10-K 1 f10k2001.txt 10-K DOCUMENT FOR YEAR ENDED 12-31-2001 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2001 Commission File Number: 0-24724 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) 589-2100 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None (Title of Exchange Class) None (Name of Each Exchange on which Registered) Securities registered pursuant to Section 12(g) of the Act: Common Stock $1.00 par value (Title of Class) 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 Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ( ) The index to exhibits follows the signature page. As of March 25, 2002, the Registrant had issued and outstanding 9,828,333 shares of the Registrant's common stock. The aggregate market value of the voting stock held by non-affiliates of the Registrant as of March 25, 2002, was $112,727,735.* Such figures include 1,871,358 shares of the Registrant's Common Stock held in a fiduciary capacity by the Trust Department of the Dubuque Bank & Trust Company, a wholly-owned subsidiary of the Registrant. * Based on the last reported price of an actual transaction in Registrant's common stock on March 25, 2002, and reports of beneficial ownership filed by directors and executive officers of Registrant and by beneficial owners of more than 5% of the outstanding shares of common stock of Registrant; however, such determination of shares owned by affiliates does not constitute an admission of affiliate status or beneficial interest in shares of Registrant's common stock. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for the 2002 Annual Meeting of Stockholders are incorporated by reference into Part III. HEARTLAND FINANCIAL USA, INC. Form 10-K Annual Report Table of Contents Part I Item 1. Business A. General Description B. Market Areas C. Competition D. Employees E. Accounting Standards F. Supervision and Regulation G. Governmental Monetary Policy and Economic Conditions Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders Part II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 8. Financial Statements and Supplementary Data Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Part III Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management Item 13. Certain Relationships and Related Transactions Part IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K PART I. ITEM 1. BUSINESS A. GENERAL DESCRIPTION Heartland Financial USA, Inc. ("Heartland"), reincorporated in the state of Delaware in 1993, is a multi-bank holding company registered under the Bank Holding Company Act of 1956, as amended ("BHCA"). Heartland has five bank subsidiaries in the states of Iowa, Wisconsin, Illinois and New Mexico and one federal savings bank subsidiary in Iowa (collectively, the "Bank Subsidiaries"). All six Bank Subsidiaries are members of the Federal Deposit Insurance Corporation ("FDIC"). Dubuque Bank and Trust Company, Dubuque, Iowa, ("DB&T") is chartered under the laws of the State of Iowa and has two wholly-owned subsidiaries: DB&T Insurance, Inc. ("DB&T Insurance"), a multi-line insurance agency and DB&T Community Development Corp. ("DB&T Development"), majority owner of a senior housing project. Galena State Bank and Trust Company, Galena, Illinois, ("GSB") and Riverside Community Bank, Rockford, Illinois, ("RCB") are chartered under the laws of the State of Illinois. First Community Bank, FSB, Keokuk, Iowa, ("FCB") is a federal savings association organized under the laws of the United States. Wisconsin Community Bank, Cottage Grove, Wisconsin, ("WCB") is chartered under the laws of the State of Wisconsin and has one subsidiary, DBT Investment Corporation ("DBT Investment"), an investment management company. New Mexico Bank & Trust, Albuquerque, New Mexico, ("NMB") is chartered under the laws of the state of New Mexico. The Bank Subsidiaries operate 32 banking locations in Iowa, Illinois, Wisconsin and New Mexico. Heartland has six non-bank subsidiaries. Citizens Finance Co. ("Citizens") is a consumer finance company. ULTEA, Inc. ("ULTEA") is a fleet leasing company headquartered in Madison, Wisconsin. Keokuk Bancshares, Inc. ("Keokuk") is an investment management company. Heartland Capital Trust I and Heartland Statutory Trust II are special purpose trust subsidiaries of Heartland formed for the purpose of the offering of cumulative capital securities. All of Heartland's subsidiaries are wholly-owned, except for NMB, of which Heartland was an 86% owner on December 31, 2001. The Bank Subsidiaries provide full service retail banking within Dubuque and Lee Counties in Iowa; within Jo Daviess, Hancock and Winnebago Counties in Illinois; within Dane, Green, Sheboygan, Brown, and Eau Claire Counties in Wisconsin; and Bernalillo and Curry Counties in New Mexico. Deposit products include checking and other demand deposit accounts, NOW accounts, savings accounts, money market accounts, certificates of deposit, individual retirement accounts and other time deposits. The deposits in the Bank Subsidiaries are insured by the FDIC to the full extent permitted by law. Loans include commercial and industrial, agricultural, real estate mortgage, consumer, home equity, credit cards and lines of credit. Other products and services include VISA debit cards, automatic teller machines, safe deposit boxes and trust services. The principal service of the Bank Subsidiaries consists of making loans to businesses and individuals. These loans are made at the offices of the Bank Subsidiaries. The Bank Subsidiaries also engage in activities that are closely related to banking, including investment brokerage. Operating Strategy Heartland's primary operating strategy is to differentiate the company as a growing consortium of strong community banks through community involvement, active boards of directors, local presidents and local decision-making. As part of the operating strategy, all directors, officers and employees are encouraged to maintain a strong ownership interest in Heartland. As of December 31, 2001, these individuals owned approximately 45% of Heartland's outstanding common stock. Management believes that the personal and professional service that is offered to customers provides an appealing alternative to the "megabanks" that have resulted from the recent mergers and acquisitions in the financial services industry. While Heartland employs a community banking philosophy, management believes that Heartland's size, combined with the full line of financial products and services, is sufficient to effectively compete in the respective market areas. At the same time, management realizes that to remain price competitive Heartland must manage expense levels by centralizing the back office support functions to gain economies of scale. Each of the subsidiaries of Heartland operates under the direction of its own board of directors, although Heartland has standard operating policies regarding asset/liability management, liquidity management, investment management, lending policies and deposit structure management. In order to accomplish these strategic objectives, management has focused on improving the performance of the existing subsidiaries while simultaneously pursuing an acquisition and expansion strategy. With respect to the existing subsidiaries, Heartland has primarily focused on the following strategies: - Improving the bank subsidiaries' funding costs by reducing the levels of higher-cost certificates of deposit, increasing the percentage of lower-cost transaction accounts such as checking, savings and money market accounts, emphasizing relationship banking and capitalizing on cross-selling opportunities; - Emphasizing the expansion of non-traditional sources of income, including trust and investment services, consumer finance and vehicle leasing and fleet management; - Centralizing back office support functions to enable the Bank Subsidiaries to operate as efficiently as possible; and - Continually evaluating new technology and acquiring it when the expected return justifies the cost. Acquisition and Expansion Strategy Heartland's strategy is to diversify both its market area and asset base while increasing profitability through acquisitions and through expansion of its current subsidiaries. The goal is to expand through the acquisition of established financial services organizations, primarily commercial banks or thrifts, when suitable candidates can be identified and acceptable business terms negotiated. Heartland has also formed de novo banking institutions in market areas where management has identified market potential and management with banking expertise and philosophy similar to Heartland's. In evaluating expansion and acquisition opportunities, Heartland has focused on geographic areas in the Midwest or Southwest with growth potential. Heartland continually seeks and evaluates opportunities to establish branches, loan production offices or other business facilities as a means of expanding its presence in current or new market areas. Heartland also looks for opportunities beyond the Midwest and beyond the categories of community banks and thrifts when the Heartland board of directors and management believes that the opportunity will provide a desirable strategic fit without posing undue risk. Heartland does not currently have any definitive understandings or agreements for any acquisitions material to Heartland. However, Heartland will continue to look for further expansion opportunities. Lending Activities General The Bank Subsidiaries provide a range of commercial and retail lending services to corporations, partnerships and individuals. These credit activities include agricultural, commercial, residential real estate and installment loans, as well as loan participations and lines of credit. The Bank Subsidiaries aggressively market their services to qualified lending customers. Lending officers actively solicit the business of new companies entering their market areas as well as long-standing members of the Bank Subsidiaries' respective business communities. Through professional service and competitive pricing, the Bank Subsidiaries have been successful in attracting new lending customers. Heartland also actively pursues consumer lending opportunities. With convenient locations, advertising and customer communications, the Bank Subsidiaries have been successful in capitalizing on the credit needs of their market areas. Commercial Loans The Bank Subsidiaries have a strong commercial loan base and DB&T, in particular, continues to be a premier commercial lender in the tri-state area of northeast Iowa, northwest Illinois and southwest Wisconsin. The Bank Subsidiaries' areas of emphasis include, but are not limited to, loans to wholesalers, hotel and real estate developers, manufacturers, building contractors, business services companies and retailers. The Bank Subsidiaries provide 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. 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. DB&T and WCB have also generated loans that are guaranteed by the U.S. Small Business Administration, and these entities have been certified as Preferred Lenders by the agency. Management believes that making these guaranteed loans helps its local communities as well as provides Heartland with a source of income and solid future lending relationships as such businesses grow and prosper. DB&T is also currently one of the state of Iowa's top lenders in the "Linked Investment for Tomorrow" program. This state- sponsored program offers interest rate reductions to businesses opened by minorities and those in rural areas. The primary repayment risk for commercial real estate loans is the failure of the business due to economic events or governmental regulations outside of the control of the borrower or lender that negatively impact the future cash flow and market values of the affected properties. In most cases, the Bank Subsidiaries have collateralized these loans and/or taken personal guarantees to help assure repayment. The Bank Subsidiaries' commercial loans and leases are primarily made based on the identified cash flow of the borrower and secondarily on the underlying collateral provided by the borrower. Credit support provided by the borrower for most of these loans and leases and the probability of repayment is based on the liquidation of the pledged collateral and enforcement of a personal guarantee, if any exists. The primary repayment risks of commercial loans and leases are that the cash flows of the borrower may be unpredictable, and the collateral securing these loans may fluctuate in value. As the credit portfolios of the Bank Subsidiaries have continued to grow, several changes have been made in their lending departments resulting in an overall increase in these departments' skill levels. Commercial lenders interact with their respective Boards of Directors each month. Heartland also utilizes an internal loan review function to analyze credits of the Bank Subsidiaries and to provide periodic reports to the respective boards of directors. Management has attempted to identify problem loans at an early date and to aggressively seek a resolution of these situations. Agricultural Loans Agricultural loans are emphasized by DB&T, WCB's Monroe banking center and NMB's Clovis banking offices due to their concentration of customers in rural markets. DB&T maintains its status as one of the largest agricultural lenders in the state of Iowa. Agricultural loans remain balanced, however, in proportion to the rest of Heartland's loan portfolio, constituting approximately 13% of the total loan portfolio at December 31, 2001. In connection with their agricultural lending, all of the Bank Subsidiaries have remained close to their traditional geographic market areas. The majority of the outstanding agricultural operating and real estate loans are within 60 miles of their main or branch offices. 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. The ability of the borrower to repay may be affected by many factors outside of the borrower's control including adverse weather conditions, loss of livestock due to disease or other factors, declines in market prices for agricultural products and the impact of government regulations. Payments on agricultural loans are ultimately dependent on the profitable operation or management of the farm property securing the loan. The agricultural loan departments work closely with all of their customers, including companies and individual farmers, and review the preparation of 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 once a year. In addition, the Bank Subsidiaries work closely with governmental agencies, including the Farmers Home Administration, to assist agricultural customers in obtaining credit enhancement products such as loan guarantees. Real Estate Mortgage Loans Mortgage lending has been a focal point of the Bank Subsidiaries as each of them continues to build real estate lending business. As long-term rates decreased during 2001, customers refinanced their mortgage loans into fifteen- and thirty-year fixed rate loans, which Heartland usually sells into the secondary market. Conversely, during 2000, customers elected to take adjustable- rate mortgage loans, which Heartland elected to retain in its loan portfolio, during this period of increasing long-term rates. As interest rates rose during 1999 and the early months of 2000, residential mortgage outstandings grew as customers elected to take three-, five- and seven-year adjustable rate mortgage loans, which were retained in the loan portfolios. Management believes that the retention of mortgage servicing provides the Bank Subsidiaries with a relatively steady source of fee income as compared to fees generated solely from mortgage origination operations. Moreover, the retention of such servicing rights allows each of the Bank Subsidiaries to continue to have regular contact with mortgage customers. Consumer Lending The Bank Subsidiaries' consumer lending departments provide all types of consumer loans including motor vehicle, home improvement, home equity, student loans, credit cards, signature loans and small personal credit lines. Consumer loans typically have shorter terms and lower balances with higher yields as compared to one- to four-family residential mortgage loans, but generally carry higher risks of default. Consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Consumer loan demand is also serviced through Citizens, which currently serves the consumer credit needs of almost 6,000 customers in the three state area of Iowa, Illinois and Wisconsin from its Dubuque, Iowa, Madison and Appleton, Wisconsin, and Loves Park, Illinois offices. Citizens typically lends to borrowers with past credit problems or limited credit histories. Heartland expects to incur a higher level of credit losses on Citizens loans as compared to other consumer loans. Trust Departments The trust departments for DB&T, GSB and FCB have been providing trust services to their respective communities for many years. Trust personnel from DB&T also work with RCB, WCB and NMB personnel to provide trust services to all Bank Subsidiaries. Currently, the Bank Subsidiaries have over $701 million of consolidated assets under management and provide a full complement of trust and investment services for individuals and corporations. The trust department of DB&T is nationally recognized as a leading provider of socially responsible investment services and manages investment portfolios for religious and other non-profit organizations located throughout the United States. The Bank Subsidiaries' trust departments are also active in the management of employee benefit and retirement plans in their market areas. The Bank Subsidiaries have targeted their trust departments as primary areas for future growth. Brokerage and Other Services Heartland contracts with a third-party vendor, Invest Financial Corporation, to operate independent securities offices at DB&T, GSB, RCB and FCB. Invest Financial Corporation offers full- service stock and bond trading, direct investments, annuities and mutual funds. DB&T Insurance has continued to grow its personal insurance lines and the number of independent insurance companies it represents. DB&T Insurance is a multi-line insurance agency in the Dubuque area and offers a complete array of vehicle, property and casualty, life and disability insurance and tax-free annuities. B. MARKET AREAS DB&T is located in Dubuque County, Iowa, which encompasses the city of Dubuque and a number of surrounding rural communities. The city of Dubuque is located in northeastern Iowa, on the Mississippi River, approximately 175 miles west of Chicago, Illinois, and approximately 200 miles northeast of Des Moines, Iowa. It is strategically situated at the intersection of the state borders of Iowa, Illinois and Wisconsin. Based upon the results of the 2000 census, the city of Dubuque had a total population of approximately 58,000. In addition to its main banking office, DB&T has seven branch offices, all of which are located in the Dubuque County area. As a subsidiary of DB&T, DB&T Insurance has substantially the same market area as the parent organization. Citizens also operates within this market area, and, in addition, offices were opened in Madison, Wisconsin, during June, 1996, Appleton, Wisconsin, during August, 1998 and Loves Park, Illinois during February, 1999. GSB is located in Galena, Illinois, which is less than five miles from the Mississippi River, approximately 20 miles east of Dubuque and 155 miles west of Chicago. GSB also has an office in Stockton, Illinois, and as such, services customers in Jo Daviess County, Illinois. Based on the 2000 census, the county had a population of approximately 22,000. FCB's main office is in Keokuk, Iowa, which is located in the southeast corner of Iowa near the borders of Iowa, Missouri and Illinois. Due to its location, FCB serves customers in the tri- county region of Lee County, Iowa, Hancock County, Illinois and Clark County, Missouri. Lee, Hancock and Clark Counties have populations of approximately 38,000, 20,000 and 7,400, respectively. FCB has one branch office in Keokuk and another branch in the city of Carthage in Hancock County, Illinois. Keokuk is an industrial community with a population of approximately 11,000. RCB is located on the northeast edge of Rockford, Illinois, which is approximately 75 miles west of Chicago in Winnebago County. In addition to its main banking office, RCB has two branch offices, all of which are located in the Winnebago County area. Based on the 2000 census, the county had a population of 278,000 and the city of Rockford had a population of 150,000. WCB operates one office from its location in Cottage Grove, Wisconsin, which is approximately 10 miles east of Madison in Dane County. A branch office was opened in Middleton, a suburb of Madison, in February, 1998. According to the 2000 census, the county had a population of 427,000, and the village of Cottage Grove had a population of 3,800. Wisconsin Business Bank, a branch of WCB, opened three offices in Sheboygan, DePere and Eau Claire, Wisconsin during 1999. These three facilities are located in the northeastern Wisconsin counties of Sheboygan and Brown and the west central Wisconsin county of Eau Claire with populations of 113,000, 227,000 and 93,000, respectively, according to the 2000 census. WCB also acquired the Bank One Monroe Wisconsin banking center in July of 1999. The city of Monroe, which is approximately 50 miles southwest of Madison, is located in Green County in south central Wisconsin. According to the 2000 census, Monroe had a population of 11,000, and Green County had a population of 34,000. NMB operates five offices within Albuquerque, New Mexico in Bernalillo County. Based upon the 2000 census, the county had a population of 557,000, and the city had a population of 449,000. NMB also operates four locations in the New Mexico communities of Clovis and Melrose, both located in Curry County. Clovis is located in east central New Mexico, approximately 220 miles from Albuquerque, 100 miles northwest of Lubbock, Texas and 105 miles southwest of Amarillo, Texas. Clovis had a population of approximately 33,000 according to the 2000 census, and Curry County had a population of 45,000. C. COMPETITION Heartland encounters competition in all areas of its business pursuits. In order to compete effectively, to develop its market base, to maintain flexibility and to move in pace with changing economic and social conditions, Heartland continuously refines and develops its products and services. The principal methods of competition in the financial services industry are price, service and convenience. The Bank Subsidiaries' combined market area is highly competitive. Many financial institutions based in the communities surrounding the Bank Subsidiaries actively compete for customers within Heartland's market area. The Bank Subsidiaries also face competition from finance companies, insurance companies, mortgage companies, securities brokerage firms, money market funds, loan production offices and other providers of financial services. Under the Gramm-Leach-Bliley Act, effective in March 2000, securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. The Gramm-Leach-Bliley Act may significantly change the competitive environment in which Heartland and the Bank Subsidiaries conduct business. The financial services industry is also likely to become more competitive as further technological advances enable more companies to provide financial services. These technological advances may diminish the importance of depository institutions and other financial intermediaries in the transfer of funds between parties. Heartland competes for loans principally through the range and quality of the services it provides, interest rates and loan fees. Heartland believes that its long-standing presence in the community and personal service philosophy enhance its ability to compete favorably in attracting and retaining individual and business customers. Heartland actively solicits deposit-oriented clients and competes for deposits by offering customer's personal attention, professional service and competitive interest rates. D. EMPLOYEES At December 31, 2001, Heartland employed 581 full-time equivalent employees. Heartland places a high priority on staff development, which involves extensive training, including customer service training. New employees are selected on the basis of both technical skills and customer service capabilities. None of Heartland's employees are covered by a collective bargaining agreement. Heartland offers a variety of employee benefits and management considers its employee relations to be excellent. E. ACCOUNTING STANDARDS In July 2001, the FASB issued FAS No. 141, Business Combinations, and FAS No. 142, Goodwill and Other Intangible Assets. FAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, as well as all purchase method business combinations completed after June 30, 2001. FAS No. 141 also specifies criteria that intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill. FAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of FAS No. 142. FAS No. 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with FAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long- Lived Assets to Be Disposed Of. Heartland adopted the provisions of FAS No. 141 immediately, and FAS No. 142 effective January 1, 2002. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001, continued to be amortized and tested for impairment in accordance with the appropriate pre-FAS No. 142 accounting requirements prior to adoption of FAS No. 142. As of December 31, 2001, Heartland had unamortized goodwill in the amount of $16.064 million and unamortized identifiable intangible assets in the amount of $2.931 million. Amortization expense related to goodwill was $1.064 million and $1.063 million for the years ended December 31, 2001, and December 31, 2000, respectively. Amortization expense related to identifiable intangible assets was $608 thousand and $751 thousand for the years ended December 31, 2001, and December 31, 2000, respectively. All of Heartland's identifiable intangible assets are core deposit premiums related to acquisitions. The estimated impact of adopting FAS No. 141 and 142 on January 1, 2002 will be the discontinuance of amortization on $9.521 million of Heartland's unamortized goodwill. The corresponding amortization expense for the year ended December 31, 2001 was $538 thousand. Goodwill in the amount of $6.543 million will continue to be amortized in accordance with the provisions of FAS No. 