 
 
 
3.98
%
 
 
 
 
 
3.76
%
Net interest income, fully taxable equivalent (non-GAAP) to total earning assets(3)
 
 
 
 
4.15
%
 
 
 
 
 
3.96
%
Interest bearing liabilities to earning assets
71.74
%
 
 
 
 
 
73.74
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Reconciliation of Annualized Net Interest Margin, Fully Taxable Equivalent (non-GAAP)(3)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income, fully taxable equivalent (non-GAAP)
 
 
$
228,914

 
 
 
 
 
$
178,687

 
 
Adjustments for taxable equivalent interest(1)
 
 
(9,408
)
 
 
 
 
 
(7,389
)
 
 
Net interest income (GAAP)
 
 
$
219,506

 
 
 
 
 
$
171,298

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Average Earning Assets
$
7,368,856

 
 
 
 
 
$
6,030,612

 
 
 
 
Annualized net interest margin (GAAP)
 
 
 
 
3.98
%
 
 
 
 
 
3.80
%
Annualized net interest margin, fully taxable equivalent (non-GAAP)
 
 
 
 
4.15
%
 
 
 
 
 
3.96
%
 
 
 
 
 
 
 
 
 
 
 
 
(1) Computed on a taxable equivalent basis using an effective tax rate of 35%.
(2) Nonaccrual loans are included in the average loans outstanding.
(3) Annualized net interest margin, fully taxable equivalent is a non-GAAP measure, which adjusts net interest income for the tax-favored status of certain loans and securities. Management believes this measure enhances the comparability of net interest income arising from taxable and tax-exempt sources. This measure should not be considered a substitute for operating results determined in accordance with GAAP.






Provision For Loan Losses

The allowance for loan losses is established through a provision charged to expense to provide, in Heartland management's opinion, an appropriate allowance for loan losses. The provision for loan losses was $5.3 million for the third quarter of 2016 compared to $2.1 million for the second quarter of 2016 and $3.2 million for the third quarter of 2015. Contributing to the lower provision during the second quarter of 2016 was a $2.3 million recovery on a previously charged-off loan. A contributing factor to the higher 2016 third quarter provision for loan losses was a $946,000 allowance for impairment recorded on two agricultural loans at New Mexico Bank & Trust classified as impaired during the quarter. Also affecting the provision for loan losses during the third quarter of 2016 were higher charge-offs at Citizens Finance Co., Heartland's consumer finance company. For the first nine months of 2016, the provision for loan losses was $9.5 million compared to $10.5 million for the first nine months of 2015.

In determining that the allowance for loan losses is appropriate, management uses factors that include the overall composition of the loan portfolio, general economic conditions, types of loans, loan collateral values, past loss experience, loan delinquencies, substandard credits, and doubtful credits. For additional details on the specific factors considered, refer to the discussion of critical accounting policies set forth in Management's Discussion and Analysis of Financial Condition and Results of Operations contained in Heartland's Annual Report on Form 10-K for the year ended December 31, 2015, and under the caption "Allowance For Loan Losses" in this Form 10-Q report. Heartland believes the allowance for loan losses as of September 30, 2016, was at a level commensurate with the overall risk exposure of the loan portfolio. However, if economic conditions should become more unfavorable, certain borrowers may experience difficulty and the level of nonperforming loans, charge-offs and delinquencies could rise and require further increases in the provision for loan losses.

Noninterest Income

The tables below show Heartland's noninterest income for the three- and nine-month periods ended September 30, 2016 and 2015, in thousands:
 
Three Months Ended
September 30,
 
 
 
2016
 
2015
 
Change
 
% Change
Service charges and fees
$
8,278

 
$
6,350

 
$
1,928

 
30
 %
Loan servicing income
873

 
1,368

 
(495
)
 
(36
)
Trust fees
3,689

 
3,507

 
182

 
5

Brokerage and insurance commissions
1,006

 
869

 
137

 
16

Securities gains, net
1,584

 
1,767

 
(183
)
 
(10
)
Net gains on sale of loans held for sale
11,459

 
9,823

 
1,636

 
17

Valuation adjustment on commercial servicing rights
5

 

 
5

 
100

Income on bank owned life insurance
620

 
372

 
248

 
67

Other noninterest income
1,028

 
924

 
104

 
11

  Total noninterest income
$
28,542

 
$
24,980

 
$
3,562

 
14
 %
 
 
Nine Months Ended
September 30,
 
 
 
 
 
2016
 
2015
 
Change
 
% Change
Service charges and fees
$
23,462

 
$
17,654

 
$
5,808

 
33
 %
Loan servicing income
3,433

 
3,572

 
(139
)
 
(4
)
Trust fees
11,127

 
11,051

 
76

 
1

Brokerage and insurance commissions
2,914

 
2,872

 
42

 
1

Securities gains, net
9,732

 
9,230

 
502

 
5

Net gains on sale of loans held for sale
33,794

 
38,164

 
(4,370
)
 
(11
)
Valuation adjustment on commercial servicing rights
(41
)
 

 
(41
)
 
(100
)
Income on bank owned life insurance
1,733

 
1,355

 
378

 
28

Other noninterest income
2,992

 
2,406

 
586

 
24

  Total noninterest income
$
89,146

 
$
86,304

 
$
2,842

 
3
 %






Noninterest income totaled $28.5 million during the third quarter of 2016 compared to $25.0 million during the third quarter of 2015, an increase of $3.6 million or 14%. This increase reflected higher service charges and fees and increased net gains on sale of loans held for sale. For the nine month period ended on September 30, noninterest income totaled $89.1 million during 2016 compared to $86.3 million during 2015, an increase of $2.8 million or 3%. This increase reflected higher service charges and fees, the effect of which was partially offset by decreased net gains on sale of loans held for sale.

Service charges and fees increased $1.9 million or 30% during the third quarter of 2016 compared to the third quarter of 2015 and $5.8 million or 33% during the first nine months of 2016 compared to the first nine months of 2015. Service charges on checking and savings accounts recorded during the third quarter of 2016 were $2.0 million compared to $1.5 million during the third quarter of 2015, an increase of $527,000 or 35%. For the nine months ended September 30, service charges on checking and savings accounts totaled $6.0 million during 2016 compared to $4.4 million during 2015, an increase of $1.6 million or 37%. Overdraft fees were $2.3 million during the third quarter of 2016 compared to $1.9 million during the third quarter of 2015, an increase of $372,000 or 19%. For the nine months ended September 30, overdraft fees totaled $6.3 million during 2016 compared to $5.3 million during 2015, an increase of $1.1 million or 21%. Interchange revenue from activity on bank debit cards, along with surcharges on ATM activity, resulted in service charges and fees of $2.6 million during the third quarter of 2016 compared to $2.2 million during the third quarter of 2015, an increase of $454,000 or 21%. These same fees were $7.5 million during first nine months of 2016 compared to $6.1 million during the first nine months of 2015, an increase of $1.4 million or 24%. These increases were primarily attributable to a larger demand deposit customer base, a portion of which is attributable to the acquisitions completed during the last half of 2015 and first quarter of 2016. Fees associated with credit card services were $1.3 million during the third quarter of 2016 compared to $644,000 during the third quarter of 2015, an increase of $646,000 or 100%. For the first nine months of 2016, these fees were $3.4 million compared to $1.5 million during the first nine months of 2015, an increase of $1.9 million or 124%. Fees for credit card services grew in both 2016 periods, primarily as a result of efforts to increase the level of commercial credit card services provided at Heartland's subsidiary banks, including at the offices of the newly acquired banks in California and Colorado.

Loan servicing income includes the fees collected for the servicing of commercial, agricultural, and mortgage loans, which are dependent upon the aggregate outstanding balances of these loans, rather than quarterly production and sale of these loans. Loan servicing income totaled $873,000 during the third quarter of 2016 compared to $1.4 million during the third quarter of 2015, a decrease of $495,000 or 36%. On a nine-month comparative basis, loan servicing income totaled $3.4 million during the first nine months of 2016 compared to $3.6 million during the first nine months of 2015, a decrease of $139,000 or 4%. Loan servicing income related to the servicing of commercial and agricultural loans totaled $730,000 during the third quarter of 2016 compared to $718,000 during the third quarter of 2015, an increase of $12,000 or 2%. For the first nine months of the year, fees collected for commercial and agricultural loan servicing totaled $2.2 million for both 2016 and 2015. Fees collected for the servicing of mortgage loans, primarily for government sponsored entities, were $3.1 million during the third quarter of 2016 compared to $2.7 million during the third quarter of 2015, an increase of $373,000 or 14%. For the first nine months of the year, fees collected for the servicing of mortgage loans, primarily for government sponsored entities, were $9.0 million during 2016 compared to $7.8 million during 2015, an increase of $1.2 million or 16%. Included in and offsetting loan servicing income is the amortization of capitalized servicing rights, which was $3.4 million during the third quarter of 2016 compared to $2.4 million during the third quarter of 2015, an increase of $970,000 or 40%. For the first nine months of the year, the amortization of capitalized servicing rights was $9.0 million during 2016 compared to $7.2 million during 2015, an increase of $1.8 million or 25%. The portfolio of mortgage loans serviced primarily for government sponsored entities by Heartland totaled $4.26 billion at September 30, 2016, compared to $3.96 billion at September 30, 2015.