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions. No transitional impairment charges are anticipated. In August 2001, the FASB issued FAS Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which supersedes both FAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business (as previously defined in that Opinion). FAS No. 144 retains the fundamental provisions in FAS No. 121 for recognizing and measuring impairment losses on long-lived assets held for use and long-lived assets to be disposed of by sale, while also resolving significant implementation issues associated with FAS No. 121. For example, FAS No. 144 provides guidance on how a long-lived asset that is used as part of a group should be evaluated for impairment, establishes criteria for when a long-lived asset is held for sale, and prescribes the accounting for a long-lived asset that will be disposed of other than by sale. FAS No. 144 retains the basic provisions of Opinion 30 on how to present discontinued operations in the income statement but broadens that presentation to include a component of an entity (rather than a segment of a business). Unlike FAS No. 121, an impairment assessment under FAS No. 144 will never result in a write-down of goodwill. Rather, goodwill is evaluated for impairment under FAS No. 142, Goodwill and Other Intangible Assets. Heartland is required to adopt FAS No. 144 no later than the year beginning after December 15, 2001, and plans to adopt its provisions for the quarter ending March 31, 2002. Management does not expect the adoption of FAS No. 144 for long-lived assets held for use to have a material impact on Heartland's financial statements because the impairment assessment under FAS No. 144 is largely unchanged from FAS No. 121. The provisions of FAS No. 144 for assets held for sale or other disposal generally are required to be applied prospectively after the adoption date to newly initiated disposal activities. Therefore, management cannot determine the potential effects that adoption of FAS No. 144 will have on Heartland's financial statements. In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("FAS") No. 133, Accounting for Derivative Instruments and Hedging Activities. In July 1999, the FASB issued FAS No. 137, Deferring Statement 133's Effective Date, which defers the effective date for implementation of FAS NO. 133 by one year, making FAS No. 133 effective no later than January 1, 2001, for Heartland's financial statements. In June 2000, the FASB issued FAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of FAS No. 133. Heartland implemented FAS No. 133 on January 1, 2001, and reclassified, at that date, all investments previously included in its held to maturity investment portfolio to the available for sale investment portfolio. There was no material impact on the consolidated financial statements as a result of the implementation. F. SUPERVISION AND REGULATION General Financial institutions and their holding companies are extensively regulated under federal and state law. As a result, the growth and earnings performance of Heartland can be affected not only by management decisions and general economic conditions, but also by the requirements of applicable state and federal statutes and regulations and the policies of various governmental regulatory authorities, including the Iowa Superintendent of Banking ("Iowa Superintendent"), the Illinois Commissioner of Banks and Real Estate ("Illinois Commissioner"), the Division of Banking of the Wisconsin Department of Financial Institutions ("Wisconsin DFI"), the New Mexico Financial Institutions Division ("New Mexico Division"), the Office of Thrift Supervision ("OTS"), the Board of Governors of the Federal Reserve System ("Federal Reserve"), the FDIC, the Internal Revenue Service and state taxing authorities and the Securities and Exchange Commission ("SEC"). The effect of applicable statutes, regulations and regulatory policies can be significant, and cannot be predicted with a high degree of certainty. Federal and state laws and regulations generally applicable to financial institutions, such as Heartland and its subsidiaries, regulate, among other things, the scope of business, investments, reserves against deposits, capital levels relative to operations, the nature and amount of collateral for loans, the establishment of branches, mergers, consolidations and dividends. The system of supervision and regulation applicable to Heartland and its subsidiaries establishes a comprehensive framework for their respective operations and is intended primarily for the protection of the FDIC's deposit insurance funds and the depositors, rather than the shareholders, of financial institutions. The following is a summary of the material elements of the regulatory framework that applies to Heartland and its subsidiaries. It does not describe all of the statutes, regulations and regulatory policies that apply to Heartland and its subsidiaries, nor does it restate all of the requirements of the statutes, regulations and regulatory policies that are described. As such, the following is qualified in its entirety by reference to the applicable statutes, regulations and regulatory policies. Any change in applicable law, regulations or regulatory policies may have a material effect on the business of Heartland and its subsidiaries. Recent Regulatory Developments The terrorist attacks in September, 2001, have impacted the financial services industry and have already led to federal legislation that attempts to address certain related issues involving financial institutions. On October 26, 2001, President Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the "USA PATRIOT Act"). Among its other provisions, the USA PATRIOT Act requires each financial institution: (i) to establish an anti-money laundering program; (ii) to establish due diligence policies, procedures and controls with respect to its private banking accounts and correspondent banking accounts involving foreign individuals and certain foreign banks; and (iii) to avoid establishing, maintaining, administering, or managing correspondent accounts in the United States for, or on behalf of, foreign banks that do not have a physical presence in any country. The USA PATRIOT Act also requires the Secretary of the Treasury to prescribe, by regulations to be issued jointly with the federal banking regulators and certain other agencies, minimum standards that financial institutions must follow to verify the identity of customers, both foreign and domestic, when a customer opens an account. In addition, the USA PATRIOT Act contains a provision encouraging cooperation among financial institutions, regulatory authorities and law enforcement authorities with respect to individuals, entities and organizations engaged in, or reasonably suspected of engaging in, terrorist acts or money laundering activities. At this time, Heartland is unable to determine whether the provisions of the USA PATRIOT Act will have a material impact on the business of Heartland and its subsidiaries. Heartland General. Heartland, as the sole shareholder of DB&T, GSB, RCB and WCB and the controlling shareholder of NMB, is a bank holding company. As a bank holding company, Heartland is registered with, and is subject to regulation by, the Federal Reserve under the Bank Holding Company Act, as amended ("BHCA"). In accordance with Federal Reserve policy, Heartland is expected to act as a source of financial strength to the Bank Subsidiaries and to commit resources to support the Bank Subsidiaries in circumstances where Heartland might not otherwise do so. Under the BHCA, Heartland is subject to periodic examination by the Federal Reserve. Heartland is also required to file with the Federal Reserve periodic reports of Heartland's operations and such additional information regarding Heartland and its subsidiaries as the Federal Reserve may require. Heartland's ownership of FCB makes Heartland a savings and loan holding company, as defined in the Home Owners' Loan Act, as amended ("HOLA"). Although savings and loan holding companies generally are subject to supervision and regulation by the OTS, companies that, like Heartland, are both bank holding companies and savings and loan holding companies are generally exempt from OTS supervision. Federal law, however, requires the Federal Reserve to consult with the OTS, as appropriate, in establishing the scope of a Federal Reserve examination of such holding company, to provide the OTS, upon request, with copies of Federal Reserve examination reports and other supervisory information concerning any such holding company, and to cooperate with the OTS in any enforcement action against any such holding company if the conduct at issue involves the company's savings association subsidiary. Investments and Activities. Under the BHCA, a bank holding company must obtain Federal Reserve approval before: (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after the acquisition, it would own or control more than 5% of the voting shares of the other bank or bank holding company (unless it already owns or controls the majority of such shares); (ii) acquiring all or substantially all of the assets of another bank; or (iii) merging or consolidating with another bank holding company. Subject to certain conditions (including certain deposit concentration limits established by the BHCA), the Federal Reserve may allow a bank holding company to acquire banks located in any state of the United States without regard to whether the acquisition is prohibited by the law of the state in which the target bank is located. In approving interstate acquisitions, however, the Federal Reserve is required to give effect to applicable state law limitations on the aggregate amount of deposits that may be held by the acquiring bank holding company and its insured depository institution affiliates in the state in which the target bank is located (provided that those limits do not discriminate against out-of-state depository institutions or their holding companies) and state laws which require that the target bank have been in existence for a minimum period of time (not to exceed five years) before being acquired by an out-of-state bank holding company. The BHCA also generally prohibits Heartland from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to banks and their subsidiaries. This general prohibition is subject to a number of exceptions. The principal exception allows bank holding companies to engage in, and to own shares of companies engaged in, certain businesses found by the Federal Reserve to be "so closely related to banking ... as to be a proper incident thereto." Under current regulations of the Federal Reserve, this authority would permit Heartland to engage in a variety of banking-related businesses, including the operation of a thrift, sales and consumer finance, equipment leasing, the operation of a computer service bureau (including software development), and mortgage banking and brokerage. Additionally, bank holding companies that meet certain eligibility requirements prescribed by the BHCA and elect to operate as financial holding companies may engage in, or own shares in companies engaged in, a wider range of nonbanking activities, including securities and insurance activities and any other activity that the Federal Reserve, in consultation with the Secretary of the Treasury, determines by regulation or order is financial in nature, incidental to any such financial activity or complementary to any such financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally. The BHCA generally does not place territorial restrictions on the domestic activities of nonbank subsidiaries of bank holding companies or financial holding companies. As of the date of this filing, Heartland has neither applied for nor received approval to operate as a financial holding company. Federal law also prohibits any person or company from acquiring "control" of an FDIC-insured depository institution or its holding company without prior notice to the appropriate federal bank regulator. "Control" is defined in certain cases as the acquisition of 10% or more of the outstanding shares of an institution or holding company. Capital Requirements. Bank holding companies are required to maintain minimum levels of capital in accordance with Federal Reserve capital adequacy guidelines. If capital falls below minimum guideline levels, a bank holding company, among other things, may be denied approval to acquire or establish additional banks or nonbank businesses. The Federal Reserve's capital guidelines establish the following minimum regulatory capital requirements for bank holding companies: (i) a risk-based requirement expressed as a percentage of total risk-weighted assets; and (ii) a leverage requirement expressed as a percentage of total assets. The risk- based requirement consists of a minimum ratio of total capital to total risk-weighted assets of 8%, and a minimum ratio of Tier 1 capital to total risk-weighted assets of 4%. The leverage requirement consists of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly rated companies, with a minimum requirement of 4% for all others. For purposes of these capital standards, Tier 1 capital consists primarily of permanent stockholders' equity less intangible assets (other than certain loan servicing rights and purchased credit card relationships). Total capital consists primarily of Tier 1 capital plus certain other debt and equity instruments which do not qualify as Tier 1 capital and a portion of Heartland's allowance for loan and lease losses. The risk-based and leverage standards described above are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual banking organizations. For example, the Federal Reserve's capital guidelines contemplate that additional capital may be required to take adequate account of, among other things, interest rate risk, or the risks posed by concentrations of credit, nontraditional activities or securities trading activities. Further, any banking organization experiencing or anticipating significant growth would be expected to maintain capital ratios, including tangible capital positions (i.e., Tier 1 capital less all intangible assets), well above the minimum levels. As of December 31, 2001, Heartland had regulatory capital in excess of the Federal Reserve's minimum requirements. Dividends. The Delaware General Corporation Law ("DGCL") allows Heartland to pay dividends only out of its surplus (as defined and computed in accordance with the provisions of the DGCL) or if Heartland has no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Additionally, the Federal Reserve has issued a policy statement with regard to the payment of cash dividends by bank holding companies. The policy statement provides that a bank holding company should not pay cash dividends which exceed its net income or which can only be funded in ways that weaken the bank holding company's financial health, such as by borrowing. The Federal Reserve also possesses enforcement powers over bank holding companies and their nonbank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies. Federal Securities Regulation. Heartland's common stock is registered with the SEC under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended ("Exchange Act"). Consequently, Heartland is subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act. The Bank Subsidiaries General. DB&T is an Iowa-chartered bank, the deposit accounts of which are insured by the FDIC's Bank Insurance Fund ("BIF"). As a BIF- insured, Iowa-chartered bank, DB&T is subject to the examination, supervision, reporting and enforcement requirements of the Iowa Superintendent, as the chartering authority for Iowa banks, and the FDIC, which under federal law is designated as the primary federal regulator of state-chartered, FDIC-insured banks that are not members of the Federal Reserve System. GSB and RCB are Illinois-chartered banks, the deposit accounts of which are insured by the BIF of the FDIC. As BIF-insured, Illinois-chartered banks, GSB and RCB are subject to the examination, supervision, reporting and enforcement requirements of the Illinois Commissioner, as the chartering authority for Illinois banks, and the FDIC, as the primary federal regulator of state-chartered, FDIC-insured banks that are not members of the Federal Reserve System. WCB is a Wisconsin-chartered bank, the deposit accounts of which are insured by the BIF of the FDIC. As a BIF-insured, Wisconsin- chartered bank, WCB is subject to the examination, supervision, reporting and enforcement requirements of the Wisconsin DFI, as the chartering authority for Wisconsin banks, and the FDIC, as the primary federal regulator of state-chartered, FDIC-insured banks that are not members of the Federal Reserve System. NMB is a New Mexico-chartered bank, the deposit accounts of which are insured by the BIF of the FDIC. As a BIF-insured, New Mexico- chartered bank, NMB is subject to the examination, supervision, reporting and enforcement requirements of the New Mexico Division, as the chartering authority for New Mexico banks, and the FDIC, as the primary federal regulator of state-chartered, FDIC-insured banks that are not members of the Federal Reserve System. FCB is a federally chartered savings association, the deposits of which are insured by the FDIC's Savings Association Insurance Fund ("SAIF"). As a SAIF-insured, federally chartered savings association, FCB is subject to the examination, supervision, reporting and enforcement requirements of the OTS, as the chartering authority for federal savings associations, and the FDIC, as administrator of the SAIF. Deposit Insurance. As FDIC-insured institutions, the Bank Subsidiaries are required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums based upon their respective levels of capital and results of supervisory evaluations. Institutions classified as well-capitalized (as defined by the FDIC) and considered healthy pay the lowest premium while institutions that are less than adequately capitalized (as defined by the FDIC) and considered of substantial supervisory concern pay the highest premium. Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period. During the year ended December 31, 2001, both BIF and SAIF assessments ranged from 0% of deposits to 0.27% of deposits. For the semi-annual assessment period beginning January 1, 2002, both BIF and SAIF assessment rates will continue to range from 0% of deposits to 0.27% of deposits. The FDIC may terminate the deposit insurance of any insured depository institution if the FDIC determines, after a hearing, that the institution: (i) has engaged or is engaging in unsafe or unsound practices; (ii) is in an unsafe or unsound condition to continue operations; or (iii) has violated any applicable law, regulation, order, or any condition imposed in writing by, or written agreement with, the FDIC. The FDIC may also suspend deposit insurance temporarily during the hearing process for a permanent termination of insurance if the institution has no tangible capital. Management of Heartland is not aware of any activity or condition that could result in termination of the deposit insurance of the Bank Subsidiaries. FICO Assessments. Since 1987, a portion of the deposit insurance assessments paid by SAIF members has been used to cover interest payments due on the outstanding obligations of the Financing Corporation ("FICO"). FICO was created in 1987 to finance the recapitalization of the Federal Savings and Loan Insurance Corporation, the SAIF's predecessor insurance fund. As a result of federal legislation enacted in 1996, beginning as of January 1, 1997, both SAIF members and BIF members became subject to assessments to cover the interest payments on outstanding FICO obligations until the final maturity of such obligations in 2019. These FICO assessments are in addition to amounts assessed by the FDIC for deposit insurance. During the year ended December 31, 2001, the FICO assessment rate for BIF and SAIF members was approximately 0.02% of deposits. Supervisory Assessments. All Iowa banks, Illinois banks, Wisconsin banks, New Mexico banks and federal savings associations are required to pay supervisory assessments to the Iowa Superintendent, the Illinois Commissioner, the Wisconsin DFI, the New Mexico Division and the OTS, respectively, to fund the operations of such agencies. In general, the amount of such supervisory assessments is based upon each institution's total assets. During the year ended December 31, 2001, the Bank Subsidiaries paid supervisory assessments totaling $256 thousand. Capital Requirements. The FDIC has established the following minimum capital standards for state-chartered insured non-member banks, such as DB&T, GSB, RCB, WCB and NMB: (i) a leverage requirement consisting of a minimum ratio of Tier 1 capital to total assets of 3% for the most highly-rated banks with a minimum requirement of at least 4% for all others; and (ii) a risk-based capital requirement consisting of a minimum ratio of total capital to total risk- weighted assets of 8%, and a minimum ratio of Tier 1 capital to total risk-weighted assets of 4%. For purposes of these capital standards, Tier 1 capital and total capital consist of substantially the same components as Tier 1 capital and total capital under the Federal Reserve's capital guidelines for bank holding companies (see "--Heartland--Capital Requirements"). Pursuant to the HOLA and OTS regulations, savings associations, such as FCB, are subject to the following minimum capital requirements: a core capital requirement, consisting of a minimum ratio of core capital to total assets of 3% for savings associations assigned a composite rating of 1 as of the association's most recent OTS examination, with a minimum core capital requirement of 4% of total assets for all other savings associations; a tangible capital requirement, consisting of a minimum ratio of tangible capital to total assets of 1.5%; and a risk-based capital requirement, consisting of a minimum ratio of total capital to total risk-weighted assets of 8%, and a minimum ratio of core capital to total risk-weighted assets of 4%. Core capital consists primarily of permanent stockholders' equity less: (i) intangible assets other than certain supervisory goodwill, certain loan servicing rights and certain purchased credit card relationships; and (ii) investments in subsidiaries engaged in activities not permitted for national banks. Tangible capital is substantially the same as core capital except that all intangible assets other than certain mortgage servicing rights must be deducted. Total capital consists primarily of core capital plus certain debt and equity instruments that do not qualify as core capital and a portion of FCB's allowances for loan and leases losses. The capital requirements described above are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual institutions. For example, the regulations of the FDIC and the OTS provide that additional capital may be required to take adequate account of, among other things, interest rate risk or the risks posed by concentrations of credit or nontraditional activities. Further, federal law and regulations provide various incentives to financial institutions to maintain regulatory capital at levels in excess of minimum regulatory requirements. For example, a financial institution that is "well-capitalized" may qualify for exemptions from prior notice or application requirements otherwise applicable to certain types of activities and may qualify for expedited processing of other required notices or applications. Additionally, one of the criteria which determines a bank holding company's eligibility to operate as a financial holding company is a requirement that all of its financial institution subsidiaries be "well-capitalized". Under the regulations of the FDIC and the OTS, in order to be "well- capitalized" a financial institution must maintain a ratio of total capital to total risk-weighted assets of 10% or greater, a ratio of Tier 1 capital to total risk-weighted assets of 6% or greater and a ratio of Tier 1 capital to total assets of 5% or greater. For purposes of these provisions of OTS regulations, "Tier 1 capital" is defined to mean core capital. Federal law also provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions. The extent of the regulators' powers depends on whether the institution in question is "adequately capitalized," "undercapitalized," "significantly undercapitalized" or "critically undercapitalized," in each case as defined by regulation. Depending upon the capital category to which an institution is assigned, the regulators' corrective powers include: (i) requiring the institution to submit a capital restoration plan; (ii) limiting the institution's asset growth and restricting its activities; (iii) requiring the institution to issue additional capital stock (including additional voting stock) or to be acquired; (iv) restricting transactions between the institution and its affiliates; (v) restricting the interest rate the institution may pay on deposits; (vi) ordering a new election of directors of the institution; (vii) requiring that senior executive officers or directors be dismissed; (viii) prohibiting the institution from accepting deposits from correspondent banks; (ix) requiring the institution to divest certain subsidiaries; (x) prohibiting the payment of principal or interest on subordinated debt; and (xi) ultimately, appointing a receiver for the institution. As of December 31, 2001: (i) none of the Bank Subsidiaries was subject to a directive from the FDIC or the OTS to increase its capital to an amount in excess of the minimum regulatory capital requirements; (ii) each of the Bank Subsidiaries exceeded its minimum regulatory capital requirements under applicable capital adequacy guidelines; and (iii) each of the Bank Subsidiaries was "well-capitalized", as defined by applicable regulations. Additionally, institutions insured by the FDIC may be liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with the default of commonly controlled FDIC insured depository institutions or any assistance provided by the FDIC to commonly controlled FDIC insured depository institutions in danger of default. Because Heartland owns more than 25% of the outstanding stock of each of the Bank Subsidiaries, the Bank Subsidiaries are deemed to be commonly controlled. Dividends. In general, under applicable state law, DB&T, GSB, RCB, WCB and NMB may not pay dividends in excess of their undivided profits. OTS regulations require prior OTS approval for any capital distribution by a savings association that is not eligible for expedited processing under the OTS's application processing regulations. In order to qualify for expedited processing, a savings association must: (i) have a composite examination rating of 1 or 2; (ii) have a Community Reinvestment Act rating of satisfactory or better; (iii) have a compliance rating of 1 or 2; (iv) meet all applicable regulatory capital requirements; and (v) not have been notified by the OTS that it is a problem association or an association in troubled condition. Savings associations that qualify for expedited processing are not required to obtain OTS approval prior to making a capital distribution unless: (a) the amount of the proposed capital distribution, when aggregated with all other capital distributions during the same calendar year, will exceed an amount equal to the association's year-to-date net income plus its retained net income for the preceding two years; (b) after giving effect to the distribution, the association will not be at least "adequately capitalized" (as defined by OTS regulation); or (c) the distribution would violate a prohibition contained in an applicable statute, regulation or agreement with the OTS or the FDIC or violate a condition imposed in connection with an OTS- approved application or notice. The OTS must be given prior notice of certain types of capital distributions, including any capital distribution by a savings association that, like FCB, is a subsidiary of a holding company, or by a savings association that, after giving effect to the distribution, would not be "well- capitalized" (as defined by OTS regulation). The payment of dividends by any financial institution or its holding company is affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be undercapitalized. As described above, each of the Bank Subsidiaries exceeded its minimum capital requirements under applicable guidelines as of December 31, 2001. Further, under applicable regulations of the OTS, the FCB may not pay dividends in an amount which would reduce its capital below the amount required for the liquidation account established in connection with the FCB's conversion from the mutual to the stock form of ownership in 1991. As of December 31, 2001, approximately $34.356 million was available to be paid as dividends to Heartland by the Bank Subsidiaries. Notwithstanding the availability of funds for dividends, however, the banking regulators may prohibit the payment of any dividends by the Bank Subsidiaries if such payment is deemed to constitute an unsafe or unsound practice. Insider Transactions. The Bank Subsidiaries are subject to certain restrictions imposed by federal law on extensions of credit to Heartland and its subsidiaries, on investments in the stock or other securities of Heartland and its subsidiaries and the acceptance of the stock or other securities of Heartland or its subsidiaries as collateral for loans. Certain limitations and reporting requirements are also placed on extensions of credit by the Bank Subsidiaries to their respective directors and officers, to directors and officers of Heartland and its subsidiaries, to principal stockholders of Heartland, and to "related interests" of such directors, officers and principal stockholders. In addition, federal law and regulations may affect the terms upon which any person becoming a director or officer of Heartland or one of its subsidiaries or a principal stockholder of Heartland may obtain credit from banks with which one of the Bank Subsidiaries maintains a correspondent relationship. Safety and Soundness Standards. The federal banking agencies have adopted guidelines which establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions. The guidelines set forth standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings. In general, the safety and soundness guidelines prescribe the goals to be achieved in each area, and each institution is responsible for establishing its own procedures to achieve those goals. If an institution fails to comply with any of the standards set forth in the guidelines, the institution's primary federal regulator may require the institution to submit a plan for achieving and maintaining compliance. If an institution fails to submit an acceptable compliance plan, or fails in any material respect to implement a compliance plan that has been accepted by its primary federal regulator, the regulator is required to issue an order directing the institution to cure the deficiency. Until the deficiency cited in the regulator's order is cured, the regulator may restrict the institution's rate of growth, require the institution to increase its capital, restrict the rates the institution pays on deposits or require the institution to take any action the regulator deems appropriate under the circumstances. Noncompliance with the standards established by the safety and soundness guidelines may also constitute grounds for other enforcement action by the federal banking regulators, including cease and desist orders and civil money penalty assessments. Branching Authority. Until 2001, an Iowa state bank, such as DB&T, could only establish a bank office within the boundaries of the counties contiguous to, or cornering upon, the county in which the principal place of business of the bank was located. Further, Iowa law prohibited an Iowa bank from establishing de novo branches in a municipality other than the municipality in which the bank's principal place of business was located, if another bank already operated one or more offices in the municipality in which the de novo branch was to be located. Under a recent change to the Iowa Banking Act, until June 30, 2004, Iowa banks, such as DB&T, have authority under Iowa law to establish up to three de novo branches at any location in Iowa, subject to regulatory approval, in addition to any branches established under the branching rules described above. Beginning July 1, 2004, Iowa banks may establish any number of branches at any location in Iowa, subject to regulatory approval. Illinois banks, such as GSB and RCB, have authority under Illinois law to establish branches anywhere in the State of Illinois, subject to receipt of all required regulatory approvals. Likewise, under the laws of Wisconsin and New Mexico, Wisconsin banks and New Mexico banks, respectively, have statewide branching authority, subject to regulatory approval. Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Riegle-Neal Act"), both state and national banks are allowed to establish interstate branch networks through acquisitions of other banks, subject to certain conditions, including certain limitations on the aggregate amount of deposits that may be held by the surviving bank and all of its insured depository institution affiliates. The establishment of new interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of- state bank in its entirety) is allowed by the Riegle-Neal Act only if specifically authorized by state law. The legislation allowed individual states to "opt-out" of certain provisions of the Riegle-Neal Act by enacting appropriate legislation prior to June 1, 1997. The laws of Iowa, Illinois, Wisconsin and New Mexico permit interstate bank mergers, subject to certain conditions, including a prohibition against interstate mergers involving an Iowa, Illinois, Wisconsin or New Mexico bank, respectively, that has been in existence and continuous operation for fewer than five years. Federally chartered savings associations which qualify as "domestic building and loan associations," as defined in the Internal Revenue Code, or meet the qualified thrift lender test (see "-The Bank Subsidiaries -- Qualified Thrift Lender Test") have the authority, subject to receipt of OTS approval, to establish or acquire branch offices anywhere in the United States. If a federal savings association fails to qualify as a "domestic building and loan association," as defined in the Internal Revenue Code, and fails to meet the qualified thrift lender test, the association may branch only to the extent permitted for national banks located in the savings association's home state. As of December 31, 2001, FCB qualified as a "domestic building and loan association," as defined in the Internal Revenue Code and met the qualified thrift lender test. State Bank Activities. Under federal law and FDIC regulations, FDIC insured state banks are prohibited, subject to certain exceptions, from directly or indirectly making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank. Federal law and FDIC regulations also prohibit FDIC insured state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank or its subsidiary, respectively, unless the bank meets, and continues to meet, its minimum regulatory capital requirements and the FDIC determines the activity would not pose a significant risk to the deposit insurance fund of which the bank is a member. These restrictions have not had, and are not currently expected to have, a material impact on the operations of DB&T, GSB, RCB, WCB or NMB. Qualified Thrift Lender Test. The HOLA requires every savings association to satisfy a "qualified thrift lender" ("QTL") test. Under the HOLA, a savings association will be deemed to meet the QTL test if it either (i) maintains at least 65% of its "portfolio assets" in "qualified thrift investments" on a monthly basis in nine out of every 12 months or (ii) qualifies as a "domestic building and loan association," as defined in the Internal Revenue Code. For purposes of the QTL test, "qualified thrift investments" consist of mortgage loans, mortgage-backed securities, education loans, small business loans, credit card loans and certain other housing and consumer-related loans and investments. "Portfolio assets" consist of a savings association's total assets less goodwill and other intangible assets, the association's business properties and a limited amount of the liquid assets maintained by the association pursuant to OTS requirements. A savings association that fails to meet the QTL test must either convert to a bank charter or operate under certain restrictions on its operations and activities. Additionally, within one year following the loss of QTL status, the holding company for the savings association will be required to register as, and will be deemed to be, a bank holding company. A savings association that fails the QTL test may requalify as a QTL but it may do so only once. As of December 31, 2001, FCB satisfied the QTL test, with a ratio of qualified thrift investments to portfolio assets of 65.97%, and qualified as a "domestic building and loan association," as defined in the Internal Revenue Code. Federal Reserve System. Federal Reserve regulations, as presently in effect, require depository institutions to maintain non-interest earning reserves against their transaction accounts (primarily NOW and regular checking accounts), as follows: for transaction accounts aggregating $41.3 million or less, the reserve requirement is 3% of total transaction accounts; and for transaction accounts aggregating in excess of $41.3 million, the reserve requirement is $1.239 million plus 10% of the aggregate amount of total transaction accounts in excess of $41.3 million. The first $5.7 million of otherwise reservable balances are exempted from the reserve requirements. These reserve requirements are subject to annual adjustment by the Federal Reserve. The Bank Subsidiaries are in compliance with the foregoing requirements. G. GOVERNMENTAL MONETARY POLICY AND ECONOMIC CONDITIONS The earnings of Heartland are affected by the policies of regulatory authorities, including the Federal Reserve System whose monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Because of changing conditions in the economy and in the money markets, as a result of actions by monetary and fiscal authorities, interest rates, credit availability and deposit levels may change due to circumstances beyond the control of Heartland. Future policies of the Federal Reserve System and other authorities cannot be predicted, nor can their effect on future earnings be predicted. ITEM 2. PROPERTIES The following table is a listing of the principal operating facilities of Heartland: Main Main Facility Facility Number Name and Main Square Owned or of Facility Address Footage Leased Locations ---------------- -------- -------- --------- Banking Subsidiary DB&T 1398 Central Avenue 59,500 Owned 8 Dubuque, IA 52001 GSB 971 Gear Street 18,000 Owned 3 Galena, IL 61036 RCB 6855 E. Riverside Blvd. 8,000 Owned 3 Rockford, IL 60114 FCB 320 Concert Street 6,000 Owned 3 Keokuk, IA 52632 WCB 580 North Main Street Cottage Grove, WI 53527 6,000 Owned 6 NMB 320 Gold NW Albuquerque, NM 87102 11,400 Lease term 9 through 2006 Main Facility Number Name and Main Owned or of Facility Address Leased Locations ---------------- -------- --------- Nonbanking Subsidiaries Citizens 1275 Main Street Leased Dubuque, IA 52001 from DB&T 4 ULTEA 2976 Triverton Pike Madison, WI 53711 Leased 1 The principal offices of Heartland are located in DB&T's main office. ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which Heartland or any of its subsidiaries is a party or of which any of their property is the subject. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of 2001 to a vote of security holders. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Heartland's common stock was held by approximately 930 stockholders of record as of March 12, 2002, and is traded in the over-the-counter market. The following table shows, for the periods indicated, the range of reported prices per share of Heartland's common stock in the over-the-counter market. These quotations represent inter-dealer prices without retail markups, markdowns or commissions and do not necessarily represent actual transactions. Heartland Common Stock Calendar Quarter High Low ---- --- 2000: First $18 1/2 $14 7/8 Second 16 1/4 14 Third 15 14 Fourth 14 5/8 12 1/2 2001: First $14 1/4 $12 1/2 Second 14 10 1/4 Third 13 13/16 13 5/32 Fourth 13 1/2 12 25/32 Cash dividends have been declared by Heartland quarterly during the past two years ending December 31, 2001. The following table sets forth the cash dividends per share paid on Heartland's common stock for the past two years: Calendar Quarter 2001 2000 ---- ---- First $.09 $.09 Second .09 .09 Third .09 .09 Fourth .10 .09 ITEM 6. SELECTED FINANCIAL DATA (Dollars in thousands, except per share data) For the Years Ended December 31, 2001 2000 1999 --------------------------------- STATEMENT OF INCOME DATA Interest income $ 110,088 $ 104,250 $ 74,154 Interest expense 60,193 59,709 40,849 ---------- ---------- ---------- Net interest income 49,895 44,541 33,305 Provision for loan and lease losses 4,283 3,301 2,626 ---------- ---------- ---------- Net interest income after provision for loan and lease losses 45,612 41,240 30,679 Noninterest income 30,334 27,008 25,424 Noninterest expense 58,818 54,446 44,722 Provision for income taxes 5,714 4,216 3,156 ---------- ---------- ---------- Net income $ 11,414 $ 9,586 $ 8,225 ========== ========== ========== PER COMMON SHARE DATA Net income-basic $ 1.19 $ 1.00 $ 0.86 Net income-diluted 1.18 0.98 0.84 Cash dividends 0.37 0.36 0.34 Dividend payout ratio 37.07% 36.15% 39.47% Book value $ 11.06 $ 10.00 $ 9.03 Weighted average shares outstanding 9,602,520 9,628,038 9,555,194 BALANCE SHEET DATA Investments and federal funds sold $ 349,417 $ 274,365 $ 213,452 Total loans and leases, net of unearned 1,105,205 1,042,096 835,146 Allowance for loan and lease losses 14,660 13,592 10,844 Total assets 1,644,064 1,466,387 1,184,147 Total deposits 1,205,159 1,101,313 869,659 Long-term obligations 143,789 102,856 105,737 Stockholders' equity 107,090 96,146 86,573 EARNINGS PERFORMANCE DATA Return on average total assets 0.72% 0.70% 0.78% Return on average stockholders' equity 11.32 10.69 9.61 Net interest margin ratio(1) 3.65 3.74 3.64 Earnings to fixed charges: Excluding interest on deposits 2.18x 1.82x 2.15x Including interest on deposits 1.28 1.23 1.28 ASSET QUALITY RATIOS Nonperforming assets to total assets 0.52% 0.51% 0.19% Nonperforming loans and leases to total loans and leases 0.73 0.65 0.20 Net loan and lease charge-offs to average loans and leases 0.30 0.17 0.06 Allowance for loan and lease losses to total loans and leases 1.33 1.30 1.30 Allowance for loan and lease losses to nonperforming loans and leases 180.47 201.60 657.49 CAPITAL RATIOS Average equity to average assets 6.47% 6.54% 8.12% Total capital to risk-adjusted assets 10.89 9.90 11.68 Tier 1 leverage 7.53 7.25 8.85 (1) Tax equivalent using a 34% tax rate. SELECTED FINANCIAL DATA (Dollars in thousands, except per share data) For the Years Ended December 31, 1998 1997 ----------------------- STATEMENT OF INCOME DATA Interest income $ 64,517 $ 59,261 Interest expense 36,304 31,767 ---------- ---------- Net interest income 28,213 27,494 Provision for loan and lease losses 951 1,279 ---------- ---------- Net interest income after provision for loan and lease losses 27,262 26,215 Noninterest income 17,297 8,565 Noninterest expense 31,781 22,927 Provision for income taxes 3,757 3,338 ---------- ---------- Net income $ 9,021 $ 8,515 ========== ========== PER COMMON SHARE DATA Net income-basic $ 0.95 $ 0.90 Net income-diluted 0.94 0.89 Cash dividends 0.31 0.26 Dividend payout ratio 32.48% 28.96% Book value $ 8.84 $ 8.19 Weighted average shares outstanding 9,463,313 9,476,342 BALANCE SHEET DATA Investments and federal funds sold $ 259,964 $ 234,666 Total loans and leases, net of unearned 590,133 556,406 Allowance for loan and lease losses 7,945 7,362 Total assets 953,785 852,060 Total deposits 717,877 623,532 Long-term obligations 80,016 71,756 Stockholders' equity 84,270 77,772 EARNINGS PERFORMANCE DATA Return on average total assets 1.01% 1.09% Return on average stockholders' equity 11.26 11.59 Net interest margin ratio(1) 3.58 3.89 Earnings to fixed charges: Excluding interest on deposits 2.65x 2.97x Including interest on deposits 1.35 1.37 ASSET QUALITY RATIOS Nonperforming assets to total assets 0.28% 0.34% Nonperforming loans and leases to total loans and leases 0.30 0.37 Net loan and lease charge-offs to average loans and leases 0.07 0.08 Allowance for loan and lease losses to total loans and leases 1.35 1.32 Allowance for loan and lease losses to nonperforming loans and leases 453.74 362.30 CAPITAL RATIOS Average equity to average assets 9.01% 9.39% Total capital to risk-adjusted assets 12.13 12.71 Tier 1 leverage 8.58 8.76 (1) Tax equivalent using a 34% tax rate. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS The following presents management's discussion and analysis of the consolidated financial condition and results of operations of Heartland Financial USA, Inc. ("Heartland") as of the dates and for the periods indicated. This discussion should be read in conjunction with the Selected Financial Data, Heartland's Consolidated Financial Statements and the Notes thereto and other financial data appearing elsewhere in this report. The consolidated financial statements include the accounts of Heartland and its subsidiaries. All of Heartland's subsidiaries are wholly-owned except for New Mexico Bank & Trust, of which Heartland was an 86% owner on December 31, 2001. This report (including information incorporated 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. 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. Heartland's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects of Heartland and its subsidiaries include, but are not limited to, the following: - The strength of the United States economy in general and the strength of the local economies in which Heartland conducts its operations which may be less favorable than expected and may result in, among other things, a deterioration in the credit quality and value of Heartland's assets. - The economic impact of the terrorist attacks that occurred on September 11th, as well as any future threats and attacks, and the response of the United States to any such threats and attacks. - The effects of, and changes in, federal, state and local laws, regulations and policies affecting banking, securities, insurance and monetary and financial matters. - The effects of changes in interest rates (including the effects of changes in the rate of prepayments of Heartland's assets) and the policies of the Board of Governors of the Federal Reserve System. - The ability of Heartland to compete with other financial institutions as effectively as Heartland currently intends due to increases in competitive pressures in the financial services sector. - The inability of Heartland to obtain new customers and to retain existing customers. - The timely development and acceptance of products and services, including products and services offered through alternative delivery channels such as the Internet. - Technological changes implemented by Heartland and by other parties, including third party vendors, which may be more difficult or more expensive than anticipated or which may have unforeseen consequences to Heartland and its customers. - The ability of Heartland to develop and maintain secure and reliable electronic systems. - The ability of Heartland to retain key executives and employees and the difficulty that Heartland may experience in replacing key executives and employees in an effective manner. - Consumer spending and saving habits which may change in a manner that affects Heartland's business adversely. - Business combinations and the integration of acquired businesses may be more difficult or expensive than expected. - The costs, effects and outcomes of existing or future litigation. - Changes in accounting policies and practices, as may be adopted by state and federal regulatory agencies and the Financial Accounting Standards Board. - The ability of Heartland to manage the risks associated with the foregoing as well as anticipated. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Additional information concerning Heartland and its business, including other factors that could materially affect Heartland's financial results, is included in Heartland's filings with the Securities and Exchange Commission. OVERVIEW Heartland is a diversified financial services holding company providing full-service community banking through six banking subsidiaries with a total of 32 banking locations in Iowa, Illinois, Wisconsin and New Mexico. In addition, Heartland has separate subsidiaries in the consumer finance, vehicle leasing/fleet management, insurance agency and investment management businesses. Heartland's primary strategy is to balance its focus on increasing profitability with asset growth and diversification through acquisitions, de novo bank formations, branch openings and expansion into non-bank subsidiary activities. 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, fees and gains on loans, rental income on operating leases and trust income, also affects Heartland's results of operations. Heartland's principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy and equipment costs, depreciation on equipment under operating leases and provision for loan and lease losses. The year 2001 proved to be a challenging one as the economy weakened and the effects of the September 11 tragedy lingered. In spite of all the turmoil occurring, Heartland was able to record double-digit growth in both earnings and assets for the second consecutive year. For the year ended December 31, 2001, net income totaled $11.414 million, an increase of $1.828 million or 19% when compared to the net income of $9.586 million recorded in 2000. Diluted earnings per common share grew to $1.18 from the $.98 recorded during 2000. Return on common equity was 11.32% and return on assets was .72% for 2001, compared to 10.69% and .70%, respectively, for 2000. Contributing to the increased earnings during 2001 was the 12% increase in net interest income, due in large part to growth in average earning assets. Additionally, noninterest income experienced a 12% increase, primarily due to additional gains on sale of loans and service charges and fees. As interest rates moved downward throughout the year, customers frequently elected to refinance into fifteen- and thirty-year, fixed-rate mortgage loans, which Heartland usually elects to sell into the secondary market while retaining servicing. Total assets reached $1.644 billion at year-end 2001, an increase of 12% over year-end 2000. Even though the economy weakened throughout the year, Heartland was able to grow its loan portfolio by 6% and its deposit account balances by 9% in 2001. For the year ended December 31, 2000, earnings increased $1.361 million or nearly 17% when compared to the net income of $8.225 million recorded in 1999. Earnings grew to $.98 per diluted common share compared to $.84 recorded during 1999. Return on common equity was 10.69% and return on assets was .70% for 2000, compared to 9.61% and .78%, respectively, for the same period in 1999. The improvement in earnings during 2000 resulted primarily from an expansion of net interest income by 34%. Noninterest income improved by 6% and noninterest expenses began to level off at a 22% increase over the prior year. Total assets reached $1.466 billion at year-end 2000, an increase of 24% over year-end 1999. Of particular note was the significant growth experienced in the loan portfolio, which increased 25% in 2000. Growth in deposits was also substantial, increasing 27% in 2000. The initiatives undertaken in previous years to position Heartland for the increased earnings experienced in 2001 and 2000 were: - New Mexico Bank & Trust was established in Albuquerque, New Mexico, in May of 1998 and subsequently opened three branches during the second and third quarters of 1999 and one during the last quarter of 2001. The First National Bank of Clovis was acquired and subsequently merged into New Mexico Bank & Trust on January 1, 2000. Total assets at New Mexico Bank & Trust reached $300.2 million at December 31, 2001. - Wisconsin Community Bank was acquired in March of 1997 and subsequently opened a branch office in Middleton, Wisconsin in early 1998. Additional offices were opened during 1999 in Sheboygan, Green Bay and Eau Claire, Wisconsin and the acquisition of Bank One Wisconsin's Monroe branch was completed in July of 1999. Total assets at this entity grew from $54.0 million at year-end 1998 to $233.1 million on December 31, 2001. - Riverside Community Bank, Heartland's 1995 de novo bank in Rockford, Illinois, opened two additional branch locations, one in July of 1999 and the other in March of 2000. Total assets at Riverside Community Bank reached $131.6 million at December 31, 2001. RESULTS OF OPERATIONS NET INTEREST INCOME Net interest income is the difference between interest income earned on earning assets and interest expense paid on interest bearing liabilities. As such, net interest income is affected by changes in the volume and yields on earning assets and the volume and rates paid on interest bearing liabilities. Net interest margin is the ratio of tax equivalent net interest income to average earning assets. Net interest margin, expressed as a percentage of average earning assets, decreased from 3.74% during 2000 to 3.65% during 2001. During 2000, national prime increased from 8.50% at the beginning of the year to 9.50% at the end of the year. Conversely, during 2001, national prime decreased from 9.50% to 4.75%. Heartland's negative gap position suggested a larger improvement in the net interest margin during such a period of downward movement in interest rates, but management elected to remain competitive in the market areas it serves and not reprice its deposit products as quickly. In addition to the delay in repricing of deposit products, also negatively impacting the net interest margin was the change in the composition of the balance sheet, as the percentage of average loans to total average earning assets decreased from 80% in 2000 to 76% in 2001. Loan growth slowed due to paydowns experienced in the mortgage loan portfolio and reduced demand in the commercial loan portfolio. As rates declined, the real estate loan portfolio experienced refinancing activity into fifteen- and thirty-year mortgages, which Heartland usually elects to sell into the secondary market. Growth in the commercial loan portfolio increased during the last half of 2001 and management continues to feel that opportunities for growth within this portfolio will exist during 2002. Net interest margin expressed as a percentage of average earning assets increased to 3.74% during 2000 compared to 3.64% for 1999. Heartland was able to improve its net interest margin in spite of a turbulent rate environment due, in part, to the 52% growth in average noninterest bearing demand deposit balances. These balances made up 12% of the total average deposits during 2000 compared to 10% during 1999. Additionally, the percentage of average loans to average earning assets increased from 75% during 1999 to 80%. Net interest income on a fully tax equivalent basis was $50.986, $45.658 and $34.125 million for 2001, 2000 and 1999, respectively, an increase of 12% for 2001 and 34% for 2000. These increases were the largest contributors to the double-digit growth in earnings experienced during both years and were primarily attributable to the growth in earning assets and the ability to keep the increase in interest expense below the growth in interest income. Average earning assets grew $175 million or 14% and $282 million or 30% during 2001 and 2000, respectively. Heartland continues to manage its balance sheet on a proactive basis. 