The following table summarizes Heartland's residential mortgage loan activity during the most recent five quarters, in thousands:
 
As Of and For the Quarter Ended
 
9/30/2016
 
6/30/2016
 
3/31/2016
 
12/31/2015
 
9/30/2015
Mortgage Servicing Fees
$
3,111

 
$
2,989

 
$
2,931

 
$
2,921

 
$
2,738

Mortgage Servicing Rights Amortization
(2,968
)
 
(2,567
)
 
(2,259
)
 
(2,154
)
 
(2,088
)
  Total Residential Mortgage Loan Servicing Income
$
143

 
$
422

 
$
672

 
$
767

 
$
650

Net Gains On Sale of Residential Mortgage Loans
$
11,061

 
$
10,707

 
$
10,368

 
$
6,789

 
$
8,489

Total Residential Mortgage Loan Applications
$
445,107

 
$
440,907

 
$
406,999

 
$
307,163

 
$
443,294

Residential Mortgage Loans Originated
$
324,337

 
$
324,633

 
$
238,266

 
$
258,939

 
$
370,956

Residential Mortgage Loans Sold
$
315,917

 
$
302,448

 
$
220,381

 
$
260,189

 
$
360,172

Residential Mortgage Loan Servicing Portfolio
$
4,259,459

 
$
4,203,429

 
$
4,112,519

 
$
4,057,861

 
$
3,963,677







Net gains on sale of loans held for sale totaled $11.5 million during the third quarter of 2016 compared to $9.8 million during the third quarter of 2015, an increase of $1.6 million or 17%. During the first nine months of 2016, net gains on sale of loans held for sale totaled $33.8 million compared to $38.2 million during the same period in 2015, a decrease of $4.4 million or 11%. These gains result primarily from the gain or loss on sales of mortgage loans into the secondary market, related fees and fair value marks on the associated derivatives. Mortgage loan applications were $445.1 million in the third quarter of 2016 compared to $443.3 million in the third quarter of 2015, an increase of $1.8 million or less than 1%. During the first nine months of 2016, mortgage loan applications were $1.29 billion compared to $1.71 billion during the same period in 2015, a decrease of $413.2 million or 24%. The volume of mortgage loans sold totaled $315.9 million during the third quarter of 2016, a $44.3 million or 12% decrease from the $360.2 million sold during the third quarter of 2015. During the first nine months of 2016, mortgage loans sold totaled $838.7 million compared to $1.03 billion during the same period in 2015, a decrease of $192.4 million or 19%. These decreases were attributable to the decreasing interest rate environment during the last quarter of 2014 through the second of quarter of 2015 compared to an interest rate environment that remained relatively flat during the last quarter of 2015 and first quarter of 2016. The percentage of residential mortgage loans that represented refinancings was 38% during the third quarter of 2016 compared to 32% in the third quarter of 2015. Net gains on sale of loans held for sale also includes gains on the sale of commercial and agricultural loans, which totaled $398,000 during the third quarter of 2016 compared to $1.0 million during the third quarter of 2015. During the first nine months of 2016, gains on sales of commercial and agricultural loans totaled $1.7 million, compared to $2.0 million during the same period in 2015. An area of emphasis for Heartland's bank subsidiary, Wisconsin Bank & Trust, particularly after the acquisition of the Community Banc-Corp of Sheboygan, Inc. bank branches in January 2015, has been the origination for sale of small business loans written under the United States Small Business Administration and United States Department of Agriculture Rural Development Business and Industry loan programs.

Income on bank owned life insurance increased $248,000 or 67% from $372,000 during the third quarter of 2015 to $620,000 during the same quarter in 2016. For the nine-month period ended September 30, income on bank owned life insurance increased $378,000 or 28% from $1.4 million during 2015 to $1.7 million in 2016. These increases were primarily attributable to the acquisitions completed during the last half of 2015 and first quarter of 2016.

Other noninterest income was $1.0 million during the third quarter of 2016 compared to $924,000 during the third quarter of 2015, an increase of $104,000 or 11%. For the first nine months of 2016, noninterest income totaled $3.0 million during 2016 compared to $2.4 million during the first nine months of 2015, an increase of $586,000 or 24%. The increase during the nine month comparative period was primarily attributable to the reimbursement from a customer for loan workout expenses that had been incurred and paid in prior years.

Noninterest Expenses

The tables below show Heartland's noninterest expenses for the three- and nine-month periods ended September 30, 2016 and 2015, in thousands:
 
Three Months Ended
September 30,
 
 
 
2016
 
2015
 
Change
 
% Change
Salaries and employee benefits
$
40,733

 
$
37,033

 
$
3,700

 
10
 %
Occupancy
5,099

 
4,307

 
792

 
18

Furniture and equipment
2,746

 
2,121

 
625

 
29

Professional fees
5,985

 
5,251

 
734

 
14

FDIC insurance assessments
1,180

 
1,018

 
162

 
16

Advertising
1,339

 
1,327

 
12

 
1

Intangible assets amortization
1,291

 
734

 
557

 
76

Other real estate and loan collection expenses
640

 
496

 
144

 
29

(Gain)/loss on sales/valuations of assets, net
794

 
721

 
73

 
10

Other noninterest expenses
8,620

 
8,988

 
(368
)
 
(4
)
  Total Noninterest Expenses
$
68,427

 
$
61,996

 
$
6,431

 
10
 %
 
 
 
 
 
 
 
 
Efficiency ratio, fully taxable equivalent (non-GAAP)(1)
63.88
%
 
69.85
%
 
 
 
 
 
 
 
 
 
 
 
 
(1) Refer to the "Reconciliation of Non-GAAP Measure-Efficiency Ratio" table that follows for details on this non-GAAP measure.





 
Nine Months Ended
September 30,
 
 
 
2016
 
2015
 
Change
 
% Change
Salaries and employee benefits
$
124,432

 
$
110,522

 
$
13,910

 
13
 %
Occupancy
15,322

 
12,594

 
2,728

 
22

Furniture and equipment
7,301

 
6,403

 
898

 
14

Professional fees
20,481

 
16,544

 
3,937

 
24

FDIC insurance assessments
3,468

 
2,873

 
595

 
21

Advertising
4,174

 
3,841

 
333

 
9

Intangible assets amortization
4,483

 
2,080

 
2,403

 
116

Other real estate and loan collection expenses
1,871

 
1,714

 
157

 
9

(Gain)/loss on sales/valuations of assets, net
1,064

 
2,583

 
(1,519
)
 
(59
)
Other noninterest expenses
27,160

 
25,938

 
1,222

 
5

  Total Noninterest Expenses
$
209,756

 
$
185,092

 
$
24,664

 
13
 %
 
 
 
 
 
 
 
 
Efficiency ratio, fully taxable equivalent (non-GAAP)(1)
66.23
%
 
69.37
%
 
 
 
 
 
 
 
 
 
 
 
 
(1) Refer to the "Reconciliation of Non-GAAP Measure-Efficiency Ratio" table that follows for details on this non-GAAP measure.
Reconciliation of Non-GAAP Measure-Efficiency Ratio
 
For the Three Months Ended
September 30,
 
For the Nine Months Ended
September 30,
 
2016
 
2015
 
2016
 
2015
Net interest income
$
73,681

 
$
59,724

 
$
219,506

 
$
171,298

Taxable equivalent adjustment(1)
3,221

 
2,588

 
9,408

 
7,389

Fully taxable equivalent net interest income
76,902

 
62,312

 
228,914

 
178,687

Noninterest income
28,542

 
24,980

 
89,146

 
86,304

Securities gains, net
(1,584
)
 
(1,767
)
 
(9,732
)
 
(9,230
)
Adjusted income
$
103,860

 
$
85,525

 
$
308,328

 
$
255,761

 
 
 
 
 
 
 
 
Total noninterest expenses
$
68,427

 
$
61,996

 
$
209,756

 
$
185,092

Less:
 
 
 
 
 
 
 
Intangible assets amortization
1,291

 
734

 
4,483

 
2,080

Partnership investment in historic rehabilitation tax credits

 
805

 

 
2,995

(Gain)/loss on sales/valuations of assets, net
794

 
721

 
1,064

 
2,583

Adjusted noninterest expenses
$
66,342

 
$
59,736

 
$
204,209

 
$
177,434

 
 
 
 
 
 
 
 
Efficiency ratio, fully taxable equivalent (non-GAAP)(2)
63.88
%
 
69.85
%
 
66.23
%
 
69.37
%
 
 
 
 
 
 
 
 
(1) Computed on a tax equivalent basis using an effective tax rate of 35%.
(2) Efficiency ratio, fully taxable equivalent, expresses noninterest expenses as a percentage of fully taxable equivalent net interest income and noninterest income. This efficiency ratio is presented on a taxable equivalent basis, which adjusts net interest income and noninterest expenses for the tax favored status of certain loans, securities and historic rehabilitation tax credits. Management believes the presentation of this non-GAAP measure provides supplemental useful information for proper understanding of the financial results as it enhances the comparability of income and expenses arising from taxable and nontaxable sources and excludes specific items, as noted in the table. This measure should not be considered a substitute for operating results determined in accordance with GAAP.