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 years indicated. 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 are included in each respective loan category. ANALYSIS OF AVERAGE BALANCES, TAX EQUIVALENT YIELDS AND RATES(1) (Dollars in thousands) For the Year Ended December 31, 2001 Average Balance Interest Rate ------- -------- ---- EARNING ASSETS Securities: Taxable $ 253,290 $ 14,143 5.58% Nontaxable(1) 30,909 2,712 8.77 ---------- ---------- Total securities 284,199 16,855 5.93 ---------- ---------- Interest bearing deposits 7,320 243 3.32 Federal funds sold 49,126 1,981 4.03 ---------- ---------- Loans and leases: Commercial and commercial real estate(1) 595,969 47,187 7.92 Residential mortgage 191,081 15,364 8.04 Agricultural and agricultural real estate(1) 139,421 11,767 8.44 Consumer 126,027 13,278 10.54 Direct financing leases, net 16,574 1,242 7.49 Fees on loans - 3,262 - Less: allowance for loan and lease losses (14,528) - - ---------- ---------- Net loans and leases 1,054,544 92,100 8.73 ---------- ---------- Total earning assets 1,395,189 111,179 7.97 ---------- ---------- NONEARNING ASSETS Total nonearning assets 163,143 - - ---------- ---------- TOTAL ASSETS $1,558,332 $ 111,179 7.13% ========== ========== ====== INTEREST BEARING LIABILITIES Interest bearing deposits: Savings accounts $ 427,953 $ 11,967 2.80% Time, $100 and over 143,429 8,227 5.74 Other time deposits 441,505 25,714 5.82 Short-term borrowings 151,626 5,963 3.93 Other borrowings 123,959 8,322 6.71 ---------- ---------- Total interest bearing liabilities 1,288,472 60,193 4.67 ---------- ---------- NONINTEREST BEARING LIABILITIES Noninterest bearing deposits 139,870 - - Accrued interest and other liabilities 29,154 - - ---------- ---------- Total noninterest bearing liabilities 169,024 - - ---------- ---------- Stockholders' Equity 100,836 - - ---------- ---------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,558,332 $ 60,193 3.86% ========== ========== ====== Net interest income(1) $ 50,986 ========== Net interest income to total earning assets(1) 3.65% ====== Interest bearing liabilities to earning assets 92.35% ========== (1) Tax equivalent basis is calculated using an effective tax rate of 34%. ANALYSIS OF AVERAGE BALANCES, TAX EQUIVALENT YIELDS AND RATES(1) (Dollars in thousands) For the Year Ended December 31, 2000 Average Balance Interest Rate ------- -------- ---- EARNING ASSETS Securities: Taxable $ 189,610 $ 11,824 6.24% Nontaxable(1) 31,026 2,748 8.86 ---------- ---------- Total securities 220,636 14,572 6.60 ---------- ---------- Interest bearing deposits 5,796 333 5.75 Federal funds sold 16,874 911 5.40 ---------- ---------- Loans and leases: Commercial and commercial real estate(1) 520,777 45,228 8.68 Residential mortgage 202,429 16,376 8.09 Agricultural and agricultural real estate(1) 133,043 11,848 8.91 Consumer 118,455 12,625 10.66 Direct financing leases, net 15,027 1,056 7.03 Fees on loans - 2,418 - Less: allowance for loan and lease losses (12,984) - - ---------- ---------- Net loans and leases 976,747 89,551 9.17 ---------- ---------- Total earning assets 1,220,053 105,367 8.64 ---------- ---------- NONEARNING ASSETS Total nonearning assets 150,345 - - ---------- ---------- TOTAL ASSETS $1,370,398 $ 105,367 7.69% ========== ========== ====== INTEREST BEARING LIABILITIES Interest bearing deposits: Savings accounts $ 385,047 $ 13,913 3.61% Time, $100 and over 99,322 6,001 6.04 Other time deposits 400,096 23,281 5.82 Short-term borrowings 120,717 6,993 5.79 Other borrowings 128,745 9,521 7.40 ---------- ---------- Total interest bearing liabilities 1,133,927 59,709 5.27 ---------- ---------- NONINTEREST BEARING LIABILITIES Noninterest bearing deposits 124,117 - - Accrued interest and other liabilities 22,681 - - ---------- ---------- Total noninterest bearing liabilities 146,798 - - ---------- ---------- Stockholders' Equity 89,673 - - ---------- ---------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,370,398 $ 59,709 4.36% ========== ========== ====== Net interest income(1) $ 45,658 ========== Net interest income to total earning assets(1) 3.74% ====== Interest bearing liabilities to earning assets 92.94% ========== (1) Tax equivalent basis is calculated using an effective tax rate of 34%. ANALYSIS OF AVERAGE BALANCES, TAX EQUIVALENT YIELDS AND RATES(1) (Dollars in thousands) For the Year Ended December 31, 1999 Average Balance Interest Rate ------- -------- ---- EARNING ASSETS Securities: Taxable $ 200,559 $ 11,113 5.54% Nontaxable(1) 21,010 1,842 8.77 ---------- ---------- Total securities 221,569 12,955 5.85 ---------- ---------- Interest bearing deposits 8,176 468 5.72 Federal funds sold 7,741 410 5.30 ---------- ---------- Loans and leases: Commercial and commercial real estate(1) 365,199 29,790 8.16 Residential mortgage 162,878 12,773 7.84 Agricultural and agricultural real estate(1) 86,505 7,382 8.53 Consumer 86,132 8,683 10.08 Direct financing leases, net 9,401 659 7.01 Fees on loans - 1,854 - Less: allowance for loan and lease losses (9,336) - - ---------- ---------- Net loans and leases 700,779 61,141 8.72 ---------- ---------- Total earning assets 938,265 74,974 7.99 ---------- ---------- NONEARNING ASSETS Total nonearning assets 115,757 - - ---------- ---------- TOTAL ASSETS $1,054,022 $ 74,974 7.11% ========== ========== ====== INTEREST BEARING LIABILITIES Interest bearing deposits: Savings accounts $ 324,476 $ 10,789 3.33% Time, $100 and over 59,822 3,222 5.39 Other time deposits 312,051 17,169 5.50 Short-term borrowings 87,376 4,046 4.63 Other borrowings 84,967 5,623 6.62 ---------- ---------- Total interest bearing liabilities 868,692 40,849 4.70 ---------- ---------- NONINTEREST BEARING LIABILITIES Noninterest bearing deposits 81,511 - - Accrued interest and other liabilities 18,254 - - ---------- ---------- Total noninterest bearing liabilities 99,765 - - ---------- ---------- Stockholders' Equity 85,565 - - ---------- ---------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,054,022 $ 40,849 3.88% ========== ========== ====== Net interest income(1) $ 34,125 ========== Net interest income to total earning assets(1) 3.64% ====== Interest bearing liabilities to earning assets 92.58% ========== (1) Tax equivalent basis is calculated using an effective tax rate of 34%. The following table allocates the changes in net interest income to differences in either average balances or average rates for earning assets and interest bearing liabilities. The changes have been allocated proportionately to the change due to volume and change due to rate. Interest income is measured on a tax equivalent basis using a 34% tax rate. ANALYSIS OF CHANGES IN NET INTEREST INCOME (Dollars in thousands) For the Year Ended December 31, 2001 Compared to 2000 Change Due to Volume Rate Net -------------------------- EARNING ASSETS/INTEREST INCOME Securities Taxable $ 3,971 $(1,652) $ 2,319 Nontaxable (10) (26) (36) Interest bearing deposits 88 (178) (90) Federal funds sold 1,741 (671) 1,070 Loans and leases 7,133 (4,584) 2,549 ------- ------- ------- TOTAL EARNING ASSETS 12,923 (7,111) 5,812 LIABILITIES/INTEREST EXPENSE Interest bearing deposits Savings accounts 1,550 (3,496) (1,946) Time, $100 and over 2,665 (439) 2,226 Other time deposits 2,410 23 2,433 Short-term borrowings 1,791 (2,821) (1,030) Other borrowings (354) (845) (1,199) ------- ------- ------- TOTAL INTEREST BEARING LIABILITIES 8,062 (7,578) 484 ------- ------- ------- NET INTEREST INCOME $ 4,861 $ 467 $ 5,328 ======= ======= ======= ANALYSIS OF CHANGES IN NET INTEREST INCOME (Dollars in thousands) For the Year Ended December 31, 2000 Compared to 1999 Change Due to Volume Rate Net -------------------------- EARNING ASSETS/INTEREST INCOME Securities Taxable $ (607) $ 1,318 $ 711 Nontaxable 878 28 906 Interest bearing deposits (136) 1 (135) Federal funds sold 484 17 501 Loans and leases 24,077 4,333 28,410 ------- ------- ------- TOTAL EARNING ASSETS 24,696 5,697 30,393 LIABILITIES/INTEREST EXPENSE Interest bearing deposits Savings accounts 2,014 1,110 3,124 Time, $100 and over 2 127 652 2,779 Other time deposits 4,844 1,268 6,112 Short-term borrowings 1,544 1,403 2,947 Other borrowings 2,897 1,001 3,898 ------- ------- ------- TOTAL INTEREST BEARING LIABILITIES 13,426 5,434 18,860 ------- ------- ------- NET INTEREST INCOME $11,270 $ 263 $11,533 ======= ======= ======= PROVISION FOR LOAN AND LEASE LOSSES The allowance for loan and lease losses is established through a provision charged to expense. The provision for loan and lease losses was $4.283 million during 2001, $3.301 million during 2000 and $2.626 million during 1999, increases of $982 thousand or 30% during 2001 and $675 thousand or 26% during 2000. In part, these increases were recorded in response both to the loan growth experienced and to an increase in nonperforming loans. They were made to provide, in Heartland's opinion, an adequate allowance for loan and lease losses. The adequacy of the allowance for loan and lease losses is determined by management using factors that include the overall composition of the loan portfolio, general economic conditions, types of loans, past loss experience, loan delinquencies, and probable substandard and doubtful credits. A weakening economy will inevitably result in increased problem loans, but Heartland expects the problems to be manageable and of a lesser scope for Heartland than for the industry as a whole. For additional details on the specific factors considered, refer to the allowance for loan and lease losses section of this report. NONINTEREST INCOME (Dollars in thousands) For the Years Ended December 31, 2001 2000 1999 --------------------------- Service charges and fees $ 6,381 $ 5,386 $ 3,906 Trust fees 3,148 3,088 2,662 Brokerage commissions 615 846 655 Insurance commissions 807 862 803 Securities gains, net 1,489 501 713 Loss on trading account securities (417) - - Impairment loss on equity securities (773) (244) - Rental income on operating leases 15,446 14,918 14,718 Gains on sale of loans 2,738 521 1,028 Other noninterest income 900 1,130 939 ------- ------- ------- Total noninterest income $30,334 $27,008 $25,424 ======= ======= ======= The above table shows Heartland's noninterest income for the years indicated. Total noninterest income increased $3.326 million or 12% during 2001, compared to an increase of $1.584 million or 6% during 2000. During both periods, the noninterest income categories reflecting significant improvement were service charges and fees and gains on sale of loans. Emphasis during the past several years on enhancing revenues from services provided to customers has resulted in significant growth in service charges and fees. These fees increased $995 thousand or 18% during 2001. Exclusive of the Clovis, New Mexico acquisition, these fees increased $1.102 million or 28% during 2000. Average noninterest bearing checking account balances increased $15.753 million or 13% during 2001. These balances increased $16.796 million or 21%, exclusive of the Clovis acquisition, during 2000. The growth in these types of accounts generates additional service charge revenue as activity fees are charged to these accounts. Service fees are also collected on the mortgage loans Heartland has sold into the secondary market while retaining servicing. Heartland's servicing portfolio was $188.258 million at year-end 1999, $183.880 million at year-end 2000 and $268.625 million at year-end 2001. Also contributing to the increase in service charges and fees was the growth in fees collected for the processing of merchant credit card activity. Gains on sale of loans totaled $2.738 million during 2001, $521 thousand during 2000 and $1.028 million during 1999. The volume of mortgage loans sold into the secondary market during 2001 was significantly greater than those sold during 2000. As rates moved downward, customers frequently elected to take fifteen- and thirty-year, fixed-rate mortgage loans, which Heartland usually elects to sell into the secondary market. The volume of mortgage loans sold into the secondary market began to decline during 1999 as rates moved upward and customers elected to take three- and five-year adjustable rate mortgage loans, which Heartland elected to retain in its loan portfolio. The volume of mortgage loans sold into the secondary market continued to fall significantly during the first half of 2000 as rates continued to move upward. The continual decline of interest rates during 2001 provided an opportunity for Heartland to realize securities gains in its bond portfolio. Securities gains recorded during 2001 totaled $1.489 million compared to the total of $501 thousand recorded during 2000. Securities gains would have been even larger had it not been for losses realized in Heartland's equity securities portfolio, driven primarily by the continued decline in the stock market during 2001. Even with the decline in the stock market, some net gains were realized in the equity securities portfolio, but the majority of the securities gains during 2001 were realized in the bond securities portfolio. Securities gains decreased $212 thousand or 30% during 2000 as gains on the equity securities portfolio were partially offset by losses realized when short term agency securities were sold and replaced with longer term agency securities to enhance the future total return of the bond securities portfolio by lengthening the portfolio. These trades were made during the first quarter of 2000 because of the Heartland interest rate forecast, which called for declining rates during the remainder of 2000. As rates declined in 2001, Heartland's interest rate forecast changed to an upward bias and therefore, longer-term agency securities were sold at a gain to shorten the portfolio. In order to reduce the interest rate risk of rising interest rates, the proceeds were invested in well-seasoned premium mortgaged backed securities that were projected to outperform the agency securities in a rising interest rate environment. During the first quarter of 2001, Heartland elected to begin classifying some of its new equity securities purchases as trading. Losses on this portfolio totaled $417 thousand for the year, primarily as a result of the continual decline in the stock market. Impairment losses on equity securities totaled $773 thousand during 2001. Heartland was a limited partner in an investment partnership that had a portion of its funds invested in a company that filed bankruptcy under Chapter 11 in 2001. The impairment loss recorded on this investment totaled $700 thousand and reflected Heartland's 30% ownership. Since year-end, Heartland has begun the process of divesting its interest in this partnership. The remaining $73 thousand of impairment losses recorded during 2001 related to common stock held in the available for sale equity securities portfolio. The carrying value of this stock on Heartland's balance sheet at December 31, 2001, was $75 thousand. Similarly, during 2000, an impairment loss on equity securities of $244 thousand was recorded. This loss resulted from the announcement that Safety Kleen Corp. had filed bankruptcy under Chapter 11. Heartland held 20,000 shares of Safety Kleen's common stock in its equity portfolio. The carrying value of this stock on Heartland's balance sheet as of December 31, 2001, was $4 thousand. Rental income on operating leases increased $528 thousand or 4% during 2001. This increase resulted from the normal replacement of vehicles under lease at our vehicle leasing and fleet management subsidiary, ULTEA. As vehicles within a fleet are replaced every three or four years, rent levels rise correspondingly to the increase in the cost of new vehicles. NONINTEREST EXPENSE (Dollars in thousands) For the Years Ended December 31, 2001 2000 1999 --------------------------- Salaries and employee benefits $25,460 $23,876 $18,945 Occupancy 3,076 2,904 2,076 Furniture and equipment 3,193 3,015 2,416 Depreciation on equipment under operating leases 11,805 11,199 10,844 Outside services 3,470 2,661 2,239 FDIC deposit insurance assessment 208 228 121 Advertising 1,596 1,492 1,376 Goodwill and core deposit intangibles amortization 1,672 1,814 682 Other noninterest expenses 8,338 7,257 6,023 ------- ------- ------- Total noninterest expense $58,818 $54,446 $44,722 ======= ======= ======= Efficiency ratio(1) 73.68% 75.45% 76.01% ======= ======= ======= (1) Noninterest expense divided by the sum of net interest income and noninterest income less securities gains. The above table shows Heartland's noninterest expense for the years indicated. Noninterest expense increased $4.372 million or 8% in 2001 and $9.724 million or 22% in 2000. Growth in some of these expenses began to taper off in 2001 as Heartland began to realize the full utilization of the resources it expended during the early stages of its 1999 and 2000 growth initiatives. Salaries and employee benefits expense, the largest component of noninterest expense, experienced increases of $1.584 million or 7% and $4.931 million or 26% during 2001 and 2000, respectively. In addition to the normal merit and cost of living raises, these increases, particularly during 2000, were attributable to Heartland's acquisition and expansion efforts. The number of full- time equivalent employees increased from 484 at December 31, 1999, to 544 at December 31, 2000, and 581 at December 31, 2001. Expansion efforts resulted in additional occupancy, furniture and equipment and advertising/public relations costs during 2000. The growth in these expenses leveled off in 2001. In the aggregate, these expenses increased $1.543 million or 26% during 2000 compared to $454 thousand or 6% during 2001. Consistent with the vehicle replacement activity occurring at ULTEA, the depreciation on equipment under operating leases grew $355 thousand or 3% during 2000 and $606 thousand or 5% during 2001. Fees for outside services increased $809 thousand or 30% during 2001 and $422 thousand or 19% during 2000. Contributing to these increases were the following: - Beginning in 2001, Heartland elected to outsource its internal audit function instead of fully staffing an internal audit department. - As on-line banking has grown in popularity, Heartland has incurred additional costs to provide this service to its customers. - As a result of enhancing the fleet card program at ULTEA, additional conversion costs were incurred during 2001. - Legal and professional fees related to Heartland's continuing exploration of potential acquisitions were paid during 2001. The Clovis acquisition made at the beginning of 2000 resulted in additional goodwill and core deposit intangible amortization. Additionally, 2000 was the first full year of amortization on the merger-related intangibles that resulted from the acquisition of Bank One Wisconsin's Monroe branch in July of 1999. This amortization of merger-related intangibles increased $1.132 million or 166% during 2000. Other noninterest expenses increased $1.081 million or 15% during 2001 and $1.234 million or 20% during 2000. Over half of the 2001 increase was the result of additional processing fees related to the increased activity in the merchant credit card processing area. Some of the expenses included within the other noninterest expenses that experienced significant growth as a result of expansion efforts were amortization and maintenance expense on software, office supplies, postage and telephone charges. During 2000, the conversion of the Clovis entity to the banking software utilized by the Heartland banks also contributed to the increase in this category. INCOME TAXES Income tax expense increased $1.498 million or 36% for 2001 and $1.060 million or 34% for 2000, primarily as a result of increased pre-tax earnings. Heartland's effective tax rate was 33.36% for 2001, 30.55% for 2000 and 27.73% for 1999. The effective tax rate has grown over the years, in part, as a result of the amount of additional merger-related goodwill and other intangibles amortization expense recorded that is not deductible for federal income tax purposes. These expenses have grown as a percentage of pre-tax income from 2.90% in 1999 to 4.26% in 2000 and 5.71% in 2001. Additionally, tax-exempt interest income on securities and loans as a percentage of pre-tax income has varied over the past several years. Tax-exempt interest income was 12% of pre-tax income during 2001 compared to 16% for 2000 and 14% for 1999. FINANCIAL CONDITION LENDING ACTIVITIES Heartland's major source of income is interest on loans and leases. The table below presents the composition of Heartland's loan portfolio at the end of the years indicated. LOAN PORTFOLIO (Dollars in thousands) December 31, 2001 2000 Amount Percent Amount Percent ---------- ------- ---------- ------- Commercial and commercial real estate $ 651,479 58.73% $ 550,366 52.62% Residential mortgage 168,912 15.23 215,638 20.62 Agricultural and agricultural real estate 145,460 13.11 133,614 12.78 Consumer 127,874 11.53 128,685 12.30 Lease financing, net 15,570 1.40 17,590 1.68 ---------- ------- ---------- ------- Gross loans and leases 1,109,295 100.00% 1,045,893 100.00% ======= ======= Unearned discount (3,457) (3,397) Deferred loan fees (633) (400) ---------- ---------- Total loans and leases 1,105,205 1,042,096 Allowance for loan and lease losses (14,660) (13,592) ---------- ---------- Loans and leases, net $1,090,545 $1,028,504 ========== ========== LOAN PORTFOLIO (Dollars in thousands) December 31, 1999 1998 Amount Percent Amount Percent ---------- ------- ---------- ------- Commercial and commercial real estate $ 448,991 53.53% $ 277,765 46.88% Residential mortgage 180,347 21.50 156,415 26.40 Agricultural and agricultural real estate 92,936 11.08 77,211 13.03 Consumer 103,608 12.35 72,642 12.26 Lease financing, net 12,886 1.54 8,508 1.43 ---------- ------- ---------- ------- Gross loans and leases 838,768 100.00% 592,541 100.00% ======= ======= Unearned discount (3,169) (2,136) Deferred loan fees (453) (272) ---------- ---------- Total loans and leases 835,146 590,133 Allowance for loan and lease losses (10,844) (7,945) ---------- ---------- Loans and leases, net $ 824,302 $ 582,188 ========== ========== LOAN PORTFOLIO (Dollars in thousands) December 31, 1997 Amount Percent -------- ------- Commercial and commercial real estate $242,868 43.46% Residential mortgage 175,268 31.37 Agricultural and agricultural real estate 69,302 12.40 Consumer 64,223 11.49 Lease financing, net 7,171 1.28 -------- ------- Gross loans and leases 558,832 100.00% ======= Unearned discount (2,077) Deferred loan fees (349) -------- Total loans and leases 556,406 Allowance for loan and lease losses (7,362) -------- Loans and leases, net $549,044 ======== The table below sets forth the remaining maturities by loan and lease category. MATURITY AND RATE SENSITIVITY OF LOANS AND LEASES(1) December 31, 2001 (Dollars in thousands) Over 1 Year Through 5 Years One Year Fixed Floating or less Rate Rate ---------------------------------- Commercial and commercial real estate $ 264,794 $ 199,547 $ 102,924 Residential mortgage 28,690 25,202 11,005 Agricultural and agricultural real estate 70,984 41,221 16,491 Consumer 36,883 50,997 15,570 Lease financing, net 4,890 10,206 - ---------- ---------- ---------- Total $ 406,241 $ 327,173 $ 145,990 ========== ========== ========== Over 5 Years Fixed Floating Rate Rate Total ---------------------------------- Commercial and commercial real estate $ 24,643 $ 59,571 $ 651,479 Residential mortgage 33,870 70,145 168,912 Agricultural and agricultural real estate 8,848 7,916 145,460 Consumer 9,877 14,547 127,874 Lease financing, net 474 - 15,570 ---------- ---------- ---------- Total $ 77,712 $ 152,179 $1,109,295 ========== ========== ========== (1) Maturities based upon contractual dates. Heartland experienced growth in net loans and leases during both 2001 and 2000. This growth was $62.0 million or 6% in 2001 and $204.2 million or 25% in 2000. Loan growth during 2001 was slower than during 2000 due to paydowns experienced in the mortgage loan portfolio and reduced demand in the commercial loan portfolio, particularly during the first half of the year. Growth in the commercial loan portfolio increased during the remaining half of 2001 and management continues to feel that opportunities for growth within this portfolio will expand during 2002. The acquisition of the bank in Clovis, New Mexico at the beginning of 2000, accounted for $66.5 million or 33% of the loan growth in 2000. During both years, the largest growth occurred in commercial and commercial real estate loans, which increased $101.1 million or 18% during 2001 and $101.4 million or 23% during 2000. All the bank subsidiaries experienced growth in this loan category, principally as a result of continued calling efforts. The Clovis acquisition was responsible for $26.5 million or 26% of the growth in 2000. Agricultural and agricultural real estate loans outstanding experienced an increase of $11.8 million or 9% during 2001. The majority of this growth occurred at New Mexico Bank & Trust's office in Clovis and at Dubuque Bank and Trust Company, Heartland's flagship bank in Dubuque, Iowa. During 2000, agricultural and agricultural real estate loans outstanding grew $40.7 million or 44%. The Clovis acquisition was responsible for $33.0 million or 81% of the agricultural loan growth as nearly half of the acquired loans were in the agricultural sector. The remaining growth during 2000 occurred at Heartland's banks in Wisconsin and Keokuk, Iowa. The residential mortgage loan portfolio experienced a decline of $46.7 million or 22% during 2001. As long-term rates decreased, customers refinanced their mortgage loans into fifteen- and thirty-year fixed rate loans, which Heartland usually sells into the secondary market. Servicing is retained on a majority of these loans so that the Heartland bank subsidiaries have an opportunity to continue providing their customers the excellent service they expect. Conversely, during 2000, the residential mortgage loan portfolio grew by $35.3 million or 20%. Customers elected to take adjustable-rate mortgage loans, which Heartland elected to retain in its loan portfolio, during this period of increasing long-term rates. The Clovis acquisition did not initially contribute to the growth in 2000, as it had not maintained a mortgage loan portfolio prior to joining the Heartland group. Consumer loan outstandings remained relatively flat during 2001, as the economy weakened and consumers were provided other sources of financing, i.e., zero percent automobile financing through dealerships. Consumer loan outstandings, exclusive of the $8.0 million portfolio at Clovis, grew $17.1 million or 16% during 2000. The majority of this growth resulted from increased selling efforts at Riverside Community Bank and Wisconsin Community Bank. Although the risk of nonpayment for any reason exists with respect to all loans, specific risks are associated with each type of loan. The primary risks associated with commercial and agricultural loans are the quality of the borrower's management and the impact of national and regional economic factors. Additionally, risks associated with commercial and agricultural real estate loans include fluctuating property values and concentrations of loans in a specific type of real estate. Repayment on consumer loans, including those on residential real estate, are dependent on the borrower's continuing financial stability, and thus are more likely to be affected by adverse personal circumstances and deteriorating economic conditions. Heartland monitors its loan concentrations and does not believe it has concentrations in any specific industry. Heartland's strategy with respect to the management of these types of risks, whether loan demand is weak or strong, is to encourage the Heartland banks to follow tested and prudent loan policies and underwriting practices which include: (i) granting loans on a sound and collectible basis; (ii) ensuring that primary and secondary sources of repayment are adequate in relation to the amount of the loan; (iii) administering loan policies through a board of directors and an officers' loan committee; (iv) developing and maintaining adequate diversification of the loan portfolio as a whole and of the loans within each loan category; and (v) ensuring that each loan is properly documented and, if appropriate, guaranteed by government agencies and that insurance coverage is adequate. NONPERFORMING LOANS AND LEASES AND OTHER NONPERFORMING ASSETS The table below sets forth the amounts of nonperforming loans and leases and other nonperforming assets on the dates indicated. NONPERFORMING ASSETS (Dollars in thousands) December 31, 2001 2000 1999 1998 1997 ------------------------------------ Nonaccrual loans and leases $7,269 $5,860 $1,414 $1,324 $1,819 Loan and leases contractually past due 90 days or more 500 523 236 426 187 Restructured loans and leases 354 357 - - 26 ------ ------ ------ ------ ------ Total nonperforming loans and leases 8,123 6,740 1,650 1,750 2,032 Other real estate 130 489 514 832 722 Other repossessed assets 343 219 138 102 176 ------ ------ ------ ------ ------ Total nonperforming assets $8,596 $7,448 $2,302 $2,684 $2,930 ====== ====== ====== ====== ====== Nonperforming loans and leases to total loans and leases 0.73% 0.65% 0.20% 0.30% 0.37% Nonperforming assets to total loans and leases plus repossessed property 0.78% 0.71% 0.28% 0.45% 0.53% Nonperforming assets to total assets 0.52% 0.51% 0.19% 0.28% 0.34% Under Heartland's internal loan review program, a loan review officer is responsible for reviewing existing loans and leases, identifying potential problem loans and leases and monitoring the adequacy of the allowance for loan and lease losses at the Heartland banks. Heartland constantly monitors and continues to develop systems to oversee the quality of its loan portfolio. One integral part is a loan rating system, which assigns a rating on each loan and lease within the portfolio based on the borrower's financial position, repayment ability, collateral position and repayment history. This emphasis on quality is reflected in Heartland's credit quality figures, which compare favorably to peer data in the Bank Holding Company Performance Reports published by the Federal Reserve Board for bank holding companies with total assets of $1 to $3 billion. In this report, the peer group reported nonperforming assets to total assets of 0.61% and 0.53% for September 30, 2001, and December 31, 2000, respectively. Heartland's ratios at December 31, 2001 and 2000, were 0.52% and 0.51%, respectively. Nonperforming loans, defined as nonaccrual loans, restructured loans and loans past due ninety days or more, increased to 0.73% of total loans and leases at December 31, 2001, compared to 0.65% of total loans and leases at December 31, 2000. Contributing to the $1.4 million increase in nonperforming loans at year-end 2001 were a $1.4 million and $1.5 million increase at Wisconsin Community Bank and New Mexico Bank & Trust, respectively. These increases were attributable to a few large credits and not felt to be an indication of a trend in either of these newer markets for Heartland. These increases were offset by a $2.3 million reduction in nonperforming loans at Dubuque Bank and Trust Company, as payments totaling $1.5 million were received during the first quarter of 2001 and a $900 thousand charge-off was recorded during the last quarter of 2001 on the same credit. The $5.1 million increase in nonperforming assets during 2000 was primarily the result of this same commercial loan customer at Dubuque Bank and Trust Company and a few agricultural customers in the Clovis, New Mexico market. Workout plans are in process on a majority of Heartland's nonperforming loans and, because of the net realizable value of collateral, guarantees and other factors, anticipated losses on these credits are expected to be minimal. A weakening economy will inevitably result in increased problem loans, but Heartland expects the problems to be manageable and of a lesser scope for Heartland than for the industry as a whole. ALLOWANCE FOR LOAN AND LEASE LOSSES The process utilized by Heartland to estimate the adequacy of the allowance for loan and lease losses is considered a critical accounting practice for Heartland. The allowance for loan and lease losses represents management's estimate of identified and unidentified losses in the existing loan portfolio. The miscalculation of this estimate could have a material impact on Heartland's earnings. The adequacy of the allowance for loan and lease losses is determined using factors that include the overall composition of the loan portfolio, general economic conditions, types of loans, past loss experience, loan delinquencies, and potential substandard and doubtful credits. The adequacy of the allowance for loan and lease losses is monitored on an ongoing basis by the loan review staff, senior management and the board of directors. Factors considered by the loan review committee included the following: - The amount of Heartland's nonperforming loans has trended upward. - The nation has been in a period of economic slowdown. - During the last several years, Heartland has entered new markets in which it had little or no previous lending experience. - Heartland has continued to experience growth in more- complex commercial loans as compared to relatively lower- risk residential real estate loans. The allowance for loan and lease losses increased by $1.1 million or 8% during 2001. The allowance for loan and lease losses at December 31, 2001, was 1.33% of loans and 180% of nonperforming loans, compared to 1.30% of loans and 202% of nonperforming loans at year-end 2000. The allowance for loan and lease losses increased by $2.7 million or 25% during 2000, primarily as a result of the Clovis acquisition which accounted for $1.1 million or 42% of this change. The remaining growth occurred, in part, as a result of the expansion of the loan portfolio and growth in nonperforming loans. There can be no assurances that the allowance for loan and lease losses will be adequate to cover all losses, but management believes that the allowance for loan and lease losses was adequate at December 31, 2001. While management uses available information to provide for loan and lease losses, the ultimate collectibility of a substantial portion of the loan portfolio and the need for future additions to the allowance will be based on changes in economic conditions. Along with other financial institutions, management shares a concern for the possible continued softening of the economy. Should the economic climate continue to deteriorate, borrowers may experience difficulty, and the level of non-performing loans, charge-offs, and delinquencies could rise and require further increases in the provision for loan and lease losses. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan and lease losses carried by the Heartland subsidiaries. Such agencies may require Heartland to make additional provisions to the allowance based upon their judgment about information available to them at the time of their examinations. During 2001, Heartland recorded net charge offs of $3.2 million compared to $1.7 million in 2000. The Clovis acquisition was responsible for 45% of the net charge-offs during 2000 and $468 thousand or 15% of the net charge-offs during 2001. Heartland's loan review area, along with management at New Mexico Bank & Trust, have spent considerable time aggressively managing the exposure within the loan portfolio in this newest market for Heartland. Citizens Finance Co., Heartland's consumer finance subsidiary, was responsible for $1.0 million or 32% of the net charge-offs during 2001 and $614 thousand or 36% during 2000. Increased losses at Citizens relate directly to the rapid growth it experienced during the previous two years with expansion into the Appleton, Wisconsin, and Rockford, Illinois, markets. Identification of problem loans in a portfolio begin to occur as the portfolio matures. Additionally, the weakened economy has affected the ability of borrowers to repay their consumer loans. Losses as a percentage of gross loans at Citizens were 4.37% for 2001 compared to 2.87% for 2000. Loans with payments past due for more than thirty days increased from 4.67% of gross loans at December 31, 2000, to 5.30% at December 31, 2001. Management believes these ratios still compare favorably to the consumer finance industry. The table below summarizes activity in the allowance for loan and lease losses for the years indicated, including amounts of loans and leases charged off, amounts of recoveries, additions to the allowance charged to income and the ratio of net charge-offs to average loans and leases outstanding. ANALYSIS OF ALLOWANCE FOR LOAN AND LEASE LOSSES (Dollars in thousands) For the years ended December 31, 2001 2000 1999 1998 1997 ------------------------------------------ Allowance at beginning of year $13,592 $10,844 $ 7,945 $7,362 $6,191 Charge-offs: Commercial and commercial real estate 1,477 407 81 289 93 Residential mortgage 32 54 - 20 21 Agricultural and agricultural real estate 463 580 8 41 21 Consumer 1,785 1,239 546 473 449 Lease financing - - - - - ------- ------- ------- ------ ------ Total charge-offs 3,757 2,280 635 823 584 ------- ------- ------- ------ ------ Recoveries: Commercial and commercial real estate 79 97 74 372 36 Residential mortgage - 4 12 - 8 Agricultural and agricultural real estate 108 176 6 1 2 Consumer 355 308 151 82 99 Lease financing - - - - - ------- ------- ------- ------ ------ Total recoveries 542 585 243 455 145 ------- ------- ------- ------ ------ Net charge-offs(1) 3,215 1,695 392 368 439 Provision for loan and lease losses 4,283 3,301 2,626 951 1,279 Additions related to acquisitions - 1,142 665 - 331 ------- ------- ------- ------ ------ Allowance at end of period $14,660 $13,592 $10,844 $7,945 $7,362 ======= ======= ======= ====== ====== Net charge-offs to average loans and leases 0.30% 0.17% 0.06% 0.07% 0.08% ======= ====== ======= ====== ====== (1) Includes net charge-offs at Citizens Finance, Heartland's consumer finance company, of $1,043 for 2001, $614 for 2000, $256 for 1999, $278 for 1998 and $256 for 1997. The table below shows Heartland's allocation of the allowance for loan and lease losses by types of loans and leases and the amount of unallocated reserves. The amount of unallocated reserves has decreased over the past two years as Heartland has enhanced its allowance adequacy methodology to identify a specific allowance for each credit. ALLOCATION OF ALLOWANCE FOR LOAN AND LEASE LOSSES (Dollars in thousands) As of December 31, 2001 2000 --------------------------------------- Loan/ Loan/ Lease Lease Category Category to Gross to Gross Loans & Loans & Amount Leases Amount Leases ------ -------- ------ -------- Commercial and commercial real estate $ 7,534 58.73% $ 7,324 52.62% Residential mortgage 1,192 15.23 1,004 20.62 Agricultural and agricultural real estate 2,214 13.11 2,377 12.78 Consumer 2,009 11.53 1,743 12.30 Lease financing 162 1.40 106 1.68 Unallocated 1,549 - 1,038 - ------- ------- ------- ------- $14,660 100.00% $13,592 100.00% ======= ======= ======= ======= ALLOCATION OF ALLOWANCE FOR LOAN AND LEASE LOSSES (Dollars in thousands) As of December 31, 1999 1998 --------------------------------------- Loan/ Loan/ Lease Lease Category Category to Gross to Gross Loans & Loans & Amount Leases Amount Leases ------- ------- ------ ------- Commercial and commercial real estate $ 6,108 53.53% $2,180 46.88% Residential mortgage 756 21.50 697 26.40 Agricultural and agricultural real estate 1,016 11.08 583 13.03 Consumer 1,917 12.35 1,096 12.26 Lease financing 91 1.54 44 1.43 Unallocated 956 - 3,345 - ------- ------- ------ ------- $10,844 100.00% $7,945 100.00% ======= ======= ====== ======= ALLOCATION OF ALLOWANCE FOR LOAN AND LEASE LOSSES (Dollars in thousands) As of December 31, 1997 -------------------------- Loan/ Lease Category to Gross Loans & Amount Leases ------ ------- Commercial and commercial real estate $1,889 43.46% Residential mortgage 725 31.37 Agricultural and agricultural real estate 577 12.40 Consumer 1,044 11.49 Lease financing(1) 30 1.28 Unallocated 3,097 - ------ ------- $7,362 100.00% ====== ======= 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 20% of total assets at December 31, 2001, as compared to 16% at December 31, 2000. The amount of securities held in Heartland's portfolio was increased during 2001 as deposit growth outpaced growth in the loan portfolio. During 2000, management elected to replace paydowns received on mortgage-backed securities with U.S. government agency securities to lengthen the portfolio. U.S. government agency securities offer a better total return in a declining interest rate environment, which was Heartland's forecast at the time. The state tax-exempt nature of selected U.S. government agency securities also made them attractive purchases for Heartland's Illinois bank subsidiaries. As Heartland's interest rate forecast changed to one of rising rates, except for the short end of the yield curve, management elected to shift a portion of its securities portfolio into mortgage-backed securities from U.S. government agencies during 2001. Tightly structured tranches in well-seasoned mortgage-backed securities were purchased to enhance the performance of the portfolio given a rise in interest rates. Because of the well-seasoned nature of the mortgage-backed securities purchased, management anticipates that risk of prepayment within Heartland's securities portfolio has been minimized. Heartland implemented Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, on January 1, 2001. At that date, all investments previously included in Heartland's held to maturity investment portfolio were reclassified to the available for sale investment portfolio. The tables below present the composition and maturities of the securities portfolio by major category. SECURITIES PORTFOLIO COMPOSITION (Dollars in thousands) Total % of December 31, 2001 Amount Portfolio ------------------- U.S. government corporations and agencies and treasuries $ 79,234 24.48% Mortgage-backed securities 183,661 56.74 States and political subdivisions 30,948 9.56 Other securities 29,846 9.22 -------- ------- Total $323,689 100.00% ======== ======= SECURITIES PORTFOLIO COMPOSITION (Dollars in thousands) Held to Maturity Available for Sale % of % of December 31, 2000 Amount Portfolio Amount Portfolio --------------------------------------- U.S. government corporations and agencies and treasuries $ - -% $118,897 52.13% Mortgage-backed securities - - 53,407 23.42 States and political subdivisions 2,111 0.93 31,933 14.00 Other securities - - 21,717 9.52 ------ ------- -------- ------- Total $2,111 0.93% $225,954 99.07% ====== ======= ======== ======= SECURITIES PORTFOLIO COMPOSITION (Dollars in thousands) Total % of December 31, 2000 Amount Portfolio ------------------- U.S. government corporations and agencies and treasuries $118,897 52.13% Mortgage-backed securities 53,407 23.42 States and political subdivisions 34,044 14.93 Other securities 21,717 9.52 -------- ------- Total $228,065 100.00% ======== ======= SECURITIES PORTFOLIO COMPOSITION (Dollars in thousands) Held to Maturity Available for Sale % of % of December 31, 1999 Amount Portfolio Amount Portfolio --------------------------------------- U.S. government corporations and agencies and treasuries $ - -% $ 90,536 42.79% Mortgage-backed securities - - 75,637 35.75 States and political subdivisions 2,196 1.04 23,708 11.20 Other securities - - 19,500 9.22 ------ ------- -------- ------- Total $2,196 1.04% $209,381 98.96% ====== ======= ======== ======= SECURITIES PORTFOLIO COMPOSITION (Dollars in thousands) Total % of December 31, 1999 Amount Portfolio ------------------- U.S. government corporations and agencies and treasuries $ 90,536 42.79% Mortgage-backed securities 75,637 35.75 States and political subdivisions 25,904 12.24 Other securities 19,500 9.22 -------- ------- Total $211,577 100.00% ======== ======= SECURITIES PORTFOLIO MATURITIES (Dollars in thousands) After One But Within One Year Within Five Years --------------- ----------------- December 31, 2001 Amount Yield Amount Yield ------------------------------------ U.S. government corporations and agencies and treasuries $11,182 4.60% $ 68,052 5.92% Mortgage-backed securities 46,112 4.46 121,586 5.75 States and political subdivisions(1) 412 7.41 4,161 7.33 Other securities(2) 523 5.85 - - ------- -------- Total $58,229 4.52% $193,799 5.84% ======= ====== ======== ======= SECURITIES PORTFOLIO MATURITIES (Dollars in thousands) After Five But Within Ten Years After Ten Years ---------------- ----------------- Amount Yield Amount Yield ------------------------------------ U.S. government corporations and agencies and treasuries - -% $ - -% Mortgage-backed securities 14,025 6.35 1,938 7.60 States and political subdivisions(1) 11,338 7.51 15,037 8.11 Other securities(2) - - - - ------- ------- Total $25,363 6.87% $16,975 8.05% ======= ======= ======= ====== SECURITIES PORTFOLIO MATURITIES (Dollars in thousands) Total Amount Yield ------------------- U.S. government corporations and agencies and treasuries $ 79,234 5.73% Mortgage-backed securities 183,661 5.49 States and political subdivisions(1) 30,948 7.77 Other securities(2) 523 5.85 -------- Total $294,366 5.80% ======== ====== (1) Rates on obligations of states and political subdivisions have been adjusted to tax equivalent yields using a 34% income tax rate. (2) Other securities does not include equity securities. DEPOSITS AND BORROWED FUNDS Total average deposits experienced an increase of $144.2 million or 14% during 2001 compared to an increase of $230.7 million or 30% during 2000. Total average deposits were $1.153 billion during 2001, $1.009 billion during 2000 and $777.9 million during 1999. The Clovis acquisition comprised $97.5 million or 42% of the increase in 2000. Exclusive of this acquisition, growth was $133.2 million or 17% during 2000. All of the subsidiary banks grew average deposits during both years. The de novo community banks in Rockford, Illinois and Albuquerque, New Mexico made up $58.9 million or 59% of the 2001 growth and $46.4 million or 35% of the 2000 growth, exclusive of the acquisition. During 2001, the demand and savings deposit categories experienced growth in excess of 10% and most of this growth was reflective of increased marketing efforts and customers' election to keep funds on deposit in a financial institution as the volatility in the stock market continued. Half of the $15.8 million or 13% growth in average demand deposits occurred at New Mexico Bank & Trust in Albuquerque, New Mexico. The $42.9 million or 11% growth in average savings deposits resulted from growth in all of the markets served by the Heartland banks. The money market product line was enhanced last year and much of the growth in savings was attributable to marketing efforts focused on attracting new customers into this product line, as well as, customers' election to keep funds on deposit in a financial institution as the volatility in the stock market continued. Average time deposits grew by $85.5 million or 17%. Again, all the Heartland banks experienced growth in this deposit category. As long-term rates moved downward during 2001, efforts were focused on attracting customers into certificates of deposit with a maturity exceeding two years. Heartland focused efforts on shifting the mix of total deposits from the time deposit category to the demand and savings deposit categories during 2000. In order to attract additional deposit customers into these categories, the subsidiary banks enhanced their checking and money market deposit product lines. As a result, all the banks experienced success in growing demand deposit balances, as each grew these balances by more than 3%, with much more significant growth occurring in Heartland's newer markets targeted by New Mexico Bank & Trust, Wisconsin Community Bank and Riverside Community Bank. The shift in 2000 from savings to certificate of deposit accounts occurred as interest rates rose over the year and deposit customers became more interested in certificate of deposit products and less interested in savings products. The table below sets forth the distribution of Heartland's average deposit account balances and the average interest rates paid on each category of deposits for the years indicated. AVERAGE DEPOSITS (Dollars in thousands) For the year ended December 31, 2001 Percent Average of Balance Deposits Rate -------------------------- Demand deposits $ 139,870 12.13% -% Savings accounts 427,953 37.13 2.80 Time deposits less than $100 441,505 38.30 5.82 Time deposits of $100 or more 143,429 12.44 5.74 ---------- ------- Total deposits $1,152,757 100.00% ========== ======= AVERAGE DEPOSITS (Dollars in thousands) For the year ended December 31, 2000 Percent Average of Balance Deposits Rate -------------------------- Demand deposits $ 124,117 12.30% -% Savings accounts 385,047 38.18 3.61 Time deposits less than $100 400,096 39.67 5.82 Time deposits of $100 or more 99,322 9.85 6.04 ---------- ------- Total deposits $1,008,582 100.00% ========== ======= AVERAGE DEPOSITS (Dollars in thousands) For the year ended December 31, 1999 Percent Average of Balance Deposits Rate -------------------------- Demand deposits $ 81,511 10.48% -% Savings accounts 324,476 41.71 3.33 Time deposits less than $100 312,051 40.12 5.50 Time deposits of $100 or more 59,822 7.69 5.39 ---------- ------- Total deposits $ 777,860 100.00% ========== ======= The following table sets forth the amount and maturities of time deposits of $100,000 or more at December 31, 2001. Time Deposits $100,000 and Over (Dollars in thousands) December 31, 2001 ------------ 3 months or less $ 41,237 Over 3 months through 6 months 23,711 Over 6 months through 12 months 23,752 Over 12 months 22,771 -------- $111,471 ======== Short-term borrowings generally include federal funds purchased, treasury tax and loan note options, securities sold under agreement to repurchase and short-term Federal Home Loan Bank ("FHLB") advances. These funding alternatives are utilized in varying degrees depending on their pricing and availability. At year-end 2001, the amount of short-term borrowings was $160.7 million, an increase of $20.8 million or 15% over the $139.9 million short-term borrowings outstanding at year-end 2000. All of the bank subsidiaries provide repurchase agreements to their customers as a cash management tool, sweeping excess funds from demand deposit accounts into these agreements. This source of funding does not increase the bank's reserve requirements, nor does it create an expense relating to FDIC premiums on deposits. Although the aggregate balance of repurchase agreements is subject to variation, the account relationships represented by these balances are principally local. With the entry into new markets, these balances have grown from $66.8 million at December 31, 1999, to $93.0 million at December 31, 2000, and $108.6 million at December 31, 2001. On September 28, 2000, Heartland entered into a credit agreement with two unaffiliated banks to replace an existing term credit line as well as to increase availability under a revolving credit line. Under the new unsecured revolving credit lines, Heartland may borrow up to $50.0 million, a $10.0 million increase over the then existing line. This additional credit capacity was established primarily to provide additional working capital to the nonbanking subsidiaries and to meet general corporate commitments. At December 31, 2001 and 2000, $29.2 million and $39.3 million, respectively, was outstanding on the revolving credit lines with the total classified as short-term borrowings. The following table reflects short-term borrowings, which in the aggregate have average balances during the period greater than 30% of stockholders' equity at the end of the period. SHORT-TERM BORROWINGS (Dollars in thousands) At or for the Year Ended December 31, 2001 2000 1999 ---------------------------- Balance at end of period $160,703 $139,909 $103,219 Maximum month-end amount outstanding 162,744 144,604 118,019 Average month-end amount outstanding 151,139 122,777 91,613 Weighted average interest rate at year-end 1.39% 5.60% 4.35% Weighted average interest rate for the year 3.93% 5.79% 4.63% Other borrowings include all debt arrangements Heartland and its subsidiaries have entered into with original maturities that extend beyond one year. These borrowings were $143.8 million on December 31, 2001, compared to $102.9 million on December 31, 2000. The change in these account balances primarily results from activity in the bank subsidiaries' borrowings from the FHLB. All of the Heartland banks own stock in the FHLB of Des Moines, Chicago or Dallas, enabling them to borrow funds from their respective FHLB for short- or long-term purposes under a variety of programs. Total FHLB borrowings at December 31, 2001 and 2000, were $86.5 million and $51.1 million, respectively. Substantially all these borrowings are fixed-rate advances for terms between three and five years. As advance rates moved downward during 2001 to historically low levels, Heartland elected to obtain additional advances to lock in funding for anticipated fixed-rate commercial loan growth and replace the maturity of advances during the first half of 2002. During 2000, additional FHLB advances were utilized at the bank subsidiaries to fund a portion of the loan growth experienced. Additionally, balances outstanding on capital securities issued by Heartland in 1999 and 2001 are included in total other borrowings. The issuance in October of 1999 for $25.0 million bears an annual rate of 9.60% and matures on September 30, 2029. A private placement offering for $8.0 million was completed in December of 2001. This variable rate issuance matures on December 18, 2031. The following table summarizes significant contractual obligations and other commitments: Other Operating Borrowings Leases Total ---------------------------- 2002 $ 24,757 $ 408 $ 25,165 2003 12,781 411 13,192 2004 25,281 362 25,643 2005 16,887 289 17,176 2006 20,506 182 20,688 Thereafter 43,577 48 43,625 -------- -------- -------- Total $143,789 $ 1,700 $145,489 ======== ======== ======== Other commitments: Commitments to extend credit $325,282 Standby letter of credit 11,631 Commitments to sell residential real estate loans 30,849 CAPITAL RESOURCES Heartland's risk-based capital ratios, which take into account the different credit risks among banks' assets, met all capital adequacy requirements over the past three years. Tier 1 and total risk-based capital ratios were 9.71% and 10.89%, respectively, on December 31, 2001, compared with 8.74% and 9.90%, respectively, on December 31, 2000, and 10.56% and 11.68%, respectively, on December 31, 1999. At December 31, 2001, Heartland's leverage