For the third quarter of 2016, noninterest expenses totaled $68.4 million compared to $62.0 million during the third quarter of 2015, an increase of $6.4 million or 10%. For the first nine months of 2016, noninterest expenses totaled $209.8 million compared to $185.1 million during the first nine months of 2015, an increase of $24.7 million or 13%. The categories with the most significant





increases were salaries and employee benefits, occupancy, furniture and equipment, professional fees and intangible assets amortization. These increases were primarily attributable to the recent acquisitions.

One of Heartland's top priorities is to improve its efficiency ratio, on a fully taxable equivalent basis, by reducing it to 65% or less. During the third quarter of 2016, Heartland's efficiency ratio, on a fully taxable equivalent basis, was 63.88% in comparison with 67.95% during the second quarter of 2016, 66.90% during the first quarter of 2016, 68.53% during the fourth quarter of 2015 and 69.85% during the third quarter of 2015. In 2015 and 2016, Heartland has taken steps to improve its efficiency ratio. During the second and third quarters of 2015, management announced the consolidation of two banking centers and the closing of seven under-performing loan production offices. During the first quarter of 2016, management announced the closing of one additional loan production office located outside of Heartland's geographic footprint. Heartland also expects to improve its efficiency ratio by completing systems conversions of acquired banks as soon as possible after the closing dates. The Premier Valley Bank systems conversion was completed during the first quarter of 2016, and the systems conversion for Centennial Bank was completed during the second quarter of 2016. Heartland's efficiency ratio will show variability from quarter to quarter as a result of acquisition activities and also from the seasonality and related revenue and expense mismatches that are inherent in the residential mortgage business.

The largest component of noninterest expenses, salaries and employee benefits, increased $3.7 million or 10% during the third quarter of 2016 as compared to the same quarter in 2015. For the first nine months of 2016 in comparison with the first nine months of 2015, salaries and employee benefits increased $13.9 million or 13%. These increases were primarily attributable to the additional salaries and employee benefits for employees of Premier Valley Bank, which was acquired in the fourth quarter of 2015, and Centennial Bank, which was acquired in the first quarter of 2016. Heartland had total full-time equivalent employees of 1,846 on September 30, 2016, compared to 1,736 on September 30, 2015. Included in the full-time equivalent employees on September 30, 2016, were approximately 67 employees at Premier Valley Bank and 100 employees at Centennial Bank. The closing of out-of-footprint mortgage loan production offices resulted in a reduction of approximately 45 full-time equivalent employees during the first quarter of 2016.

Occupancy expense increased $792,000 or 18% during the third quarter of 2016 compared to the third quarter of 2015 and $2.7 million or 22% during the first nine months of 2016 compared to the first nine months of 2015. These increases were primarily attributable to the acquisitions completed during the last half of 2015 and first quarter of 2016.

Furniture and equipment expense increased $625,000 or 29% during the third quarter of 2016 compared to the third quarter of 2015 and $898,000 or 14% during the first nine months of 2016 compared to the first nine months of 2015. These increases were primarily attributable to the acquisitions completed during the last half of 2015 and first quarter of 2016.

Professional fees increased $734,000 or 14% during the third quarter of 2016 compared to the third quarter of 2015 and $3.9 million or 24% during the first nine months of 2016 compared to the first nine months of 2015, primarily a result of additional services provided to Heartland by third-party advisors, including services performed in connection with acquisitions.

Intangible assets amortization increased $557,000 or 76% during the third quarter of 2016 compared to the third quarter of 2015 and $2.4 million or 116% during the first nine months of 2016 compared to the first nine months of 2015 as a result of the acquisitions completed during the last half of 2015 and first quarter of 2016.

Net losses on sales/valuation of assets was $794,000 for the third quarter of 2016 compared to $721,000 for the third quarter of 2015, an increase of $73,000 or 10%. For the first nine months of 2016, net losses on sales/valuation of assets were $1.1 million compared to $2.6 million during the first nine months of 2015, a decrease of $1.5 million or 59%. During the second quarter of 2016, gain/loss on sales/valuation of assets, net included a $415,000 gain resulting from the condemnation by the Wisconsin Department of Transportation of real property owned by Wisconsin Bank & Trust. For the first nine months of 2016, exclusive of the gain on disposition of the condemned land, net losses on sales/valuations of assets was $1.5 million compared to $2.6 million during the first nine months of 2015, a decrease of $1.1 million or 43%.

For the third quarter of 2016, other noninterest expenses decreased $368,000 or 4% over the third quarter of 2015. Included in other noninterest expenses for the third quarter of 2015 was $805,000 in costs associated with a partnership investment in a commercial and residential real estate project which qualified for historic rehabilitation tax credits. These credits were included as a reduction to income tax expense as further described in the Income Taxes section below. Excluding the effect of the cost associated with the tax credit investment, other noninterest expenses increased $437,000 or 5% for the third quarter of 2016 in comparison with the third quarter of 2015 and $2.0 million or 8% for the first nine months of 2016 in comparison with the first nine months of 2015. These increases were primarily a result of additional investments in technology and initial and ongoing costs associated with Heartland's acquisitions.






Income Taxes

Heartland's effective tax rate was 29.02% for the third quarter of 2016 compared to 25.32% for the third quarter of 2015. Included in the determination of Heartland's income taxes for the third quarter of 2015 were federal historic rehabilitation tax credits totaling $1.1 million associated with Heartland's ownership interest in a qualifying real estate project. Federal low-income housing tax credits included in the determination of Heartland's income taxes totaled $304,000 during the third quarter of 2016 compared to $145,000 during the third quarter of 2015. Heartland's effective tax rate was also affected by the level of tax-exempt interest income which, as a percentage of pre-tax income, was 21.01% during the third quarter of 2016 compared to 24.61% during the third quarter of 2015.

Heartland's effective tax rate was 31.55% for the first nine months of 2016 compared to 26.67% for the first nine months of 2015. Included in the determination of Heartland's income taxes for the first nine months of 2015 were the $4.0 million federal historic rehabilitation tax credits referred to above. Federal low-income housing tax credits included in the determination of Heartland's income taxes totaled $912,000 during the first nine months of 2016 compared to $435,000 during the first nine months of 2015. Tax-exempt interest income as a percentage of pre-tax income was 19.55% during the first nine months of 2016 compared to 22.14% during the first nine months of 2015.

Segment Reporting

Heartland has two reportable segments: community and other banking and retail mortgage banking. Revenues from community and other banking operations consist primarily of interest earned on loans and investment securities, fees from deposit and ancillary services and net security gains. Retail mortgage banking operating revenues consist of interest earned on mortgage loans held for sale, gains on sale of mortgage loans into the secondary market, the servicing of mortgage loans for various investors and loan origination fee income. See Note 9 to our consolidated financial statements for further information regarding our segment reporting.

Income before taxes for the community and other banking segment for the third quarter of 2016 was $26.7 million compared to $21.8 million for the third quarter of 2015, a $4.9 million or 23% increase. For the first nine months of 2016, income before taxes for the community and other banking segment was $85.0 million compared to $59.5 million for the first nine months of 2015, a $25.5 million or 43% increase. These increases resulted primarily from increased net interest income and noninterest income, the effect of which was partially offset by increased noninterest expenses.

Net interest income from the community and other banking segment was $72.7 million during the third quarter of 2016 compared to $58.1 million during the third quarter of 2015, a $14.6 million or 25% improvement. For the first nine months of 2016, net interest income from the community and other banking segment was $216.2 million compared to $167.0 million for the first nine months of 2015, an increase of $49.2 million or 29%. These increases in net interest income were primarily a result of additional earning assets from the four acquisitions completed during 2015 and the CIC Bancshares, Inc. acquisition completed during the first quarter of 2016, combined with strong loan growth experienced during the last half of 2015.

Provision for loan losses allocable to the community and other banking segment was $5.3 million for the third quarter of 2016 compared to $3.2 million during the third quarter of 2015. A contributing factor to the higher provision for loan losses during the third quarter of 2016 was a $946,000 allowance for impairment recorded on two agricultural loans at New Mexico Bank & Trust classified as impaired during the quarter. Also affecting the provision for loan losses during the third quarter of 2016 were higher charge-offs at Citizens Finance Co., Heartland's consumer finance company. For the first nine months of 2016, the provision for loan losses allocable to the community and other banking segment was $9.5 million compared to $10.5 million for the first nine months of 2015. Contributing to the decrease for the first nine months of 2016 was a $2.3 million recovery on a previously charged-off loan recorded during the second quarter of 2016.

Noninterest income allocable to the community and other banking segment totaled $17.3 million during the third quarter of 2016 compared to $16.0 million during the third quarter of 2015, an increase of $1.3 million or 8%. For the first nine months of 2016, noninterest income allocable to the community and other banking segment totaled $55.8 million compared to $48.7 million during 2015, an increase of $7.1 million or 15%. These increases were primarily a result of increased service charges and fees.

Noninterest expenses allocable to the community and other banking segment totaled $58.0 million during the third quarter of 2016 compared to $49.2 million during the third quarter of 2015, an increase of $8.8 million or 18%. For the first nine months of 2016, noninterest expenses allocable to the community and other banking segment totaled $177.4 million compared to $145.6 million during 2015, an increase of $31.8 million or 22%. These increases were primarily a result of Heartland's recent acquisitions.