ratio, the ratio of Tier 1 capital to total average assets, was 7.53% compared to 7.25% and 8.85% at December 31, 2000 and 1999, respectively. It has been management's intent to fully utilize its capital resources and, as planned, these capital ratios have declined over the years as Heartland experienced substantial growth. All the Heartland banks have been, and will continue to be, managed so they meet the well capitalized requirements under the regulatory framework for prompt corrective action. Commitments for capital expenditures are an important factor in evaluating capital adequacy. As a result of the acquisition of National Bancshares, Inc., the one-bank holding company of First National Bank of Clovis, remaining requisite cash payments under the notes payable total $855 thousand in 2002, and $637 thousand in 2003 and 2004, plus interest at 7.00%. Immediately following the closing of the acquisition, the bank was merged into New Mexico Bank & Trust. As a result of this affiliate bank merger, Heartland's ownership in New Mexico Bank & Trust increased to approximately 88%. In June of 2000, Heartland offered a portion of its shares of New Mexico Bank & Trust's common stock to interested investors. In no case would Heartland's interest be allowed to fall below 80%. All minority stockholders, including the initial investors, entered into a stock transfer agreement before shares were issued to them. This stock transfer agreement imposes certain restrictions on the investor's sale, transfer or other disposition of their shares and requires Heartland to repurchase the shares from the investor on April 9, 2003. As of December 31, 2001, Heartland's ownership in New Mexico Bank & Trust was 86%. Heartland has an obligation to certain employees of one of the bank subsidiaries to make a payment based upon certain performance criteria. The obligation is being accrued over the performance period. On December 18, 2001, Heartland completed a private placement offering of $8.0 million of variable rate cumulative capital securities representing undivided beneficial interests in Heartland Financial Statutory Trust II, a special purpose trust subsidiary formed for the sole purpose of this offering. The proceeds from the offering were used by the trust to purchase junior subordinated debentures from Heartland. The proceeds are being used by Heartland for general corporate purposes. Interest is payable quarterly on March 18, June 18, September 18 and December 18 of each year. The debentures will mature and the capital securities must be redeemed on December 18, 2031. Heartland has the option to shorten the maturity date to a date not earlier than December 18, 2006. Heartland will not shorten the maturity date without prior approval of the Board of Governors of the Federal Reserve System, if required. Prior redemption is permitted under certain circumstances, such as changes in tax or regulatory capital rules. All of these securities qualified as Tier 1 capital for regulatory purposes as of December 31, 2001. In October of 1999, Heartland completed an offering of $25.0 million of 9.60% cumulative capital securities representing undivided beneficial interests in Heartland Capital Trust I, a special purpose trust subsidiary formed for the sole purpose of this offering. The proceeds from the offering were used by the trust to purchase junior subordinated debentures from Heartland. The proceeds were used by Heartland for general corporate purposes. All of these securities continued to qualify as Tier 1 capital for regulatory purposes as of December 31, 2001. Heartland continues to explore opportunities to expand its umbrella of independent community banks through mergers and acquisitions as well as de novo and branching opportunities. As evidenced by the recent expansion into New Mexico, Heartland is seeking to operate in high growth areas, even if they are outside of its traditional Midwest market areas. Future expenditures relating to these efforts are not estimable at this time. Heartland's capital ratios are detailed in the table below. RISK-BASED CAPITAL RATIOS(1) (Dollars in thousands) December 31, 2001 2000 Amount Ratio Amount Ratio -------------------------------------- Capital Ratios: Tier 1 capital $ 121,112 9.71% $ 102,443 8.74% Tier 1 capital minimum requirement 49,891 4.00 46,878 4.00 ---------- ------ ---------- ------ Excess $ 71,221 5.71% $ 55,565 4.74% ========== ====== ========== ====== Total capital $ 135,770 10.89% $ 116,034 9.90% Total capital minimum requirement 99,782 8.00 93,756 8.00 ---------- ------ ---------- ------ Excess $ 35,988 2.89% $ 22,278 1.90% ========== ====== ========== ====== Total risk- adjusted assets $1,247,274 $1,171,951 ========== ========== RISK-BASED CAPITAL RATIOS(1) (Dollars in thousands) December 1999 Amount Ratio ------------------ Capital Ratios: Tier 1 capital $ 101,665 10.56% Tier 1 capital minimum requirement 38,517 4.00 ---------- ------ Excess $ 63,148 6.56% ========== ====== Total capital $ 112,508 11.68% Total capital minimum requirement 77,035 8.00 ---------- ------ Excess $ 35,473 3.68% ========== ====== Total risk- adjusted assets $ 962,933 ========== (1) Based on the risk-based capital guidelines of the Federal Reserve, a bank holding company is required to maintain a Tier 1 to risk-adjusted assets ratio of 4.00% and total capital to risk-adjusted assets ratio of 8.00%. LEVERAGE RATIOS(1) (Dollars in thousands) December 31, 2001 2000 Amount Ratio Amount Ratio -------------------------------------- Capital Ratios: Tier 1 capital $ 121,112 7.53% $ 102,443 7.25% Tier 1 capital minimum requirement(2) 64,336 4.00 56,492 4.00 ---------- ----- ---------- ------ Excess $ 56,776 3.53% $ 45,951 3.25% ========== ===== ========== ====== Average adjusted assets $1,608,402 $1,412,304 ========== ========== LEVERAGE RATIOS(1) (Dollars in thousands) December 1999 Amount Ratio ------------------ Capital Ratios: Tier 1 capital $ 101,665 8.85% Tier 1 capital minimum requirement(2) 45,965 4.00 ---------- ------ Excess $ 55,700 4.85% ========== ====== Average adjusted assets $1,149,125 ========== (1)The leverage ratio is defined as the ratio of Tier 1 capital to average total assets. (2)Management of Heartland has established a minimum target leverage ratio of 4.00%. Based on Federal Reserve guidelines, a bank holding company generally is required to maintain a leverage ratio of 3.00% plus an additional cushion of at least 100 basis points. OTHER DEVELOPMENTS In June of 2001, Heartland was saddened by the sudden death of long-time director, Evangeline K. Jansen. Ms. Jansen first joined the board of directors of Dubuque Bank and Trust in 1974 and was one of the initial directors of Heartland when it was formed in 1981. At its regular board meeting held on January 15, 2002, Heartland appointed Thomas L. Flynn a director. Mr. Flynn, who is president of Flynn Ready-Mix Concrete and an Iowa state senator, is also a member of the board of directors of Dubuque Bank and Trust Company, Heartland's lead bank. Mr. Flynn's appointment fills the vacancy created last June by the death of Ms. Jansen. At Heartland's annual stockholders meeting in May, Mr. Flynn will stand for election to a full term. Additionally, at this same board meeting, Gregory R. Miller resigned as a director of Heartland. Mr. Miller had served on the board since 1987 and his term was due to expire in 2004. LIQUIDITY Liquidity refers to Heartland's ability to maintain a cash flow, which 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. Heartland's usual and primary sources of funding have been deposits, loan and mortgage-backed security principal repayments, sales of loans, cash flow generated from operations and FHLB borrowings. Net cash outflows from investing activities was $171.1 million during 2001, an increase of $55.2 million when compared to 2000. The net increase in loans and leases was $55.1 million during 2001, a $77.6 million decrease from 2000. During 2001, proceeds from the sale and maturity of securities increased by $85.4 million and the purchases of securities increased by $185.4 million when compared to 2000. As loan growth was below the levels experienced during 2000, additional securities purchases were made to enhance the net interest margin. During 2000, the net cash outflows from investing activities was $115.9 million, a decrease of $35.0 million when compared to 1999. Acquisitions provided net cash and cash equivalents of $18.6 million during 2000 and $43.7 million during 1999, a decrease of $25.1 million. The net increase in loans and leases was $132.8 million during 2000 compared to $201.2 million during 1999, a decrease of $68.4 million. During 2000, proceeds from the sale and maturity of securities decreased by $29.0 million and the purchases of securities decreased by $10.7 million when compared to 1999. Financing activities provided net cash of $162.7 million during 2001 compared to $148.6 million during 2000, an increase of $14.0 million. A net increase in demand and savings deposit accounts provided cash of $111.3 million during 2001 compared to $26.1 million during 2000. Conversely, a net decrease in time deposit accounts used cash of $7.5 million during 2001 whereas, a net increase in time deposit accounts provided cash of $111.2 million during 2000. The $42.9 million additional cash provided by a net increase in other borrowings during 2001 was reflective of new FHLB long-term advances. Financing activities provided net cash of $148.6 million during 2000 compared to $131.1 million during 1999, an increase of $17.5 million. A net increase in demand and savings deposit accounts provided cash of $26.1 million during 2000 compared to $42.2 million during 1999, a $16.1 million decrease. Conversely, a net increase in time deposit accounts provided cash of $111.2 million during 2000 compared to $18.2 million during 1999. Short-term borrowings provided cash of $25.8 million in 2000 and $47.3 million in 1999, a decrease of $21.5 million. Cash used for the repayment of other borrowings increased during 2000 to $32.3 million compared to $11.1 million during 1999. Total cash inflows from operating activities was $17.3 million during 2001, $16.0 million during 2000 and $12.9 million during 1999, increases of $1.3 million for 2001 and $3.1 million for 2000. 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 growth in net interest cash flows. Heartland's short-term borrowing balances are dependent on commercial cash management and smaller correspondent bank relationships and, as such, will normally fluctuate. Heartland believes these balances, on average, to be stable sources of funds; however, it intends to rely on deposit growth and additional FHLB borrowings in the future. In the event of short-term liquidity needs, the bank subsidiaries may purchase federal funds from each other or from correspondent banks and may also borrow from the Federal Reserve Bank. Additionally, the subsidiary banks' FHLB memberships give them the ability to borrow funds for short- and long-term purposes under a variety of programs. Heartland's revolving credit agreements, as of December 31, 2001, provided an additional borrowing capacity of $20.8 million. These agreements contain specific covenants which, among other things, limit dividend payments and restrict the sale of assets by Heartland under certain circumstances. Also contained within the agreements are certain financial covenants, including the maintenance by Heartland of a maximum nonperforming assets to total loans ratio, minimum return on average assets ratio and maximum funded debt to total equity capital ratio. In addition, Heartland and each of its bank subsidiaries must remain well capitalized, as defined from time to time by the federal banking regulators. At December 31, 2001, Heartland was in compliance with all the covenants contained in this credit agreement. MARKET RISK MANAGEMENT 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 current fair market values of Heartland's assets, liabilities and off-balance sheet contracts. The objective is to measure this risk and manage the balance sheet to avoid unacceptable potential for economic loss. Heartland 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 at the banks and, on a consolidated basis, by the Heartland management team and board of directors. Monthly, management utilizes both the standard balance sheet GAP report and an independently developed income statement GAP report to analyze the effect of changes in interest rates on net interest income and to manage interest rate risk. Also utilized periodically during the year is an interest rate sensitivity analysis, which simulates changes in net interest income in response to various interest rate scenarios. This analysis considers current portfolio rates, existing maturities, repricing opportunities and market interest rates, in addition to prepayments and growth under different interest rate assumptions. Through the use of these tools, Heartland has determined that the balance sheet is structured such that changes in net interest margin in response to changes in interest rates would be minimal, all other factors being held constant. Management does not believe that Heartland's primary market risk exposures and how those exposures were managed in 2001 have materially changed when compared to 2000. Derivative financial instruments include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. Heartland's use of derivative financial instruments relates to the management of the risk that changes in interest rates will affect its future interest payments. Heartland utilizes an interest rate swap contract to effectively convert a portion of its variable rate interest rate debt to fixed interest rate debt. Under the interest rate swap contract, Heartland agrees to pay an amount equal to a fixed rate of interest times a notional principal amount, and to receive in return an amount equal to a specified variable rate of interest times the same notional principal amount. The notional amounts are not exchanged and payments under the interest rate swap contract are made monthly. Heartland is exposed to credit-related losses in the event of nonperformance by the counterparty to the swap contract, which has been minimized by entering into the contract with a large, stable financial institution. As of December 31, 2001, Heartland had an interest rate swap contract to pay a fixed rate of interest and receive a variable rate of interest on $25.0 million of indebtedness. This contract expires on November 1, 2006. The fair market value of the interest rate swap contract was $350 thousand as of December 31, 2001. Heartland does enter 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 to a customer as long as there is no violation of any condition established in the contract. 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 with specified terms and conditions. These commitments to extend credit and standby letters of credit are not recorded on the balance sheet until the instrument is exercised. The table below summarizes the scheduled maturities of market risk sensitive assets and liabilities as of December 31, 2001. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK TABLE OF MARKET RISK-SENSITIVE INSTRUMENTS (Dollars in thousands) December 31, 2001 MATURING IN: 2002 2003 2004 2005 -------------------------------------- ASSETS Federal funds sold $ 24,200 $ - $ - $ - Time deposits in other financial institutions 3 561 - - Securities: Trading - - - - Available for sale 58,229 119,774 46,845 12,926 Loans and leases: Fixed rate loans 214,125 113,860 125,221 36,674 Variable rate loans 188,026 40,793 47,836 29,944 ---------- -------- -------- -------- Loans and leases, net 402,151 154,653 173,057 66,618 ---------- -------- -------- -------- Total Market Risk- Sensitive Assets $ 484,583 $274,988 $219,902 $ 79,544 ========== ======== ======== ======== LIABILITIES Savings $ 493,374 $ - $ - $ - Time deposits: Fixed rate time certificates less than $100 274,585 82,211 33,980 15,209 Variable rate time certificates less than $100 1,850 9,558 43 - ---------- -------- -------- -------- Time deposits less than $100 276,435 91,769 34,023 15,209 Time deposits of $100 or more 88,700 15,798 5,219 617 Federal funds purchased, securities sold under repurchase agreements and other short-term borrowings 160,703 - - - Other borrowings: Fixed rate borrowings 24,757 12,781 25,281 16,887 Variable rate borrowings - - - - ---------- -------- -------- -------- Other borrowings 24,757 12,781 25,281 16,887 ---------- -------- -------- -------- Total Market Risk- Sensitive Liabilities $1,043,969 $120,348 $ 64,523 $ 32,713 ========== ======== ======== ======== QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK TABLE OF MARKET RISK-SENSITIVE INSTRUMENTS (Dollars in thousands) December 31, 2001 Average Estimated Interest Fair MATURING IN: 2006 Thereafter Total Rate Value -------------------------------------------- ASSETS Federal funds sold $ - $ - $ 24,200 1.57% $ 24,200 Time deposits in other financial institutions - - 564 5.16 564 Securities: Trading - 1,528 1,528 0.99 1,528 Available for sale 14,254 71,661 323,689 5.80 323,689 Loans and leases: Fixed rate loans 51,418 77,712 619,010 8.24 635,220 Variable rate loans 27,417 152,179 486,195 6.57 491,292 ------- -------- ---------- ---------- Loans and leases, net 78,835 229,891 1,105,205 1,126,512 ------- -------- ---------- ---------- Total Market Risk- Sensitive Assets $93,089 $303,080 $1,455,186 $1,476,493 ======= ======== ========== ========== LIABILITIES Savings $ - $ - $ 493,374 1.67% $ 493,374 Time deposits: Fixed rate time certificates less than $100 21,821 315 428,121 5.00 439,526 Variable rate time certificates less than $100 - - 11,451 4.24 11,451 ------- -------- ---------- ---------- Time deposits less than $100 21,821 315 439,572 450,977 Time deposits of $100 or more 1,137 - 111,471 4.40 113,066 Federal funds purchased, securities sold under repurchase agreements and other short-term borrowings - - 160,703 1.39 160,703 Other borrowings: Fixed rate borrowings 20,506 35,577 135,789 5.83 148,930 Variable rate borrowings - 8,000 8,000 5.50 8,000 ------- -------- ---------- ---------- Other borrowings 20,506 43,577 143,789 156,930 ------- -------- ---------- ---------- Total Market Risk- Sensitive Liabilities $43,464 $ 43,892 $1,348,909 $1,375,050 ======= ======== ========== ========== EFFECTS OF INFLATION Consolidated financial data included in this report has been prepared in accordance with generally accepted accounting principles. Presently, these principles require reporting of financial position and operating results in terms of historical dollars, except for available for sale securities, trading securities and derivative instruments, which require reporting at fair value. Changes in the relative value of money due to inflation or recession are generally not considered. In management's opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not change at the same rate or in the same magnitude as the inflation rate. Rather, interest rate volatility is based on changes in the expected rate of inflation, as well as on changes in monetary and fiscal policies. A financial institution's ability to be relatively unaffected by changes in interest rates is a good indicator of its capability to perform in today's volatile economic environment. Heartland seeks to insulate itself from interest rate volatility by ensuring that rate-sensitive assets and rate-sensitive liabilities respond to changes in interest rates in a similar time frame and to a similar degree. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED BALANCE SHEETS December 31, 2001 and 2000 (Dollars in thousands, except per share data) Notes 2001 2000 ----- ---------- ---------- ASSETS Cash and due from banks 3 $ 45,738 $ 38,387 Federal funds sold and other short-term investments 47,812 46,300 ---------- ---------- Cash and cash equivalents 93,550 84,687 Time deposits in other financial institutions 564 1,504 Securities: 4 Trading, at fair value 1,528 - Available for sale-at fair value (cost of $318,342 for 2001 and $223,892 for 2000) 323,689 225,954 Held to maturity-at cost (approximate fair value of $2,154 for 2000) - 2,111 Loans and leases: 5 Held for sale 26,967 18,127 Held to maturity 1,078,238 1,023,969 Allowance for loan and lease losses 6 (14,660) (13,592) ---------- ---------- Loans and leases, net 1,090,545 1,028,504 Assets under operating leases 35,427 35,285 Premises, furniture and equipment, net 7 31,482 30,155 Other real estate, net 130 489 Goodwill and core deposit premium, net 18,995 20,755 Other assets 48,154 36,943 ---------- ---------- TOTAL ASSETS $1,644,064 $1,466,387 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Deposits: 8 Demand $ 160,742 $ 136,066 Savings 493,374 406,712 Time 551,043 558,535 ---------- ---------- Total deposits 1,205,159 1,101,313 Short-term borrowings 9 160,703 139,909 Other borrowings 10 143,789 102,856 Accrued expenses and other liabilities 27,323 26,163 ---------- ---------- TOTAL LIABILITIES 1,536,974 1,370,241 ----------- ---------- STOCKHOLDERS' EQUITY: 14,15,17 Preferred stock (par value $1 per share; authorized, 200,000 shares) - - Common stock (par value $1 per share; authorized, 16,000,000 and 12,000,000 shares at December 31, 2001, and December 31, 2000; issued, 9,905,783 shares at December 31, 2001, and at December 31, 2000) 9,906 9,906 Capital surplus 18,116 18,812 Retained earnings 79,107 71,253 Accumulated other comprehensive income 3,565 1,301 Treasury stock at cost (226,031 and 287,573 shares at December 31, 2001, and December 31, 2000, respectively) (3,604) (5,126) ---------- ---------- TOTAL STOCKHOLDERS' EQUITY 107,090 96,146 ---------- ---------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $1,644,064 $1,466,387 ========== ========== See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF INCOME For the years ended December 31, 2001, 2000 and 1999 (Dollars in thousands, except per share data) Notes 2001 2000 1999 ----- -------- -------- -------- INTEREST INCOME: Interest and fees on loans and leases 5 $ 91,931 $89,368 $60,947 Interest on securities: Taxable 14,143 11,824 11,113 Nontaxable 1,790 1,814 1,216 Interest on federal funds sold 1,981 911 410 Interest on interest bearing deposits in other financial institutions 243 333 468 --------- -------- -------- TOTAL INTEREST INCOME 110,088 104,250 74,154 --------- -------- -------- INTEREST EXPENSE: Interest on deposits 8 45,908 43,195 31,180 Interest on short-term borrowings 5,963 6,993 4,046 Interest on other borrowings 8,322 9,521 5,623 --------- -------- -------- TOTAL INTEREST EXPENSE 60,193 59,709 40,849 --------- -------- -------- NET INTEREST INCOME 49,895 44,541 33,305 Provision for loan and lease losses 6 4,283 3,301 2,626 --------- -------- -------- Net interest income after provision for loan and lease losses 45,612 41,240 30,679 --------- -------- -------- NONINTEREST INCOME: Service charges and fees 6,381 5,386 3,906 Trust fees 3,148 3,088 2,662 Brokerage commissions 615 846 655 Insurance commissions 807 862 803 Securities gains, net 1,489 501 713 Loss on trading account securities (417) - - Impairment loss on equity securities (773) (244) - Rental income on operating leases 15,446 14,918 14,718 Gains on sale of loans 2,738 521 1,028 Other noninterest income 900 1,130 939 --------- -------- -------- TOTAL NONINTEREST INCOME 30,334 27,008 25,424 --------- -------- -------- NONINTEREST EXPENSES: Salaries and employee benefits 13 25,460 23,876 18,945 Occupancy 14 3,076 2,904 2,076 Furniture and equipment 3,193 3,015 2,416 Depreciation on equipment under operating leases 11,805 11,199 10,844 Outside services 3,470 2,661 2,239 FDIC deposit insurance assessment 208 228 121 Advertising 1,596 1,492 1,376 Goodwill and core deposit intangibles amortization 1,672 1,814 682 Other noninterest expenses 8,338 7,257 6,023 --------- -------- -------- TOTAL NONINTEREST EXPENSES 58,818 54,446 44,722 --------- -------- -------- Income before income taxes 17,128 13,802 11,381 Income taxes 12 5,714 4,216 3,156 --------- -------- -------- NET INCOME $ 11,414 $ 9,586 $ 8,225 ========= ======== ======== EARNINGS PER COMMON SHARE-BASIC $ 1.19 $ 1.00 $ 0.86 ========= ======== ======== EARNINGS PER COMMON SHARE- DILUTED 1 $ 1.18 $ 0.98 $ 0.84 ========= ======== ======== CASH DIVIDENDS DECLARED PER COMMON SHARE $ 0.37 $ 0.36 $ 0.34 ========= ======== ======== See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME For the years ended December 31, 2001, 2000 and 1999 (Dollars in thousands, except per share data) Common Capital Retained Stock Surplus Earnings ------- ------- -------- Balance at January 1, 1999 $ 9,707 $14,984 $60,154 Net Income - 1999 8,225 Unrealized gain (loss) on securities available for sale Reclassification adjustment for gains realized in net income Income taxes Comprehensive income Cash dividends declared: Common, $0.34 per share (3,247) Purchase of 44,907 shares of common stock Sale of 96,602 shares of common stock 355 ------- ------- ------- Balance at December 31, 1999 $ 9,707 $15,339 $65,132 Net Income - 2000 9,586 Unrealized gain (loss) on securities available for sale Reclassification adjustment for gains realized in net income Income taxes Comprehensive income Cash dividends declared: Common, $0.36 per share (3,465) Purchase of 291,501 shares of common stock Issuance of 322,937 shares of common stock 199 3,473 ------- ------- ------- Balance at December 31, 2000 $ 9,906 $18,812 $71,253 Net Income - 2001 11,414 Unrealized gain (loss) on securities available for sale Unrealized gain on derivatives arising during the period, net of reclassification adjustment of $46 Reclassification adjustment for security gains realized in net income Income taxes Comprehensive income Cash dividends declared: Common, $0.37 per share (3,560) Purchase of 79,256 shares of common stock Sale of 140,798 shares of common stock (696) ------- ------- ------- BALANCE AT DECEMBER 31, 2001 $ 9,906 $18,116 $79,107 ======= ======= ======= Accumulated Other Comprehensive Treasury Income (Loss) Stock Total ------------- -------- ----- Balance at January 1, 1999 $ 2,107 $(2,682) $84,270 Net Income - 1999 8,225 Unrealized gain (loss) on securities available for sale (4,769) (4,769) Reclassification adjustment for gains realized in net income (713) (713) Income taxes 1,864 1,864 ------- Comprehensive income 4,607 Cash dividends declared: Common, $0.34 per share (3,247) Purchase of 44,907 shares of common stock (837) (837) Sale of 96,602 shares of common stock 1,425 1,780 ------- ------- ------- Balance at December 31, 1999 $(1,511) $(2,094) $86,573 Net Income - 2000 9,586 Unrealized gain (loss) on securities available for sale 4,003 4,003 Reclassification adjustment for gains realized in net income 257 257 Income taxes (1,448) (1,448) ------- Comprehensive income 12,398 Cash dividends declared: Common, $0.36 per share (3,465) Purchase of 291,501 shares of common stock (5,197) (5,197) Issuance of 322,937 shares of common stock 2,165 5,837 ------- ------- ------- Balance at December 31, 2000 $ 1,301 $(5,126) $96,146 Net Income - 2001 11,414 Unrealized gain (loss) on securities available for sale 3,796 3,796 Unrealized gain on derivatives arising during the period, net of reclassification adjustment of $46 350 350 Reclassification adjustment for security gains realized in net income (716) (716) Income taxes (1,166) (1,166) ------- Comprehensive income 13,678 Cash dividends declared: Common, $0.37 per share (3,560) Purchase of 79,256 shares of common stock (1,026) (1,026) Sale of 140,798 shares of common stock 