The retail mortgage banking segment recorded income before taxes of $1.8 million for the third quarter of 2016 compared to a loss before taxes of $2.3 million for the third quarter of 2015, an increase of $4.0 million or 177%. For the first nine months of





2016, the retail mortgage banking segment recorded income before taxes of $4.4 million compared to $2.4 million during the first nine months of 2015, an increase of $1.9 million or 79%. Noninterest income from the retail mortgage banking segment totaled $11.2 million during the third quarter of 2016 compared to $9.0 million during the third quarter of 2015, a $2.2 million or 25% increase. For the first nine months of 2016, noninterest income from the retail mortgage banking segment totaled $33.4 million compared to $37.6 million during the first nine months of 2015, a $4.3 million or 11% decrease. Retail mortgage banking income results primarily from net gains on sale of mortgage loans into the secondary market, related fees and fair value marks on the associated derivatives. Mortgage loan applications were $445.1 million in the third quarter of 2016 compared to $443.3 million in the third quarter of 2015, an increase of $1.8 million or less than 1%. During the first nine months of 2016, mortgage loan applications were $1.29 billion compared to $1.71 billion during the same period in 2015, a decrease of $413.2 million or 24%. The volume of mortgage loans sold totaled $315.9 million during the third quarter of 2016, a $44.3 million or 12% decrease from the $360.2 million sold during the third quarter of 2015. During the first nine months of 2016, mortgage loans sold totaled $838.7 million compared to $1.03 billion during the same period in 2015, a decrease of $192.4 million or 19%. These decreases were attributable to the decreasing interest rate environment during the last quarter of 2014 through the second of quarter of 2015 compared to an interest rate environment that remained relatively flat during the last quarter of 2015 and first quarter of 2016.

Noninterest expenses allocable to the retail mortgage banking segment were $10.4 million during the third quarter of 2016 compared to $12.8 million during the third quarter of 2015, a decrease of $2.4 million or 19%. For the first nine months of 2016, noninterest expenses allocable to the retail mortgage banking segment were $32.3 million compared to $39.5 million during the first nine months of 2015, a decrease of $7.1 million or 18%. During 2015, management refined its strategy with respect to its retail mortgage banking business by emphasizing growth in this line of business in bank subsidiary locations instead of out-of-footprint locations. To implement this strategy, seven under-performing mortgage loan production offices were closed during the second and third quarters of 2015, and an additional closure was announced during the first quarter of 2016. Lower expenses are attributed to reduced transaction-based compensation to mortgage banking personnel as a result of the lower volume of residential mortgage loans underwritten during the first nine months of 2016 in comparison with first nine months of 2015. The office closures also contributed to the reduction in noninterest expenses during the first nine months of 2016 in comparison with the first nine months of 2015.

FINANCIAL CONDITION

Total assets were $8.20 billion at September 30, 2016, an increase of $507.5 million or 7% since year-end 2015. Included in this growth, at fair value, was $772.6 million of assets acquired in the CIC Bancshares, Inc. transaction.

Lending Activities

Total net loans held to maturity were $5.44 billion at September 30, 2016, compared to $5.00 billion at year-end 2015, an increase of $437.2 million or 9%. This increase includes $581.5 million of total loans held to maturity, at fair value, acquired in the CIC Bancshares, Inc. transaction. Exclusive of this transaction, total loans held to maturity decreased $43.5 million during the third quarter of 2016, $20.7 million during the second quarter of 2016 and $80.0 million during the first quarter of 2016. Some of the downward trend during the first nine months of 2016 was driven by a slowdown in demand in Heartland's markets which are highly competitive and where high quality clients require significant cultivation. Additionally, Heartland has placed a higher emphasis on commercial and industrial loans instead of commercial real estate loans.






The table below presents the composition of the loan portfolio as of September 30, 2016, and December 31, 2015, in thousands:
LOAN PORTFOLIO
September 30, 2016
 
December 31, 2015
 
Amount
 
Percent
 
Amount
 
Percent
Loans receivable held to maturity:
 
 
 
 
 
 
 
Commercial
$
1,295,316

 
23.81
%
 
$
1,279,214

 
25.56
%
Commercial real estate
2,605,296

 
47.88

 
2,326,360

 
46.50
%
Agricultural and agricultural real estate
489,387

 
8.99

 
471,870

 
9.43

Residential mortgage
625,965

 
11.50

 
539,555

 
10.78

Consumer
425,582

 
7.82

 
386,867

 
7.73

Gross loans receivable held to maturity
5,441,546

 
100.00
%
 
5,003,866

 
100.00
%
Unearned discount
(721
)
 
 
 
(488
)
 
 
Deferred loan fees
(2,110
)
 
 
 
(1,892
)
 
 
Total net loans receivable held to maturity
5,438,715

 
 
 
5,001,486

 
 
Allowance for loan losses
(54,653
)
 
 
 
(48,685
)
 
 
Loans receivable, net
$
5,384,062

 
 
 
$
4,952,801

 



Loans secured by real estate, either fully or partially, totaled $3.66 billion or 67% of gross loans at September 30, 2016. Excluding purchase accounting valuations, of the properties securing non-farm, nonresidential real estate loans, 54% are owner occupied. The largest categories of Heartland's real estate secured loans at September 30, 2016, and December 31, 2015, are listed below, in thousands:
LOANS SECURED BY REAL ESTATE
 
September 30, 2016
 
December 31, 2015
Residential real estate, excluding residential construction and residential lot loans
$
1,057,902

 
$
849,296

Industrial, manufacturing, business and commercial
495,982

 
429,891

Agriculture
249,548

 
255,345

Retail
347,390

 
239,975

Office
374,624

 
275,289

Land development and lots
131,311

 
122,551

Hotel, resort and hospitality
148,122

 
115,083

Multi-family
173,636

 
179,243

Food and beverage
105,207

 
90,339

Warehousing
114,607

 
82,356

Health services
150,226

 
101,961

Residential construction
153,819

 
97,205

All other
171,684

 
164,255

Loans acquired in the quarter

 
318,797

Purchase accounting valuations
(17,863
)
 
(20,994
)
Total loans secured by real estate
$
3,656,195

 
$
3,300,592


Allowance For Loan Losses

The process utilized by Heartland to determine the appropriateness of the allowance for loan and losses is considered a critical accounting practice for Heartland and has remained consistent over the past several years. The allowance for loan losses represents management's estimate of identified and unidentified probable losses in the existing loan portfolio. For additional details on the specific factors considered in determining the allowance for loan losses, refer to the critical accounting policies section of our Annual Report on Form 10-K for the year ended December 31, 2015.

Nonperforming loans were $57.9 million or 1.06% of total loans at September 30, 2016, compared to $39.7 million or 0.79% of total loans at December 31, 2015, an increase of $18.2 million or 46%. Exclusive of $1.6 million of nonperforming loans acquired in the CIC Bancshares, Inc. transaction, nonperforming loans increased $16.7 million or 42% since year-end 2015. Contributing





to this increase was a $9.8 million agribusiness relationship at Dubuque Bank and Trust Company which is in the collection process. Based upon a current valuation of the collateral securing this loan relationship, no loss is anticipated on this credit. The increase in nonperforming loans during the first nine months of 2016 was also attributable to the loan portfolios of Heartland's recently acquired banks. Heartland's special assets group continues to work with these borrowers to obtain an appropriate resolution of these nonperforming loans. At September 30, 2016, approximately $23.2 million or 40% of Heartland's nonperforming loans had individual loan balances exceeding $1.0 million and represented loans to an aggregate of eight borrowers. The portion of Heartland's nonperforming loans covered by government guarantees was $13.9 million at September 30, 2016, and $8.9 million at December 31, 2015.

The allowance for loan losses at September 30, 2016, was 1.00% of loans and 94.39% of nonperforming loans compared to 0.97% of loans and 122.77% of nonperforming loans at December 31, 2015. The decrease in the allowance for loan losses as a percent of nonperforming loans at September 30, 2016, in comparison with December 31, 2015, was the result of an increase in nonperforming loans as discussed above. Management does not believe the increase in nonperforming loans represents a trend for Heartland for the following reasons: (1) the new nonperforming agribusiness relationship discussed above demonstrated no impairment at September 30, 2016; (2) $8.6 million of nonperforming retail loans subject Heartland to minimal loss exposure due to government guarantees; and (3) most of the balance of the increase in nonperforming loans are contained in the loan portfolios of the banks recently acquired by Heartland, which are covered by purchase accounting adjustments. At September 30, 2016, these purchase accounting adjustments totaled $28.5 million and covered $1.07 billion of acquired loans. At December 31, 2015, these purchase accounting adjustments totaled $28.7 million and covered $811.0 million of acquired loans. Excluding those loans covered by the purchase accounting adjustments, the allowance to loans ratio was 1.23% at September 30, 2016, and 1.15% at December 31, 2015.

Loans delinquent 30 to 89 days as a percent of total loans was 0.40% at September 30, 2016, in comparison with 0.31% at December 31, 2015.