2,548 1,852 ------- ------- ------- BALANCE AT DECEMBER 31, 2001 $ 3,565 $(3,604) $107,090 ======= ======= ======== See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, 2001, 2000 and 1999 (Dollars in thousands, except per share data) 2001 2000 1999 ---- ---- ---- Cash Flows from Operating Activities: Net income $ 11,414 $ 9,586 $ 8,225 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 16,616 16,167 14,294 Provision for loan and lease losses 4,283 3,301 2,626 Provision for income taxes less than (in excess of) payments (635) 41 (348) Net amortization (accretion) of premium (discount) on securities 1,285 (39) 1,417 Securities gains, net (1,489) (501) (713) Increase in trading account securities (1,528) - - Loss on impairment of equity securities 773 244 - Loans originated for sale (207,332) (42,991) (80,804) Proceeds on sales of loans 201,565 36,273 75,351 Net gain on sales of loans (2,738) (521) (1,028) Decrease (increase) in accrued interest receivable 1,603 (4,091) (826) Increase (decrease) in accrued interest payable (1,597) 2,641 353 Other, net (4,923) (4,119) (5,613) -------- -------- -------- Net cash provided by operating activities 17,297 15,991 12,934 -------- -------- -------- Cash Flows from Investing Activities: Purchase of time deposits - (600) - Proceeds on maturities of time deposits 959 5,180 43 Proceeds from the sale of securities available for sale 65,010 34,442 22,454 Proceeds from the maturity of and principal paydowns on securities held to maturity - 6,353 520 Proceeds from the maturity of and principal paydowns on securities available for sale 109,436 48,260 95,070 Purchase of securities available for sale (267,354) (81,918) (92,611) Net increase in loans and leases (55,118) (132,761) (201,186) Purchase of bank-owned life insurance policies (8,568) - - Increase in assets under operating leases (11,663) (11,409) (11,716) Capital expenditures (4,602) (3,647) (7,802) Net cash and cash equivalents received in acquisition of subsidiaries - 18,603 43,682 Net cash received from minority interest stockholders - 780 58 Net cash and cash equivalents paid in acquisition of trust assets - - (528) Proceeds on sale of OREO and other repossessed assets 790 815 1,090 -------- -------- -------- Net cash used by investing activities (171,110) (115,902) (150,926) Cash Flows from Financing Activities: Net increase in demand deposits and savings accounts 111,338 26,090 42,217 Net increase (decrease) in time deposit accounts (7,492) 111,248 18,165 Net increase in short-term borrowings 20,794 25,795 47,315 Proceeds from other borrowings 69,381 26,463 36,800 Repayments of other borrowings (28,448) (32,308) (11,079) Purchase of treasury stock (1,026) (5,197) (837) Proceeds from sale of treasury stock 1,689 19 1,780 Dividends (3,560) (3,465) (3,247) -------- -------- -------- Net cash provided by financing activities 162,676 148,645 131,114 -------- -------- -------- Net increase (decrease) in cash and cash equivalents 8,863 48,734 (6,878) Cash and cash equivalents at beginning of year 84,687 35,953 42,831 -------- -------- -------- Cash and cash equivalents at end of period $ 93,550 $ 84,687 $ 35,953 ======== ======== ======== Supplemental disclosures: Cash paid for income/ franchise taxes $ 6,365 $ 3,890 $ 3,596 Cash paid for interest $ 61,790 $ 57,068 $ 40,496 Securities held to maturity transferred to securities available for sale $ 2,154 $ - $ - Acquisitions: Assets acquired $ - $119,837 $ 40,472 Cash paid for purchase of stock $ - $(14,364) $ - Cash acquired - 32,967 43,682 -------- -------- -------- Net cash received for acquisitions $ - $ 18,603 $ 43,682 Notes issued for acquisition $ - $ 3,820 $ - Common stock issued for acquisition $ - $ 5,773 $ - See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per share data) ONE SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Operations-Heartland Financial USA, Inc. ("Heartland") is a multi-bank holding company primarily operating full-service retail banking offices in Dubuque and Lee Counties in Iowa; Jo Daviess, Hancock and Winnebago Counties in Illinois; Dane, Green, Sheboygan, Brown and Eau Claire Counties in Wisconsin; and Bernalillo and Curry Counties in New Mexico, serving communities in and around those counties. The principal services of Heartland, through its subsidiaries, are FDIC-insured deposit accounts and related services, and loans to businesses and individuals. The loans consist primarily of commercial and commercial real estate and residential real estate. Principles of Presentation-The consolidated financial statements include the accounts of Heartland and its subsidiaries: Dubuque Bank and Trust Company ("DB&T"); Galena State Bank and Trust Company ("GSB"); Riverside Community Bank ("RCB"); Wisconsin Community Bank ("WCB"); New Mexico Bank & Trust ("NMB"); First Community Bank, FSB ("FCB"); Citizens Finance Co.("Citizens"); ULTEA, Inc. ("ULTEA"); DB&T Insurance, Inc.; DB&T Community Development Corp.; DBT Investment Corporation; Keokuk Bancshares, Inc. (dba KBS Investment Corp.); Heartland Capital Trust I ("Trust I"); and Heartland Financial Statutory Trust II ("Trust II"). All of Heartland's subsidiaries are wholly-owned except for NMB, of which Heartland was an 86.47% owner on December 31, 2001. All significant intercompany balances and transactions have been eliminated in consolidation. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and with general practice within the banking industry. In preparing such financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan and lease losses. Trading Account Securities - Trading securities represent those securities Heartland intends to actively trade and are stated at fair value with changes in fair value reflected in noninterest income. During the first quarter of 2001, Heartland began purchasing securities, on a limited basis, with the intent of actively trading those securities. Securities Available for Sale-Available for sale securities consist of those securities not classified as held to maturity or trading, which management intends to hold for indefinite periods of time or that may be sold in response to changes in interest rates, prepayments or other similar factors. Such securities are stated at fair value with any unrealized gain or loss, net of applicable income tax, reported as a separate component of stockholders' equity. Security premiums and discounts are amortized/accreted using the interest method over the period from the purchase date to the maturity or call date of the related security. Gains or losses from the sale of available for sale securities are determined based upon the adjusted cost of the specific security sold. Unrealized losses judged to be other than temporary are charged to operations for both securities available for sale and securities held to maturity. Securities Held to Maturity-Securities which Heartland has the ability and positive intent to hold to maturity are classified as held to maturity. Such securities are stated at amortized cost, adjusted for premiums and discounts that are amortized/accreted using the interest method over the period from the purchase date to the maturity date of the related security. Loans and Leases-Interest on loans is accrued and credited to income based primarily on the principal balance outstanding. Income from leases is recorded in decreasing amounts over the term of the contract resulting in a level rate of return on the lease investment. The policy of Heartland is to discontinue the accrual of interest income on any loan or lease when, in the opinion of management, there is a reasonable doubt as to the timely collection of the interest and principal. 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 and lease losses. Nonaccrual loans and leases 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 policies, all nonaccrual and restructured loans are defined as impaired loans. 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, at the observable market price of the loan or the fair value of the collateral if the loan is collateral dependent. Net nonrefundable loan and lease origination fees and certain direct costs associated with the lending process are deferred and recognized as a yield adjustment over the life of the related loan or lease. Loans held for sale are stated at the lower of aggregate cost or estimated fair value. Loans are sold on a nonrecourse basis with either servicing released or retained, and gains and losses are recognized based on the difference between sales proceeds and the carrying value of the loan. Mortgage servicing rights associated with loans originated and sold, where servicing is retained, are capitalized and included in other assets in the balance sheet. The values of these capitalized servicing rights are amortized in relation to the servicing revenue expected to be earned. The carrying values of these rights are periodically reviewed for impairment. For purposes of measuring impairment, the rights are stratified into certain risk characteristics including loan type, note rate, prepayment trends and external market factors. There was no valuation allowance required as of December 31, 2001 and 2000. The following table summarizes the changes in capitalized mortgage loan servicing rights: 2001 2000 -------- -------- Balance, beginning of year $ 556 $ 498 Originations 1,626 166 Amortization (1,008) (108) ---------- ---------- Balance, end of year $ 1,174 $ 556 ========== ========== Mortgage loans serviced for others were $268,625 and $183,880 as of December 31, 2001 and 2000, respectively. Custodial escrow balances maintained in connection with the loan servicing portfolio were approximately $1,217 and $1,126 as of December 31, 2001 and 2000, respectively. Allowance for Loan and Lease Losses - The allowance for loan and lease losses is maintained at a level estimated by management to provide for known and inherent risks in the loan and lease portfolios. The allowance is based upon a continuing review of past loan and lease loss experience, current economic conditions, volume growth, the underlying collateral value of the loans and leases and other relevant factors. Loans and leases which are deemed uncollectible are charged off and deducted from the allowance. Provisions for loan and lease losses and recoveries on previously charged-off loans and leases are added to the allowance. Premises, Furniture and Equipment - Premises, furniture and equipment are stated at cost less accumulated depreciation. The provision for depreciation of premises, furniture and equipment is determined by straight-line and accelerated methods over the estimated useful lives of 18 to 39 years for buildings, 15 years for land improvements and 3 to 7 years for furniture and equipment. Other Real Estate - Other real estate represents property acquired through foreclosures and settlements of loans. Property acquired is carried at the lower of the principal amount of the loan outstanding at the time of acquisition, plus any acquisition costs, or the estimated fair value of the property, less disposal costs. The excess, if any, of such costs at the time acquired over the fair value is charged against the allowance for loan and lease losses. Subsequent write downs estimated on the basis of later evaluations, gains or losses on sales and net expenses incurred in maintaining such properties are charged to operations. Intangible Assets - Intangible assets consist of goodwill and core deposit premiums. Goodwill represents the excess of the purchase price of acquired subsidiaries' net assets over their fair value. Goodwill is amortized over periods of 15 to 25 years on the straight-line basis. Core deposit premiums are amortized over ten years on an accelerated basis. Periodically, Heartland reviews the intangible assets for events or circumstances that may indicate a change in the recoverability of the underlying basis. Income Taxes - Heartland and its subsidiaries file a consolidated federal income tax return. For state tax purposes, DB&T, GSB, RCB, FCB, WCB and NMB ("Banks") file income or franchise tax returns as required. The other entities file corporate income or franchise tax returns as required by the various states. Heartland has a tax allocation agreement which provides that each subsidiary of the consolidated group pay a tax liability to, or receive a tax refund from Heartland, computed as if the subsidiary had filed a separate return. Heartland recognizes certain income and expenses in different time periods for financial reporting and income tax purposes. The provision for deferred income taxes is based on an asset and liability approach and represents the change in deferred income tax accounts during the year, including the effect of enacted tax rate changes. Deferred tax assets are recognized if their expected realization is "more likely than not." Treasury Stock - Treasury stock is accounted for by the cost method, whereby shares of common stock reacquired are recorded at their purchase price. Trust Department Assets - Property held for customers in fiduciary or agency capacities is not included in the accompanying consolidated balance sheets, as such items are not assets of the Banks. Earnings Per Share - Amounts used in the determination of basic and diluted earnings per share for the years ended December 31, 2001, 2000 and 1999 are shown in the table below: 2001 2000 1999 ------- ------- ------- Net income $11,414 $ 9,586 $ 8,225 ======= ======= ======= Weighted average common shares outstanding for basic earnings per share (1) 9,602 9,628 9,555 Assumed incremental common shares issued upon exercise of stock options (1) 103 130 196 ------- ------- ------- Weighted average common shares for diluted earnings per share (1) 9,705 9,758 9,751 ======= ======= ======= (1) in thousands Cash Flows - For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, other short-term investments and federal funds sold. Generally, federal funds are purchased and sold for one-day periods. Effect of New Financial Accounting Standards - In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("FAS") No. 133, Accounting for Derivative Instruments and Hedging Activities. In July 1999, the FASB issued FAS No. 137, Deferring Statement 133's Effective Date, which defers the effective date for implementation of FAS No. 133 by one year, making FAS No. 133 effective no later than January 1, 2001, for Heartland's financial statements. In June 2000, the FASB issued FAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of FAS No. 133. Heartland implemented FAS No. 133 on January 1, 2001, and reclassified, at that date, all investments previously included in its held to maturity investment portfolio to the available for sale investment portfolio. There was no material impact on the consolidated financial statements as a result of the implementation. In July 2001, the FASB issued FAS No. 141, Business Combinations, and FAS No. 142, Goodwill and Other Intangible Assets. FAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, as well as all purchase method business combinations completed after June 30, 2001. FAS No. 141 also specifies criteria that intangible assets acquired in a purchase method business combination must meet to be recognized and reported apart from goodwill. FAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of FAS No. 142. FAS No. 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with FAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long- Lived Assets to Be Disposed Of. Heartland adopted the provisions of FAS No. 141 immediately, and FAS No. 142 effective January 1, 2002. Goodwill and intangible assets acquired in business combinations completed before July 1, 2001, continued to be amortized and tested for impairment in accordance with the appropriate pre-FAS No. 142 accounting requirements prior to adoption of FAS No. 142. As of December 31, 2001, Heartland had unamortized goodwill in the amount of $16,064 and unamortized identifiable intangible assets in the amount of $2,931. Amortization expense related to goodwill was $1,064 and $1,063 for the years ended December 31, 2001, and December 31, 2000, respectively. Amortization expense related to identifiable intangible assets was $608 and $751 for the years ended December 31, 2001, and December 31, 2000, respectively. All of Heartland's identifiable intangible assets are core deposit premiums related to acquisitions. The estimated impact of adopting FAS No. 141 and 142 on January 1, 2002 will be the discontinuance of amortization on $9,521 of Heartland's unamortized goodwill. The corresponding amortization expense for the year ended December 31, 2001 was $538. Goodwill in the amount of $6,543 will continue to be amortized in accordance with the provisions of FAS No. 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions. No transitional impairment charges are anticipated. In August 2001, the FASB issued FAS Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which supersedes both FAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business (as previously defined in that Opinion). FAS No. 144 retains the fundamental provisions in FAS No. 121 for recognizing and measuring impairment losses on long-lived assets held for use and long-lived assets to be disposed of by sale, while also resolving significant implementation issues associated with FAS No. 121. For example, FAS No. 144 provides guidance on how a long-lived asset that is used as part of a group should be evaluated for impairment, establishes criteria for when a long-lived asset is held for sale, and prescribes the accounting for a long-lived asset that will be disposed of other than by sale. FAS No. 144 retains the basic provisions of Opinion 30 on how to present discontinued operations in the income statement but broadens that presentation to include a component of an entity (rather than a segment of a business). Unlike FAS No. 121, an impairment assessment under FAS No. 144 will never result in a write-down of goodwill. Rather, goodwill is evaluated for impairment under FAS No. 142, Goodwill and Other Intangible Assets. Heartland is required to adopt FAS No. 144 no later than the year beginning after December 15, 2001, and plans to adopt its provisions for the quarter ending March 31, 2002. Management does not expect the adoption of FAS No. 144 for long-lived assets held for use to have a material impact on Heartland's financial statements because the impairment assessment under FAS No. 144 is largely unchanged from FAS No. 121. The provisions of FAS No. 144 for assets held for sale or other disposal generally are required to be applied prospectively after the adoption date to newly initiated disposal activities. Therefore, management cannot determine the potential effects that adoption of FAS No. 144 will have on Heartland's financial statements. Reclassifications-Certain reclassifications have been made to prior periods' consolidated financial statements to place them on a basis comparable with the current period's consolidated financial statements. TWO ACQUISITIONS Heartland regularly explores opportunities for acquisitions of financial institutions and related businesses. Generally, management does not make a public announcement about an acquisition opportunity until a definitive agreement has been signed. On January 1, 2000, Heartland completed its acquisition of National Bancshares, Inc. ("NBI"), the one-bank holding company of First National Bank of Clovis ("FNB") in New Mexico. FNB has four locations in the New Mexico communities of Clovis and Melrose, with $120,113 in assets and $97,533 in deposits at December 31, 1999. The total purchase price for NBI was $23,103, of which $5,773 was paid in common stock of Heartland to NBI's Employee Stock Ownership Plan (the "ESOP") and $3,820 in notes payable over three or five years, at the stockholders' discretion, bearing interest at 7.00%. As provided in the merger agreement, participants in the ESOP elected to receive a cash payment totaling $4,619 for 255,180 of the 319,009 shares of Heartland's common stock originally issued to them. Heartland merged FNB into its New Mexico bank subsidiary NMB immediately after the closing of the NBI acquisition. As a result of this affiliate bank merger, Heartland's ownership in NMB increased from its initial 80% to approximately 88%. The acquisition of NBI has been accounted for as a purchase; accordingly, the results of operations of FNB are included in the consolidated financial statements from the acquisition date. The resultant acquired deposit base intangible of $1,986 is being amortized over a period of 10 years, and the remaining excess purchase price over the fair value of assets acquired of $6,337 is being amortized over a period of 25 years. On July 23, 1999, WCB completed its acquisition of Bank One Wisconsin's branch in Monroe, Wisconsin. Included in the acquisition were deposits of $93,780 and loans of $38,581. Trust assets of the Monroe branch were also acquired by WCB. The acquisition was accounted for as a purchase; accordingly, the results of operations of the Monroe banking center have been included in the financial statements from the acquisition date. The resultant acquired deposit base intangible of $2,505 is being amortized over a period of 10 years and the remaining excess purchase price over the fair value of assets acquired of $8,327 is being amortized over a period of 15 years. THREE CASH AND DUE FROM BANKS The Banks are required to maintain certain average cash reserve balances as a member of the Federal Reserve System. The reserve balance requirements at December 31, 2001 and 2000 were $3,272 and $2,627 respectively. FOUR Securities The amortized cost, gross unrealized gains and losses and estimated fair values of held to maturity and available for sale securities as of December 31, 2001 and 2000, are summarized as follows: Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value --------- -------- --------- -------- 2001 Securities available for sale: U.S. government corporations and agencies and treasuries $ 76,797 $ 2,543 $ (106) $ 79,234 Mortgage-backed securities 182,179 1,764 (282) 183,661 Obligations of states and political subdivisions 29,493 1,575 (120) 30,948 Corporate debt securities 521 2 - 523 -------- -------- -------- -------- Total debt securities 288,990 5,884 (508) 294,366 Equity securities 29,352 262 (291) 29,323 -------- -------- -------- -------- Total $318,342 $ 6,146 $ (799) $323,689 ======== ======== ======== ======== Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value --------- --------- --------- --------- 2000 Securities held to maturity: Obligations of states and political subdivisions $ 2,111 $ 44 $ (1) $ 2,154 ======== ======== ======== ======== Securities available for sale: U.S. government corporations and agencies $117,610 $ 1,499 $ (212) $118,897 Mortgage-backed securities 53,201 417 (211) 53,407 Obligations of states and political subdivisions 30,619 1,441 (127) 31,933 Corporate debt securities 10,182 - (61) 10,121 -------- -------- -------- -------- Total debt securities 211,612 3,357 (611) 214,358 Equity securities 12,280 470 (1,154) 11,596 -------- -------- -------- -------- Total $223,892 $ 3,827 $ (1,765) $225,954 ======== ======== ======== ======== The amortized cost and estimated fair value of debt securities available for sale at December 31, 2001, by estimated maturity, are as follows. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without penalties. Estimated Amortized Fair Cost Value --------- --------- Securities available for sale: Due in 1 year or less $ 57,701 $ 58,229 Due in 1 to 5 years 190,365 193,799 Due in 5 to 10 years 24,746 25,363 Due after 10 years 16,178 16,975 -------- -------- Total $288,990 $294,366 ======== ======== As of December 31, 2001, securities with a fair value of $189,394 were pledged to secure public and trust deposits, short-term borrowings and for other purposes as required by law. Gross gains and losses related to sales of securities for the years ended December 31, 2001, 2000 and 1999, are summarized as follows: 2001 2000 1999 -------- -------- -------- Securities sold: Proceeds from sales $65,010 $34,442 $22,454 Gross security gains 2,233 1,084 1,007 Gross security losses 744 583 294 During the years ended December 31, 2001 and 2000, Heartland incurred other than temporary impairment losses of $773 and $244 on equity securities available for sale. FIVE LOANS AND LEASES Loans and leases as of December 31, 2001 and 2000, were as follows: 2001 2000 -------- -------- Loans: Commercial and commercial real estate $ 651,479 $ 550,366 Residential mortgage 168,912 215,638 Agricultural and agricultural real estate 145,460 133,614 Consumer 127,874 128,685 ---------- ---------- Loans, gross 1,093,725 1,028,303 Unearned discount (3,457) (3,397) Deferred loan fees (633) (400) ---------- ---------- Loans, net 1,089,635 1,024,506 ---------- ---------- Direct financing leases: Gross rents receivable 13,129 16,014 Estimated residual value 4,921 4,750 Unearned income (2,480) (3,174) ---------- ---------- Direct financing leases, net 15,570 17,590 ---------- ---------- Allowance for loan and lease losses (14,660) (13,592) ---------- ---------- Loans and leases, net $1,090,545 $1,028,504 ========== ========== Direct financing leases receivable are generally short-term equipment leases. Future minimum lease payments as of December 31, 2001, were as follows: $5,577 for 2002, $4,227 for 2003, $3,723 for 2004, $2,741 for 2005, $959 for 2006 and $823 thereafter. As DB&T is the largest subsidiary of Heartland, the majority of the loan portfolio is concentrated in northeast Iowa, northwest Illinois and southwest Wisconsin. Loans and leases on a nonaccrual status amounted to $7,269 and $5,860 at December 31, 2001 and 2000, respectively. The allowance for loan and lease losses related to these nonaccrual loans was $2,036 and $3,087, respectively. All loans were subject to a related allowance at December 31, 2001, and December 31, 2000, as Heartland's allowance adequacy methodology identifies a specific allocation for each credit. The average balances of nonaccrual loans for the years ended December 31, 2001, 2000 and 1999 were $6,980, $3,209 and $1,367, respectively. For the years ended December 31, 2001, 2000 and 1999, interest income which would have been recorded under the original terms of these loans and leases amounted to approximately $557, $323, and $63, respectively, and interest income actually recorded amounted to approximately $188, $107, and $16, respectively. Loans and leases on a restructured status amounted to $354 and $357 at December 31, 2001 and 2000, respectively. The allowance for loan and lease losses related to these nonaccrual loans was $150 and $100, respectively. All loans were subject to a related allowance at December 31, 2001, and December 31, 2000, as Heartland's allowance adequacy methodology identifies a specific allocation for each credit. The average balances of restructured loans for the years ended December 31, 2001, 2000 and 1999 were $355, $367 and $303, respectively. For the years ended December 31, 2001, 2000 and 1999, interest income which would have been recorded under the original terms of these loans and leases amounted to approximately $32, $28, and $24, respectively, and interest income actually recorded amounted to approximately $9, $28, and $0, respectively. Loans are made in the normal course of business to directors, officers and principal holders of equity securities of Heartland. The terms of these loans, including interest rates and collateral, are similar to those prevailing for comparable