The tables below present the changes in the allowance for loan losses during the three- and nine-month periods ended September 30, 2016 and 2015, in thousands:
ANALYSIS OF ALLOWANCE FOR LOAN LOSSES
Three Months Ended
September 30,
 
2016
 
2015
Balance at beginning of period
$
51,756

 
$
45,614

Provision for loan losses
5,328

 
3,181

Recoveries on loans previously charged off
852

 
749

Charge-offs on loans not covered by loss share agreements
(3,283
)
 
(2,439
)
Balance at end of period
$
54,653

 
$
47,105

Annualized ratio of net charge offs to average loans
0.17
%
 
0.14
%
 
 
 
 
 
Nine Months Ended
September 30,
 
2016
 
2015
Balance at beginning of period
$
48,685

 
$
41,449

Provision for loan losses
9,513

 
10,526

Recoveries on loans previously charged off
4,294

 
2,307

Charge-offs on loans
(7,839
)
 
(7,177
)
Balance at end of period
$
54,653

 
$
47,105

Annualized ratio of net charge offs to average loans
0.09
%
 
0.15
%






The table below presents the amounts of nonperforming loans and other nonperforming assets on the dates indicated, in thousands:
NONPERFORMING ASSETS
September 30,
 
December 31,
 
2016
 
2015
 
2015
 
2014
Not covered under loss share agreements:
 
 
 
 
 
 
 
Nonaccrual loans
$
57,799

 
$
32,577

 
$
39,655

 
$
25,070

Loans contractually past due 90 days or more
105

 
1,181

 

 

Total nonperforming loans
57,904

 
33,758

 
39,655

 
25,070

Other real estate
10,740

 
17,041

 
11,524

 
19,016

Other repossessed assets
821

 
626

 
485

 
445

Total nonperforming assets not covered under loss share agreements
$
69,465

 
$
51,425

 
$
51,664

 
$
44,531

Covered under loss share agreements:
 
 
 
 
 
 
 
Nonaccrual loans
$

 
$

 
$

 
$
278

Total nonperforming assets covered under loss share agreements
$

 
$

 
$

 
$
278

Performing troubled debt restructured loans(1)
$
10,281

 
$
10,154

 
$
11,075

 
$
12,133

Nonperforming loans not covered under loss share agreements to total loans
1.06
%
 
0.73
%
 
0.79
%
 
0.65
%
Nonperforming assets not covered under loss share agreements to total loans plus repossessed property
1.27
%
 
1.10
%
 
1.03
%
 
1.14
%
Nonperforming assets not covered under loss share agreements to total assets
0.85
%
 
0.76
%
 
0.67
%
 
0.74
%
 
 
 
 
 
 
 
 
(1) Represents accruing troubled debt restructured loans performing according to their restructured terms.

The schedules below summarize the changes in Heartland's nonperforming assets during the third quarter of 2016 and the first nine months of 2016, in thousands:
 
Nonperforming
Loans
 
Other
Real Estate
Owned
 
Other
Repossessed
Assets
 
Total
Nonperforming
Assets
June 30, 2016
$
57,053

 
$
11,003

 
$
564

 
$
68,620

Loan foreclosures
(619
)
 
598

 
21

 

Net loan charge-offs
(2,431
)
 

 

 
(2,431
)
Acquired nonperforming assets

 

 

 

New nonperforming loans
10,884

 

 

 
10,884

Reduction of nonperforming loans(1)
(6,983
)
 

 

 
(6,983
)
OREO/Repossessed assets sales proceeds

 
(341
)
 
(2
)
 
(343
)
OREO/Repossessed assets writedowns, net

 
(520
)
 
(1
)
 
(521
)
Net activity at Citizens Finance Co.

 

 
239

 
239

September 30, 2016
$
57,904

 
$
10,740

 
$
821

 
$
69,465

 
 
 
 
 
 
 
 
(1) Includes principal reductions and transfers to performing status.






 
Nonperforming
Loans
 
Other
Real Estate
Owned
 
Other
Repossessed
Assets
 
Total
Nonperforming
Assets
December 31, 2015
$
39,655

 
$
11,524

 
$
485

 
$
51,664

Loan foreclosures
(1,978
)
 
1,944

 
34

 

Net loan charge-offs
(3,545
)
 

 

 
(3,545
)
Acquired nonperforming assets
1,582

 
1,934

 

 
3,516

New nonperforming loans
43,049

 

 

 
43,049

Reduction of nonperforming loans(1)
(20,859
)
 

 

 
(20,859
)
OREO/Repossessed assets sales proceeds

 
(3,594
)
 
(78
)
 
(3,672
)
OREO/Repossessed assets writedowns, net

 
(1,068
)
 
28

 
(1,040
)
Net activity at Citizens Finance Co.

 

 
352

 
352

September 30, 2016
$
57,904

 
$
10,740

 
$
821

 
$
69,465

 
 
 
 
 
 
 
 
(1) Includes principal reductions and transfers to performing status.

Securities

The composition of Heartland's securities portfolio is managed to maximize the return on the portfolio while considering the impact it has on Heartland's asset/liability position and liquidity needs. Securities represented 24% of total assets at both September 30, 2016 and December 31, 2015. Total available for sale securities as of September 30, 2016, were $1.66 billion, an increase of $77.3 million or 5% from $1.58 billion at December 31, 2015.

The table below presents the composition of the securities portfolio, including trading, available for sale and held to maturity securities, by major category, as of September 30, 2016, and December 31, 2015, in thousands:
SECURITIES PORTFOLIO COMPOSITION
September 30, 2016
 
December 31, 2015
 
Amount
 
Percent
 
Amount
 
Percent
U.S. government corporations and agencies
$
4,955

 
0.26
%
 
$
25,766

 
1.37
%
Mortgage-backed securities
1,275,093

 
65.61

 
1,247,071

 
66.37

Obligation of states and political subdivisions
627,409

 
32.29

 
570,730

 
30.37

Corporate debt securities

 

 
846

 
0.05

Equity securities
13,541

 
0.70

 
13,138

 
0.70

Other securities
22,082

 
1.14

 
21,443

 
1.14

Total securities
$
1,943,080

 
100.00
%
 
$
1,878,994

 
100.00
%

The percentage of Heartland's securities portfolio comprised of mortgage-backed securities was 66% at both September 30, 2016, and December 31, 2015. Approximately 77% of Heartland's mortgage-backed securities were issued by government-sponsored enterprises at September 30, 2016. Heartland's securities portfolio had an expected modified duration of 4.2 years as of September 30, 2016, compared to 4.1 years at year-end 2015.

The Volcker Rule, which is scheduled to be fully implemented in 2017, prohibits insured depository institutions and their holding companies from engaging in proprietary trading except in limited circumstances, and prohibits them from owning equity interests in excess of 3% of Tier 1 Capital in private equity and hedge funds. The Volcker Rule will not have a material impact on Heartland’s investment securities portfolio.

At September 30, 2016, Heartland had $22.1 million of other securities, including capital stock in each Federal Home Loan Bank ("FHLB") of which each of its bank subsidiaries is a member. All of these securities were classified as other securities held at cost.

Deposits

Total deposits were $6.91 billion as of September 30, 2016, compared to $6.41 billion at year-end 2015, an increase of $506.9 million or 8%.






The table below presents, in thousands, the composition of Heartland's deposits by category as of September 30, 2016, and December 31, 2015:
DEPOSITS
September 30, 2016
 
December 31, 2015
 
Amount
 
Percent
 
Amount
 
Percent
Demand
$
2,238,736

 
32.39
%
 
$
1,914,141

 
29.88
%
Savings
3,753,300

 
54.29

 
3,367,479

 
52.57

Time
920,657

 
13.32

 
1,124,203

 
17.55

Total
$
6,912,693

 
100.00
%
 
$
6,405,823

 
100.00
%

The increase in deposits includes $648.1 million of deposits, at fair value, acquired in the CIC Bancshares, Inc. transaction. Excluding deposits acquired in this transaction, total deposits increased $75.1 million during the third quarter of 2016, decreased $86.8 million during the second quarter of 2016 and decreased $129.6 million during the first quarter of 2016. Demand deposits totaled $2.24 billion at September 30, 2016, an increase of $324.6 million or 17% since year-end 2015, with $164.3 million of the increase attributable to the CIC Bancshares, Inc. transaction. Excluding demand deposits acquired in this transaction, demand deposits increased $88.8 million during the third quarter of 2016, $70.4 million during the second quarter of 2016 and $1.1 million during the first quarter of 2016. Deposit composition continued to reflect a favorable mix with demand deposits at 32% of total deposits, savings deposits at 54% and time deposits at 13% at September 30, 2016, compared to demand deposits at 30% of total deposits, savings deposits at 53% and time deposits at 17% of total deposits at December 31, 2015. Contributing to the improvement in deposit mix were decreases in the level of time deposits, which decreased $75.2 million during the third quarter of 2016, $146.5 million during the second quarter of 2016 and $131.4 million during the first quarter of 2016 when excluding the $149.5 million of time deposits acquired in the CIC Bancshares, Inc. transaction. This trend of reduced time deposits is partially a result of management's focus on building its demand and savings deposit customer base. Heartland does not plan to offer highly competitive interest rates on time deposits except to customers with which it has significant banking relationships. The decrease in time deposits during the first nine months of 2016 included the reduction in brokered time deposits which decreased $134.1 million or 70% from $190.7 million at December 31, 2015, to $56.6 million at September 30, 2016.

Short-Term Borrowings

Short-term borrowings, which Heartland defines as borrowings with an original maturity of one year or less, were as follows as of September 30, 2016, and December 31, 2015, in thousands:
 
September 30, 2016
 
December 31, 2015
Securities sold under agreement to repurchase
$
182,573

 
$
253,673

Federal funds purchased
2,700

 
14,125

Advances from the FHLB
23,500

 
11,100

Notes payable to unaffiliated banks

 
15,000

Other short-term borrowings
5,332

 

Total
$
214,105


$
293,898


Short-term borrowings generally include federal funds purchased, securities sold under agreements to repurchase, short-term FHLB advances and discount window borrowings from the Federal Reserve Bank. These funding alternatives are utilized in varying degrees depending on their pricing and availability. All of Heartland's bank subsidiaries own FHLB stock in one of the Chicago, Dallas, Des Moines, San Francisco or Topeka FHLBs, enabling them to borrow funds from their respective FHLB for short- or long-term purposes under a variety of programs. The amount of short-term borrowings of Heartland's bank subsidiaries was $214.1 million at September 30, 2016, compared to $293.9 million at year-end 2015, a decrease of $79.8 million or 27%. Short-term FHLB advances of $23.5 million were included in short-term borrowings at September 30, 2016, in comparison with $11.1 million at December 31, 2015.

All of the Heartland bank subsidiaries provide retail repurchase agreements to their customers as a cash management tool, which sweep excess funds from demand deposit accounts into these agreements. This source of funding does not increase the bank's reserve requirements. Although the aggregate balance of these retail repurchase agreements is subject to variation, the account relationships represented by these balances are principally local. The balances of retail repurchase agreements were $182.6 million at September 30, 2016, compared to $253.7 million at December 31, 2015.






Also included in short-term borrowings is a $20.0 million revolving credit line Heartland has with an unaffiliated bank, primarily to provide liquidity to Heartland. No balance was outstanding on this line at September 30, 2016, and a balance of $15.0 million was outstanding on this line at December 31, 2015.

Other Borrowings

The outstanding balances of other borrowings, which Heartland defines as borrowings with an original maturity date of more than one year, are shown in the table below, net of discount and issuance costs amortization, in thousands, as of September 30, 2016, and December 31, 2015:
 
September 30, 2016
 
December 31, 2015
Advances from the FHLB
$
12,044

 
$
17,242

Wholesale repurchase agreements
30,000

 
30,000

Trust preferred securities
115,143

 
114,877

Senior notes
16,000

 
16,000

Note payable to unaffiliated bank
38,667

 
8,947

Contracts payable for purchase of real estate and other assets
2,346

 
2,434

Subordinated notes
79,739

 
73,714

Convertible debt
554

 

Total
$
294,493


$
263,214


Other borrowings include all debt arrangements Heartland and its subsidiaries have entered into with original maturities that extend beyond one year, including long-term FHLB borrowings, borrowings under term notes, subordinated notes and senior notes, convertible debt, and obligations under trust preferred capital securities. As of September 30, 2016, the amount of other borrowings was $294.5 million, an increase of $31.3 million or 12% since year-end 2015.

Long-term FHLB borrowings with an original term of more than one year totaled $12.0 million at September 30, 2016, compared to $17.2 million at December 31, 2015, a decrease of $5.2 million or 30%. Total long-term FHLB borrowings at September 30, 2016, had an average rate of 2.31% and an average maturity of 2.6 years.

Structured wholesale repurchase agreements totaled $30.0 million at both September 30, 2016, and December 31, 2015. These wholesale repurchase agreements mature in 2018.

In April 2011, Heartland obtained a $15.0 million amortizing term loan from an unaffiliated bank with a maturity date of April 20, 2016. At maturity, this amortizing term loan was repaid with an advance on Heartland's non-revolving credit line. The outstanding balance on this amortizing term loan was $8.9 million at December 31, 2015.

In addition to the revolving credit line described above, Heartland entered into another non-revolving credit facility with the same unaffiliated bank on December 15, 2015, which provided a borrowing capacity not to exceed $50.0 million when combined with the outstanding balance on its then existing amortizing term loan with the same unaffiliated bank. On July 20, 2016, the borrowing capacity on this non-revolving credit facility was increased by $25.0 million. At September 30, 2016, $38.7 million was outstanding on this non-revolving credit line compared to no balance outstanding at December 31, 2015. Any outstanding balance on the non-revolving credit line is due in April 2021.

Heartland had senior notes totaling $16.0 million outstanding at both September 30, 2016, and December 31, 2015, and subordinated notes totaling $79.7 million outstanding at September 30, 2016, and $73.7 million at December 31, 2015. Effective with the acquisition of CIC Bancshares, Inc. on February 5, 2016, Heartland assumed $2.0 million of subordinated convertible notes and $6.0 million of subordinated debentures. During the third quarter of 2016, $1.4 million of the subordinated convertible notes were converted into 52,914 shares of Heartland common stock.






A schedule of Heartland's trust preferred securities outstanding as of September 30, 2016, is as follows, in thousands:
 
Amount
Issued
 
Issuance
Date
 
Interest
Rate
 
Interest
Rate as of
9/30/16(1)
 
Maturity
Date
 
Callable
Date
Heartland Financial Statutory Trust IV
$
25,774

 
03/17/2004
 
2.75% over LIBOR
 
3.61%(2)
 
03/17/2034
 
12/17/2016
Heartland Financial Statutory Trust V
20,619

 
01/27/2006
 
1.33% over LIBOR
 
2.01%(3)
 
04/07/2036
 
01/07/2017
Heartland Financial Statutory Trust VI
20,619

 
06/21/2007
 
6.75%
 
6.75%(4)
 
09/15/2037
 
12/15/2016
Heartland Financial Statutory Trust VII
20,619

 
06/26/2007
 
1.48% over LIBOR
 
2.32%(5)
 
09/01/2037
 
12/01/2016
Morrill Statutory Trust I
8,782

 
12/19/2002
 
3.25% over LIBOR
 
4.11%(6)
 
12/26/2032
 
12/26/2016
Morrill Statutory Trust II
8,392

 
12/17/2003
 
2.85% over LIBOR
 
3.71%(7)
 
12/17/2033
 
12/17/2016
Sheboygan Statutory Trust I
6,243

 
9/17/2003
 
2.95% over LIBOR
 
3.81%
 
09/17/2033
 
12/17/2016
CBNM Capital Trust I
4,247

 
9/10/2004
 
3.25% over LIBOR
 
4.10%
 
12/15/2034
 
12/15/2016
 
$
115,295

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1) Effective weighted average interest rate as of September 30, 2016, was 4.97% due to interest rate swap transactions on the variable rate securities as discussed in Note 7 to Heartland's consolidated financial statements.
(2) Effective interest rate as of September 30, 2016, was 5.01% due to an interest rate swap transaction as discussed in Note 7 to Heartland's consolidated financial statements.
(3) Effective interest rate as of September 30, 2016, was 4.69% due to an interest rate swap transaction as discussed in Note 7 to Heartland's consolidated financial statements.
(4) Interest rate is fixed at 6.75% through June 15, 2017, then resets to 1.48% over LIBOR for the remainder of the term.
(5) Effective interest rate as of September 30, 2016, was 4.70% due to an interest rate swap transaction as discussed in Note 7 to Heartland's consolidated financial statements.
(6) Effective interest rate as of September 30, 2016, was 4.92% due to an interest rate swap transaction as discussed in Note 7 to Heartland's consolidated financial statements.
(7) Effective interest rate as of September 30, 2016, was 4.51% due to an interest rate swap transaction as discussed in Note 7 to Heartland's consolidated financial statements.

CAPITAL REQUIREMENTS

Bank regulatory agencies have adopted capital standards by which all bank holding companies are evaluated, including requirements to maintain certain core capital amounts included as Tier 1 capital at minimum levels relative to total assets (the "Tier 1 Leverage Capital Ratio") and at minimum levels relative to "risk-weighted assets" which are calculated by assigning value to assets, and off balance sheet commitments, based on their risk characteristics (the "Tier 1 Risk-Based Capital Ratio"), and to maintain total capital at minimum levels relative to risk-weighted assets (the "Total Risk-Based Capital Ratio"). Starting in 2015, bank holding companies became subject to a new Common Equity Tier 1 Capital Ratio, an increased Tier 1 Leverage Capital Ratio and an increased Tier 1 Risk-Based Capital Ratio under the Basel III rules and are required to include in Common Equity Tier 1 capital the effects of other comprehensive income adjustments, such as gains and losses on securities held to maturity, that were previously excluded from the definition of Tier 1 capital, but were allowed to make a one-time election not to include those effects. Heartland and its bank subsidiaries have been, and will continue to be, managed so they meet the well-capitalized requirements under the regulatory framework for prompt corrective action and have made the one-time election to exclude the effects of other comprehensive income adjustments on their Tier 1 capital.

Under the Basel III rules, the requirements to be categorized as well-capitalized was established at 6.5% for the Common Equity Tier 1 Capital Ratio, and changed from 4% to 5% for the Tier 1 Leverage Capital Ratio, from 6% to 8% for the Tier 1 Risk-Based Capital Ratio and remained at 10% for the Total Risk-Based Capital Ratio. The most recent notification from the Federal Deposit Insurance Corporation categorized Heartland and each of its bank subsidiaries 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 each institution's category.






Heartland's capital ratios are calculated in accordance with Federal Reserve instructions and are required regulatory financial measures. Heartland's capital ratios were as follows for the dates indicated, in thousands:
CAPITAL RATIOS
September 30, 2016
 
December 31, 2015
 
Amount
 
Ratio
 
Amount
 
Ratio
Risk-Based Capital Ratio
 
 
 
 
 
 
 
Tier 1 capital
$
690,704

 
10.79
%
 
$
683,706

 
11.56
%
Tier 1 capital minimum requirement
384,118

 
6.00
%
 
354,980

 
6.00
%
Excess
$
306,586

 
4.79
%
 
$
328,726

 
5.56
%
 
 
 
 
 
 
 
 
Common Equity Tier 1 capital
$
574,204

 
8.97
%
 
$
487,132

 
8.23
%
Common Equity Tier 1 minimum requirement
288,089

 
4.50
%
 
266,324

 
4.50
%
Excess
$
286,115

 
4.47
%
 
$
220,808

 
3.73
%
 
 
 
 
 
 
 
 
Total capital
$
822,810

 
12.85
%
 
$
812,568

 
13.74
%
Total capital minimum requirement
512,158

 
8.00
%
 
473,282

 
8.00
%
Excess
$
310,652

 
4.85
%
 
$
339,286

 
5.74
%
Total risk-weighted assets
$
6,401,973

 
 
 
$
5,916,027

 
 
 
 
 
 
 
 
 
 
Leverage Ratio
 
 
 
 
 

 
 
Tier 1 capital
$
690,704

 
8.59
%
 
$
683,706

 
9.58
%
Tier 1 capital minimum requirement
321,580

 
4.00
%
 
285,606

 
4.00
%
Excess
$
369,124

 
4.59
%
 
$
398,100

 
5.58
%
Average adjusted assets (less goodwill and other intangible assets)
$
8,039,489

 
 
 
$
7,140,152

 
 

Heartland filed a shelf registration statement with the SEC on August 28, 2013, to register up to $75.0 million in common stock, warrants or a combination of these securities, which became effective on September 9, 2013, and expired on September 9, 2016. In anticipation of the upcoming expiration of this shelf registration statement, Heartland filed a universal shelf registration statement with the SEC to register debt or equity securities on July 29, 2016. This shelf registration statement, which was effective immediately, provides Heartland with the ability to raise capital, subject to market conditions and SEC rules and limitations, if Heartland's board of directors decides to do so. This registration statement will permit Heartland, from time to time, in one or more public offerings, to offer debt securities, subordinated notes, common stock, preferred stock, rights or any combination of these securities. The amount of securities that may be offered is not specified in the registration statement, and the terms of any future offerings will be established at the time of the offering.

On February 5, 2016, Heartland completed the acquisition of CIC Bancshares, Inc., parent company of Centennial Bank, headquartered in Denver, Colorado, in a transaction valued at approximately $76.9 million. Of this amount, approximately $15.7 million was paid in cash and the remainder was provided by the issuance of 2,003,235 shares of Heartland common stock and 3,000 shares of newly issued Heartland Series D convertible preferred stock. In addition, Heartland assumed convertible notes and subordinated debt totaling approximately $7.9 million. During the third quarter of 2016, 1,922 shares of the Heartland Series D convertible preferred stock was converted into 76,665 shares of Heartland common stock and $1.4 million of the assumed convertible notes were converted into 52,914 shares of Heartland common stock. Simultaneous with closing of the transaction, Centennial Bank merged into Heartland’s Summit Bank & Trust subsidiary, with the resulting institution operating under the name Centennial Bank and Trust.

Common stockholders' equity was $703.0 million at September 30, 2016, compared to $581.5 million at December 31, 2015. Book value per common share was $28.48 at September 30, 2016, compared to $25.92 at year-end 2015. Changes in common stockholders' equity and book value per common share are the result of earnings, dividends paid, stock transactions and mark-to-market adjustment for unrealized gains and losses on securities available for sale and derivative instruments. Heartland had unrealized losses on securities available for sale and derivative instruments, net of applicable taxes, of $3.1 million at September 30, 2016, compared to unrealized losses of $6.0 million at December 31, 2015.

COMMITMENTS AND CONTRACTUAL OBLIGATIONS

Commitments and Contractual Obligations
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Heartland's bank subsidiaries evaluate the creditworthiness of customers to which they extend a credit commitment on a case-by-case basis and may require collateral to secure any credit extended. The amount of collateral obtained is based upon management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment and income-producing commercial properties. Standby letters of credit and financial guarantees are conditional commitments issued by Heartland's bank subsidiaries to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. At September 30, 2016, and December 31, 2015, commitments to extend credit aggregated $1.68 billion and $1.56 billion, respectively. Standby letters of credit aggregated $44.7 million at September 30, 2016 and $55.4 million at December 31, 2015.

Contractual obligations and other commitments were disclosed in Heartland's Annual Report on Form 10-K for the year ended December 31, 2015. As part of the CIC Bancshares, Inc. transaction completed on February 5, 2016, Heartland assumed $2.0 million of subordinated convertible notes and $6.0 million of subordinated debentures. Except for the commitments with respect to the CIC Bancshares, Inc. acquisition and the Founders Bancorp acquisition described below, there have been no material changes in Heartland's contractual obligations and other commitments since that report was filed.

On October 29, 2016, Heartland entered into a definitive merger agreement for the acquisition of Founders Bancorp, parent company of Founders Community Bank, based in San Luis Obispo, California. The transaction is valued at approximately $29.1 million, subject to adjustment. Of the merger consideration, 70% will be in the form of shares of Heartland common stock, and 30% will be in cash. As of September 30, 2016, Founders Community Bank had total assets of $198.5 million, which includes gross loans of $106.6 million and total deposits of $180.5 million. The closing of the acquisition is subject to customary closing conditions, including approvals by the Founders Bancorp shareholders and banking regulators, and is expected to occur in the first quarter of 2017. Simultaneous with the close, Founders Community Bank will be merged into Heartland's Premier Valley Bank subsidiary. Heartland expects the acquisition to be accretive to its earning per share during 2018.

On a consolidated basis, Heartland maintains a large balance of short-term securities that, when combined with cash from operations, Heartland believes are adequate to meet its funding obligations.

At the parent company level, routine funding requirements consist primarily of dividends paid to stockholders, debt service on revolving credit arrangements and trust preferred securities issuances, repayment requirements under other debt obligations and payments for acquisitions. The parent company obtains the funding to meet these obligations from dividends collected from its bank subsidiaries and the issuance of debt securities. At September 30, 2016, Heartland’s revolving credit agreement with an unaffiliated bank provided a maximum borrowing capacity of $20.0 million, of which no balance was outstanding. Heartland also has a non-revolving credit line with the same unaffiliated bank. At September 30, 2016, $27.1 million was available on this non-revolving credit line. These credit agreements contain specific financial covenants, all of which Heartland was in compliance with as of September 30, 2016.

The ability of Heartland to pay dividends to its stockholders is dependent upon dividends paid by its subsidiaries. The bank subsidiaries are subject to statutory and regulatory restrictions on the amount they may pay in dividends. To maintain acceptable capital ratios in Heartland's bank subsidiaries, certain portions of their retained earnings are not available for the payment of dividends.






Heartland continues to explore opportunities to expand its footprint of independent community banks. In the current banking industry environment, Heartland seeks these opportunities for growth through acquisitions. Heartland is primarily focused on possible acquisitions in the markets it currently serves, in which there would be an opportunity to grow market share, achieve efficiencies and provide greater convenience for current customers. Future expenditures relating to expansion efforts, in addition to those identified above, cannot be estimated at this time.

Derivative Financial Instruments
Heartland enters into mortgage banking derivatives, which are classified as free standing derivatives. These derivatives include interest rate lock commitments provided to customers to fund certain mortgage loans to be sold into the secondary market and forward commitments for the future delivery of such loans. We enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of future interest rate changes on the commitments to fund the loans as well as on the residential mortgage loans available for sale. See Note 7, "Derivative Financial Instruments," for additional information on our derivative financial instruments.

LIQUIDITY

Liquidity refers to Heartland's ability to maintain cash flow that is adequate to meet maturing obligations and existing commitments, to withstand fluctuations in deposit levels, to fund operations and to provide for customers' credit needs. The liquidity of Heartland principally depends on cash flows from operating activities, investment in and maturity of assets, changes in balances of deposits and borrowings, and its ability to borrow funds in the money or capital markets.

Operating activities provided $95.6 million of cash during the first nine months of 2016. Operating activities provided $53.6 million of cash during the first nine months of 2015. The largest factor in this change was the activity in loans originated for sale and the proceeds on sales of loans held for sale, which used cash of $3.5 million during the first nine months of 2016 compared to $31.3 million during the first nine months of 2015. Also affecting the change in cash provided from operating activities during the first nine months of 2016 was the $15.7 million increase in net income.

Investing activities provided cash of $168.7 million during the first nine months of 2016 compared to providing $3.9 million during the first nine months of 2015. The proceeds from securities sales, paydowns and maturities were $917.0 million during the first nine months of 2016 compared to $1.02 billion during the first nine months of 2015. Cash used for the purchase of securities totaled $890.8 million during the first nine months of 2016 compared to $784.5 million during the first nine months of 2015. A net change in loans provided $138.7 million of cash during the first nine months of 2016 compared to using $225.4 million during the first nine months of 2015.

Financing activities used cash of $321.0 million during the first nine months of 2016 compared to using cash of $40.3 million during the first nine months of 2015. The net increase in demand and savings deposits provided cash of $211.8 million during the first nine months of 2016 compared to a net increase in demand and savings deposits providing $118.3 million during the first nine months of 2015. The net decrease in time deposits used cash of $353.1 million during the first nine months of 2016 compared to a net decrease in time deposits using cash of $26.3 million during the first nine months of 2015. Short-term borrowings activity used cash of $115.6 million during the first nine months of 2016 compared to using $19.8 million of cash during the first nine months of 2015. Other borrowing activity provided cash of $24.4 million during the first nine months of 2016 compared to using $105.8 million of cash during the first nine months of 2015. Included in the use of cash during the first nine months of 2016 was $81.7 million of cash used for the redemption of Heartland's Series C Preferred Stock issued to the U.S. Treasury under the Small Business Lending Fund.

Management of investing and financing activities, and market conditions, determine the level and the stability of net interest cash flows. Management attempts to mitigate the impact of changes in market interest rates to the extent possible, so that balance sheet growth is the principal determinant of increases in net interest cash flows.

Heartland's short-term borrowing balances are dependent on commercial cash management and smaller correspondent bank relationships, and, as a result, short-term borrowing balances will normally fluctuate. Management believes these balances, on average, to be stable sources of funds; however, management intends to rely on deposit growth and additional FHLB borrowings in the future.

In the event of short-term liquidity needs, Heartland's bank subsidiaries may purchase federal funds from each other or from correspondent banks and may also borrow from the Federal Reserve Bank. Additionally, the bank subsidiaries’ FHLB memberships give them the ability to borrow funds for short- and long-term purposes under a variety of programs.






Heartland's revolving credit agreement with an unaffiliated bank provides a maximum borrowing capacity of $20.0 million, of which no balance had been drawn at September 30, 2016. Heartland also has a non-revolving credit line with the same unaffiliated bank under which $27.1 million was available for borrowing at September 30, 2016.







ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the risk of loss arising from adverse changes in market prices and rates. Heartland's market risk is comprised primarily of interest rate risk resulting from its core banking activities of lending and deposit gathering. Interest rate risk measures the impact on earnings from changes in interest rates and the effect on the current fair market values of Heartland's assets, liabilities and off-balance sheet contracts. Heartland's objective is to measure this risk and manage the balance sheet to avoid unacceptable potential for economic loss.

Management continually develops and applies strategies to mitigate market risk. Exposure to market risk is reviewed on a regular basis by the asset/liability committees of the banks and, on a consolidated basis, by Heartland's executive management and board of directors. Darling Consulting Group, Inc. has been engaged to provide asset/liability management position assessment and strategy formulation services to Heartland and its bank subsidiaries. At least quarterly, a detailed review of the balance sheet risk profile is performed for Heartland and each of its bank subsidiaries. Included in these reviews are interest rate sensitivity analyses, which simulate changes in net interest income in response to various interest rate scenarios. These analyses consider current portfolio rates, existing maturities, repricing opportunities and market interest rates, in addition to prepayments and growth under different interest rate assumptions. Selected strategies are modeled prior to implementation to determine their effect on Heartland's interest rate risk profile and net interest income. Heartland believes its primary market risk exposures did not change significantly in the first nine months of 2016.

The core interest rate risk analysis utilized by Heartland examines the balance sheet under increasing and decreasing interest rate scenarios that are neither too modest nor too extreme. All rate changes are ramped over a 12-month horizon based upon a parallel shift in the yield curve and then maintained at those levels over the remainder of the simulation horizon. Using this approach, management is able to see the effect that both a gradual change of rates (year 1) and a rate shock (year 2 and beyond) could have on Heartland's net interest income. Starting balances in the model reflect actual balances on the “as of” date, adjusted for material and significant transactions. Pro-forma balances remain static. This methodology enables interest rate risk embedded within the existing balance sheet structure to be isolated from the interest rate risk often caused by growth in assets and liabilities. Due to the low interest rate environment, the simulations under a decreasing interest rate scenario were prepared using a 100 basis point shift in rates. The most recent reviews at September 30, 2016, and September 30, 2015, provided the following results, in thousands:
 
2016
 
2015
 
Net Interest
Margin
 
% Change
From Base
 
Net Interest
Margin
 
% Change
From Base
Year 1
 
 
 
 
 
 
 
Down 100 Basis Points
$
278,279

 
(2.74
)%
 
$
226,875

 
(2.16
)%
Base
$
286,122

 
 
 
$
231,875

 
 
Up 200 Basis Points
$
286,325

 
0.07
 %
 
$
228,740

 
(1.35
)%
Year 2
 
 
 
 
 
 
 

Down 100 Basis Points
$
264,054

 
(7.71
)%
 
$
217,114

 
(6.37
)%
Base
$
286,429

 
0.11
 %
 
$
232,015

 
0.06
 %
Up 200 Basis Points
$
298,565

 
4.35
 %
 
$
236,465

 
1.98
 %

Heartland uses derivative financial instruments to manage the impact of changes in interest rates on its future interest income or interest expense. Heartland is exposed to credit-related losses in the event of nonperformance by the counterparties to these derivative instruments, but believes it has minimized the risk of these losses by entering into the contracts with large, stable financial institutions. The estimated fair market values of these derivative instruments are presented in Note 7 to the consolidated financial statements.

Heartland enters into 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 and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Commitments to extend credit are agreements to lend funds to a customer as long as there is no violation of any condition established in the contract relating to the commitment. Commitments generally have fixed expiration dates and may require collateral from the borrower. Standby letters of credit are conditional commitments issued by Heartland to guarantee the performance of a customer to a third party up to a stated amount and subject to specified terms and conditions. These commitments to extend credit and standby letters of credit are not recorded on the balance sheet until the loan is made or the letter or credit is issued.






Heartland periodically holds a securities trading portfolio that would also be subject to elements of market risk. These securities are carried on the balance sheet at fair value. At both September 30, 2016, and December 31, 2015, Heartland held no securities in its securities trading portfolio.

ITEM 4. CONTROLS AND PROCEDURES

Based on an evaluation, as of the end of the period covered by this quarterly report on Form 10-Q, under the supervision and with the participation of Heartland's management, including its Chief Executive Officer and Chief Financial Officer, the Chief Executive Officer and Chief Financial Officer have concluded that Heartland's disclosure controls and procedures (as defined in Rule 13a-15(e) and Rule 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended) were effective. During the quarter ended September 30, 2016, there have been no changes in Heartland's internal controls over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended) that have materially affected, or are reasonably likely to materially affect, Heartland's internal control over financial reporting.





PART II

ITEM 1. LEGAL PROCEEDINGS

There are no material pending legal proceedings to which Heartland or its subsidiaries are a party other than ordinary routine litigation incidental to their respective businesses. While the ultimate outcome of current legal proceedings cannot be predicted with certainty, it is the opinion of management that the resolution of these legal actions should not have a material effect on Heartland's consolidated financial position or results of operations.

ITEM 1A. RISK FACTORS

There have been no material changes in the risk factors applicable to Heartland from those disclosed in Part I, Item 1A. “Risk Factors” in Heartland's 2015 Annual Report on Form 10-K. Please refer to that section of Heartland's Form 10-K for disclosures regarding the risks and uncertainties related to Heartland's business.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Heartland's board of directors has authorized management to acquire and hold up to 500,000 shares of common stock as treasury shares at any one time. Heartland and its affiliated purchasers made no purchases of its common stock during the nine months ended September 30, 2016.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable

ITEM 5. OTHER INFORMATION

None.





ITEM 6. EXHIBITS

Exhibits

31.1
 
31.2
 
32.1
 
32.2
 
101
 
Financial statement formatted in Extensible Business Reporting Language: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) the Consolidated Statements of Cash Flows, (v) the Consolidated Statements of Changes in Equity, and (vi) the Notes to Consolidated Financial Statements.
 





SIGNATURES

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



HEARTLAND FINANCIAL USA, INC.
(Registrant)
 
 
/s/ Lynn B. Fuller
By: Lynn B. Fuller
Chairman and Chief Executive Officer
(Principal Executive Officer and Duly Authorized Officer)
 
 
/s/ Bryan R. McKeag
By: Bryan R. McKeag
Executive Vice President and Chief Financial Officer
(Principal Financial Officer and Duly Authorized Officer)
 
 
/s/ Janet M. Quick
By: Janet M. Quick
Executive Vice President and Deputy Chief Financial Officer
(Principal Accounting Officer and Duly Authorized Officer)
 
Dated: November 9, 2016