transactions and do not involve more than a normal risk of collectibility. Changes in such loans during the year ended December 31, 2001, were as follows: 2001 -------- Balance at beginning of year $ 24,433 Advances 46,935 Repayments (44,456) -------- Balance at end of year $ 26,912 ======== SIX ALLOWANCE FOR LOAN AND LEASE LOSSES Changes in the allowance for loan and lease losses for the years ended December 31, 2001, 2000 and 1999, were as follows: 2001 2000 1999 ------- ------- ------- Balance at beginning of year $13,592 $10,844 $ 7,945 Provision for loan and lease losses 4,283 3,301 2,626 Recoveries on loans and leases previously charged off 542 585 243 Loans and leases charged off (3,757) (2,280) (635) Additions related to acquisitions - 1,142 665 ------- ------- ------- Balance at end of year $14,660 $13,592 $10,844 ======= ======= ======= SEVEN PREMISES, FURNITURE AND EQUIPMENT Premises, furniture and equipment as of December 31, 2001 and 2000, were as follows: 2001 2000 ------- ------- Land and land improvements $ 5,279 $ 4,623 Buildings and building improvements 26,144 24,322 Furniture and equipment 19,428 18,383 ------- ------- Total 50,851 47,328 Less accumulated depreciation (19,369) (17,173) ------- ------- Premises, furniture and equipment, net $31,482 $30,155 ======= ======= Depreciation expense on premises, furniture and equipment was $2,769 for 2001, $2,667 for 2000 and $2,095 for 1999. EIGHT DEPOSITS The aggregate amount of time certificates of deposit in denominations of one hundred thousand dollars or more as of December 31, 2001 and 2000, were $111,471 and $134,468, respectively. At December 31, 2001, the scheduled maturities of time certificates of deposit were as follows: 2001 --------- 2002 $ 365,135 2003 107,567 2004 39,242 2005 15,826 2006 22,958 Thereafter 315 --------- Total $ 551,043 ========= Interest expense on deposits for the years ended December 31, 2001, 2000 and 1999, was as follows: 2001 2000 1999 ------- ------- ------- Savings and money market accounts $11,967 $13,913 $10,789 Time certificates of deposit in denominations of $100 or more 8,227 6,001 3,222 Other time deposits 25,714 23,281 17,169 ------- ------- ------- Interest expense on deposits $45,908 $43,195 $31,180 ======= ======= ======= NINE SHORT-TERM BORROWINGS Short-term borrowings as of December 31, 2001 and 2000, were as follows: 2001 2000 -------- -------- Securities sold under agreements to repurchase $108,592 $ 92,991 Federal funds purchased 10,175 4,150 U.S. Treasury demand note 10,211 3,468 Citizens short-term notes 2,500 - Notes payable to unaffiliated banks 29,225 39,300 -------- -------- Total $160,703 $139,909 ======== ======== On September 28, 2000, Heartland entered into a credit agreement with two unaffiliated banks to replace an existing term credit line, as well as to increase availability under a revolving credit line. Under the new unsecured revolving credit lines, Heartland may borrow up to $50,000 at any one time. At December 31, 2001 and December 31, 2000, $29,225 and $39,300, respectively, was outstanding on the revolving credit lines. The additional credit line was established primarily to provide additional working capital to the nonbanking subsidiaries and to meet general corporate commitments. All repurchase agreements as of December 31, 2001 and 2000, were due within six months. Average and maximum balances and rates on aggregate short-term borrowings outstanding during the years ended December 31, 2001, 2000 and 1999, were as follows: 2001 2000 1999 -------- -------- -------- Maximum month-end balance $162,744 $144,604 $118,019 Average month-end balance 151,139 122,777 91,613 Weighted average interest rate for the year 3.93% 5.79% 4.63% Weighted average interest rate at year-end 1.39 5.60 4.35 TEN OTHER BORROWINGS Other borrowings at December 31, 2001 and 2000, were as follows: 2001 2000 ------- ------- Advances from the FHLB; weighted average maturity dates at December 31, 2001 and 2000, were May, 2004 and January, 2002, respectively; and weighted average interest rates were 5.37% and 6.57%, respectively $ 86,486 $ 51,109 Notes payable on leased assets with interest rates varying from 3.95 to 9.50% 22,193 22,556 Trust preferred securities 33,000 25,000 Contracts payable to previous stock- holders of Lease Associates Group for acquisition due over a three- year schedule at 7.50% through July 2001 - 643 Contracts payable to previous stock- holders of WCB for acquisition due in annual payments over two-, three- or four-year schedules at interest rates of 7.00% to 7.50% through March 2001 - 594 Contracts payable to previous stock- holders of NBI for acquisition due over a three- or five-year schedule at 7.00% through January 2004 2,110 2,954 -------- ------- Total $143,789 $102,856 ======== ======== The Banks are members of the Federal Home Loan Bank ("FHLB") of Des Moines, Chicago, or Dallas. The advances from the FHLB are collateralized by the Banks' investment in FHLB stock of $25,552 and $6,097 at December 31, 2001 and 2000, respectively. Additional collateral is provided by the Banks' one-to-four unit residential mortgages, commercial and agricultural mortgages totaling $123,756 at December 31, 2001, and $178,706 at December 31, 2000. On December 18, 2001, Heartland completed an offering of $8,000 of variable rate cumulative capital securities representing undivided beneficial interests in Trust II. The proceeds from the offering were used by Trust II to purchase junior subordinated debentures from Heartland. The proceeds are being used for general corporate purposes, including the repayment of $8,000 of indebtedness on the revolving credit lines. Interest is payable quarterly on March 18, June 18, September 18 and December 18 of each year. The debentures will mature and the capital securities must be redeemed on December 18, 2031. Heartland has the option to shorten the maturity date to a date not earlier than December 18, 2006. Heartland may not shorten the maturity date without prior approval of the Board of Governors of the Federal Reserve System, if required. Prior redemption is permitted under certain circumstances, such as changes in tax or regulatory capital rules. In connection with this offering, the balance of deferred issuance costs included in other assets was $241 as of December 31, 2001. These deferred costs are amortized on a straight-line basis over the life of the debentures. On October 21, 1999, Heartland completed an offering of $25,000 of 9.60% cumulative capital securities representing undivided beneficial interests in Trust I, a special purpose trust subsidiary of Heartland formed for the sole purpose of this offering. The proceeds from the offering were used by Trust I to purchase junior subordinated debentures from Heartland. Interest is payable quarterly on March 31, June 30, September 30 and December 31 of each year. The debentures will mature and the capital securities must be redeemed on September 30, 2029. Heartland has the option to shorten the maturity date to a date not earlier than September 30, 2004. Heartland may not shorten the maturity date without prior approval of the Board of Governors of the Federal Reserve System, if required. Prior redemption is permitted under certain circumstances, such as changes in tax or regulatory capital rules. In connection with this offering, the balance of deferred issuance costs included in other assets was $1,065 as of December 31, 2001. The deferred costs are amortized on a straight-line basis over the life of the debentures. All of the capital securities qualified as Tier 1 capital for regulatory purposes as of December 31, 2001 and 2000. Future payments at December 31, 2001, for all other borrowings were as follows: 2002 $ 24,757 2003 12,781 2004 25,281 2005 16,887 2006 20,506 Thereafter 43,577 -------- Total $143,789 ======== ELEVEN DERIVATIVE FINANCIAL INSTRUMENTS Heartland's use of derivative financial instruments relates to the management of the risk that changes in interest rates will affect its future interest payments. Heartland utilizes an interest rate swap contract to effectively convert a portion of the variable rate interest rate debt to fixed interest rate debt. Under the interest rate swap contract, Heartland agrees to pay an amount equal to a fixed rate of interest times a notional principal amount, and to receive in return an amount equal to a specified variable rate of interest times the same notional principal amount. The notional amounts are not exchanged and payments under the interest rate swap contract are made monthly. Heartland is exposed to credit-related losses in the event of nonperformance by the counterparty to the swap contract. This risk is minimized by entering into the contract with a large, stable financial institution. As of December 31, 2001, Heartland had an interest rate swap contract to pay a fixed interest rate of 4.35% and receive a variable interest rate of 1.52% based on $25 million of indebtedness. This contract expires on November 1, 2006. The fair market value of the interest rate swap contract was an asset of $350 as of December 31, 2001 and is included in other assets. There was no ineffectiveness recognized on this interest rate swap during the year. All components of the derivative instrument's gain or loss is included in the assessment of hedge effectiveness. For the period ended December 31, 2001, there were no cash flow hedges discontinued related to forecasted transactions that are probable of not occurring. As of December 31, 2001, $219 of deferred net gains on derivative instruments included in other comprehensive income are expected to be reclassified to net income during the next twelve months. TWELVE INCOME TAXES Income taxes for the years ended December 31, 2001, 2000 and 1999, were as follows: Current Deferred Total ------- -------- ----- 2001: Federal $5,310 $ (540) $4,770 State 1,037 (93) 944 ------ ------ ------ Total $6,347 $ (633) $5,714 ====== ====== ====== 2000: Federal $3,504 $ (86) $3,418 State 850 (52) 798 ------ ------ ------ Total $4,354 $ (138) $4,216 ====== ====== ====== 1999: Federal $2,790 $ 14 $2,804 State 504 (152) 352 ------ ------ ------ Total $3,294 $ (138) $3,156 ====== ====== ====== Temporary differences between the amounts reported in the financial statements and the tax basis of assets and liabilities result in deferred taxes. No valuation allowance was required for deferred tax assets. Based upon Heartland's level of historical taxable income and anticipated future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that Heartland will realize the benefits of these deductible differences. Deferred tax assets and liabilities for the years ended December 31, 2001 and 2000, were as follows: 2001 2000 -------- -------- Deferred tax assets: Securities $ 240 $ 36 Allowance for loan and lease losses 5,635 5,008 Deferred compensation 789 518 Organization and acquisitions costs 244 182 Net operating loss carryforwards 708 670 Other 140 - -------- -------- Gross deferred tax assets $ 7,756 $ 6,414 -------- -------- Deferred tax liabilities: Tax effect of net unrealized gain on securities available for sale reflected in stockholders' equity $ (2,001) $ (761) Tax effect of net unrealized gain on derivatives reflected in stockholders' equity (131) - Premises, furniture and equipment (4,452) (4,432) Lease financing (2,791) (2,482) Tax bad debt reserves (580) (609) Purchase accounting (895) (998) Prepaid expenses (272) (214) Mortgage servicing rights (643) (207) Other (176) (158) -------- -------- Gross deferred tax liabilities $(11,941) $ (9,861) -------- -------- Net deferred tax asset(liability) $ (4,185) $ (3,447) ======== ======== The actual income tax expense differs from the expected amounts (computed by applying the U.S. federal corporate tax rate of 35% for 2001, 2000 and 1999, to income before income taxes) as follows: 2001 2000 1999 -------------------------- Computed "expected" amount $5,995 $4,831 $3,983 Increase (decrease) resulting from: Nontaxable interest income (610) (624) (515) State income taxes, net of federal tax benefit 614 520 230 Goodwill and other intangibles not deductible 270 291 84 Graduated income tax rates (36) (100) (100) Tax credits (440) (440) (440) Other (79) (262) (86) ------ ------ ------ Income taxes $5,714 $4,216 $3,156 ====== ====== ====== Effective tax rates 33.4% 30.5% 27.7% ====== ====== ====== Heartland has investments in certain low-income housing projects totaling $4,735 and $4,894 as of December 31, 2001 and 2000, respectively, which are included in other assets in the consolidated financial statements. These investments are expected to generate federal income tax credits of approximately $440 per year through 2005. THIRTEEN EMPLOYEE BENEFIT PLANS Heartland sponsors a retirement plan covering substantially all employees. Contributions to this plan are subject to approval by the Heartland Board of Directors. The Heartland subsidiaries fund and record as an expense all approved contributions. Costs charged to operating expenses were $761 for 2001, $692 for 2000 and $530 for 1999. This plan includes an employee savings program, under which the Heartland subsidiaries make matching contributions of up to 2% of the participants' wages. Costs charged to operating expenses were $275 for 2001, $262 for 2000 and $183 for 1999. Heartland also has a non-contributory, defined contribution pension plan covering substantially all employees. Annual contributions are based upon 5% of qualified compensation as defined in the plan. Costs charged to operating expense were $761 for 2001, $692 for 2000 and $530 for 1999. FOURTEEN COMMITMENTS AND CONTINGENT LIABILITIES Heartland leases certain land and facilities under operating leases. Minimum future rental commitments at December 31, 2001, for all non-cancelable leases were as follows: 2002 $ 408 2003 411 2004 362 2005 289 2006 182 Thereafter 48 ------ Total $1,700 ====== Rental expense for premises and equipment leased under operating leases was $744 for 2001, $694 for 2000 and $521 for 1999. In the normal course of business, the Banks make various commitments and incur certain contingent liabilities that are not presented in the accompanying consolidated financial statements. The commitments and contingent liabilities include various guarantees, commitments to extend credit and standby letters of credit. 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. The Banks evaluate each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Banks upon extension of credit, 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 written are conditional commitments issued by the Banks 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 December 31, 2001 and 2000, commitments to extend credit aggregated $325,282 and $371,654 and standby letters of credit aggregated $11,631 and $9,312, respectively. Heartland enters into commitments to sell mortgage loans to reduce interest rate risk on certain mortgage loans held for sale and loan commitments. At December 31, 2001 and 2000, Heartland had commitments to sell residential real estate loans totaling $30,849 and $2,194, respectively. Heartland does not anticipate any material loss as a result of the commitments and contingent liabilities. FIFTEEN STOCK PLANS Heartland's Stock Option Plan ("Plan") is administered by the Compensation Committee ("Committee") of the Board of Directors whose members determine to whom options will be granted and the terms of each option. Under the Plan, 1,200,000 common shares have been reserved for issuance. Directors and key policy-making employees are eligible for participation in the Plan. Options may be granted that are either intended to be "incentive stock options" as defined under Section 422 of the Internal Revenue Code or not intended to be incentive stock options ("non- qualified stock options"). The exercise price of stock options granted will be established by the Committee, but the exercise price for the incentive stock options may not be less than the fair market value of the shares on the date that the option is granted. Each option granted is exercisable in full at any time or from time to time, subject to vesting provisions, as determined by the Committee and as provided in the option agreement, but such time may not exceed ten years from the grant date. At December 31, 2001 and 2000 respectively, there were 201,717 and 245,467 shares available for issuance under the Plan. Under the Plan, stock appreciation rights ("SARS") may also be granted alone or in tandem with or with reference to a related stock option, in which event the grantee, at the exercise date, has the option to exercise the option or the SARS, but not both. SARS entitle the holder to receive in cash or stock, as determined by the Committee, an amount per share equal to the excess of the fair market value of the stock on the date of exercise over the fair market value at the date the SARS or related options were granted. SARS may be exercisable for up to ten years after the date of grant. No SARS have been granted under the Plan. A summary of the status of the Plan as of December 31, 2001, 2000 and 1999, and changes during the years ended follows: 2001 2000 1999 Weighted- Weighted- Weighted- Average Average Average Shares Exercise Shares Exercise Shares Exercise (000) Price (000) Price (000) Price ------ -------- ------ -------- ------ --------- Outstanding at beginning of year 798 $12 760 $11 654 $10 Granted 45 13 40 18 274 18 Exercised - - 0 - (79) 19 Forfeited (1) - (2) 16 (89) 19 --- --- --- Outstanding at end of year 842 $12 798 $12 760 $11 === === === Options exercisable at end of year 522 $ 9 389 $ 9 217 $ 9 Weighted-average fair value of options granted during the year $3.00 $4.41 $1.96 As of December 31, 2001 and 2000, options outstanding had exercise prices ranging from $8 to $18 per share and a weighted- average remaining contractual life of 4.28 and 5.48 years, respectively. The fair value of stock options granted was determined utilizing the Black Scholes Valuation model. Significant assumptions include: 2001 2000 1999 ------ ------ ------ Risk-free interest rate 5.36% 5.00% 6.28% Expected option life 10 Years 10 Years 10 Years Expected volatility 16.03% 13.04% 13.04% Expected dividends 2.77% 2.00% 1.94% Heartland applies APB Opinion No. 25 in accounting for its Plan and, accordingly, no compensation cost for its stock options has been recognized in the financial statements. Had Heartland determined compensation cost based on the fair value at the grant date for its stock options under FAS No. 123 "Accounting for Stock-Based Compensation", Heartland's net income would have been reduced to the pro forma amounts indicated below: 2001 2000 1999 ------- ------- ------- Net income as reported $11,414 $ 9,586 $ 8,225 Pro forma 11,112 9,231 7,890 Earnings per share-basic as reported $ 1.19 $ 1.00 $ .86 Pro forma 1.16 .96 .83 Earnings per share-diluted as reported $ 1.18 $ .98 $ .84 Pro forma 1.14 .95 .81 Pro forma net income reflects only options granted in 2001, 2000, 1999, 1998, 1997 and 1996. Therefore, the full impact of calculating compensation cost for stock options under FAS No. 123 is not reflected in the pro forma net income amounts presented above because compensation is reflected over the options' vesting period, and compensation cost for options granted prior to January 1, 1996, is not considered. In 2001, Heartland adopted a Director Short-Term Incentive Plan. Under the Director Short-Term Incentive Plan, the aggregate number of shares that could be obtained by the directors was set at 150,000. The exercise price of stock options granted was established by the Committee at the fair market value of the shares on the date that the options were granted. Each director was eligible to receive non-qualified options to acquire up to no more than 7,500 shares. Under the Director Short-Term Incentive Plan, 127,065 shares were issued, and under the terms of the Director Short-Term Incentive Plan, all remaining shares were considered to be forfeited at December 31, 2001. In 1996, Heartland adopted the Heartland Employee Stock Purchase Plan ("ESPP"), which permits all eligible employees to purchase shares of Heartland common stock at a price of not less than 85% of the fair market value on the determination date (as determined by the Committee). A maximum of 400,000 shares is available for sale under the ESPP. For the years ended December 31, 2001 and 2000, Heartland approved a price of 100% of fair market value at December 31, 2000 and December 31, 1999, respectively. At December 31, 2001 and 2000, respectively, 12,355 and 2,539 shares were purchased under the ESPP at no charge to Heartland's earnings. During each of the years ended December 31, 2001, 2000 and 1999, Heartland acquired shares for use in the Plan and the ESPP. Shares acquired totaled 79,256, 291,501 and 44,907 for 2001, 2000 and 1999, respectively. SIXTEEN FAIR VALUE OF FINANCIAL INSTRUMENTS Following are disclosures of the estimated fair value of Heartland's financial instruments. The estimated fair value amounts have been determined using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts Heartland could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. December 31, 2001 ------------------------- Carrying Fair Amount Value ------------------------- Financial Assets: Cash and cash equivalents $ 93,550 $ 93,550 Time deposits in other financial institutions 564 564 Trading securities 1,528 1,528 Securities available for sale 323,689 323,689 Loans and leases, net of unearned 1,105,205 1,126,512 Financial Liabilities: Demand deposits $ 160,742 $ 160,742 Savings deposits 493,374 493,374 Time deposits 551,043 564,043 Short-term borrowings 160,703 160,703 Other borrowings 143,789 156,930 December 31, 2000 ------------------------- Carrying Fair Amount Value ------------------------- Financial Assets: Cash and cash equivalents $ 84,687 $ 84,687 Time deposits in other financial institutions 1,504 1,504 Securities available for sale 225,954 225,954 Securities held to maturity 2,111 2,154 Loans and leases, net of unearned 1,042,096 1,041,554 Financial Liabilities: Demand deposits $ 136,066 $ 136,066 Savings deposits 406,712 406,712 Time deposits 558,535 559,935 Short-term borrowings 139,909 139,909 Other borrowings 102,856 95,615 Cash and Cash Equivalents and Time Deposits in Other Financial Institutions - The carrying amount is a reasonable estimate of fair value. 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. Loans and Leases - The fair value of loans is estimated 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 loans held for sale is estimated using quoted market prices. 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. 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 our 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. SEVENTEEN REGULATORY CAPITAL REQUIREMENTS AND RESTRICTIONS ON SUBSIDIARY DIVIDENDS The Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Banks' financial statements. The regulations prescribe specific capital adequacy guidelines that involve quantitative measures of a bank's assets, liabilities and certain off balance sheet items as calculated under regulatory accounting practices. Capital classification is also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Banks to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of December 31, 2001 and 2000, that the Banks met all capital adequacy requirements to which they were subject. As of December 31, 2001, the most recent notification from the FDIC categorized each of the Banks as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Banks must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following table. There are no conditions or events since that notification that management believes have changed each institution's category. The Banks' actual capital amounts and ratios are also presented in the table below. To Be Well Capitalized Under Prompt For Capital Corrective Adequacy Action Actual Purposes Provisions -------------- -------------- -------------- Amount Ratio Amount Ratio Amount Ratio ------- ----- ------- ----- ------- ----- As of December 31, 2001 Total Capital (to Risk-Weighted Assets) Consolidated $135,770 10.89% $100,099 8.0% N/A - DB&T 54,802 10.35 42,363 8.0 $ 52,954 10.0% GSB 13,996 11.91 9,402 8.0 11,753 10.0 FCB 9,230 11.47 6,440 8.0 8,050 10.0 RCB 9,651 10.80 7,150 8.0 8,938 10.0 WCB 20,001 11.52 13,892 8.0 17,366 10.0 NMB 24,997 10.48 19,073 8.0 23,841 10.0 Tier 1 Capital (to Risk-Weighted Assets) Consolidated $121,112 9.71% $ 50,049 4.0% N/A - DB&T 49,334 9.32 21,182 4.0 $ 31,773 6.0% GSB 12,700 10.81 4,701 4.0 7,052 6.0 FCB 8,223 10.21 3,220 4.0 4,830 6.0 RCB 8,787 9.83 3,575 4.0 5,363 6.0 WCB 17,829 10.27 6,946 4.0 10,419 6.0 NMB 22,177 9.30 9,536 4.0 14,305 6.0 Tier 1 Capital (to Average Assets) Consolidated $121,112 7.53% $ 64,336 4.0% N/A - DB&T 49,334 7.45 26,502 4.0 $ 33,128 5.0% GSB 12,700 7.21 7,044 4.0 8,805 5.0 FCB 8,223 7.04 4,674 4.0 5,843 5.0 RCB 8,787 6.92 5,082 4.0 6,352 5.0 WCB 17,829 8.14 8,756 4.0 10.945 5.0 NMB 22,177 7.83 11,323 4.0 14,153 5.0 To Be Well Capitalized Under Prompt For Capital Corrective Adequacy Action Actual Purposes Provisions -------------- -------------- -------------- Amount Ratio Amount Ratio Amount Ratio ------- ----- ------- ----- ------- ----- As of December 31, 2000 Total Capital (to Risk- Weighted Assets) Consolidated $116,034 9.90% $ 93,756 8.0% N/A - DB&T 52,824 10.93 38,679 8.0 $ 48,349 10.0% GSB 12,691 10.91 9,305 8.0 11,632 10.0 FCB 9,045 11.45 6,321 8.0 7,901 10.0 RCB 8,063 10.10 6,385 8.0 7,982 10.0 WCB 17,978 11.35 12,674 8.0 15,842 10.0 NMB 22,512 11.41 15,790 8.0 19,737 10.0 Tier 1 Capital (to Risk- Weighted Assets) Consolidated $102,443 8.74% $ 46,878 4.0% N/A - DB&T 47,448 9.81 19,340 4.0 $ 29,009 6.0% GSB 11,470 9.86 4,653 4.0 6,979 6.0 FCB 8,035 10.17 3,160 4.0 4,741 6.0 RCB 7,269 9.11 3,193 4.0 4,789 6.0 WCB 15,997 10.10 6,337 4.0 9,505 6.0 NMB 20,117 10.19 7,895 4.0 11,842 6.0 Tier 1 Capital (to Average Assets) Consolidated $102,443 7.25% $ 56,492 4.0% N/A - DB&T 47,448 7.94 23,900 4.0 $29,875 5.0% GSB 11,470 7.51 6,111 4.0 7,639 5.0 FCB 8,035 7.70 4,173 4.0 5,217 5.0 RCB 7,269 7.26 4,005 4.0 5,006 5.0 WCB 15,997 8.39 7,631 4.0 9,539 5.0 NMB 20,117 8.75 9,193 4.0 11,491 5.0 The ability of Heartland to pay dividends to its stockholders is dependent upon dividends paid by its subsidiaries. The Banks are subject to certain statutory and regulatory restrictions on the amount they may pay in dividends. To maintain acceptable capital ratios in the Banks, certain portions of their retained earnings are not available for the payment of dividends. Retained earnings which could be available for the payment of dividends to Heartland totaled approximately $34,356 as of December 31, 2001, under the most restrictive minimum capital requirements. EIGHTEEN PARENT COMPANY ONLY FINANCIAL INFORMATION Condensed financial information for Heartland Financial USA, Inc. is as follows: Balance Sheets December 31, 2001 2000 -------- -------- Assets: Cash and interest bearing deposits $ 323 $ 642 Trading securities 1,528 - Securities available for sale 3,666 - Investment in subsidiaries 148,966 145,842 Other assets 4,375 2,844 Due from subsidiaries 15,500 16,750 -------- -------- Total $174,358 $166,078 ======== ======== Liabilities and stockholders' equity: Liabilities: Short-term borrowings $ 29,225 $ 39,300 Other borrowings 36,138 29,328 Accrued expenses and other liabilities 1,905 1,304 -------- -------- Total liabilities 67,268 69,932 -------- -------- Stockholders' equity: Common stock 9,906 9,906 Capital surplus 18,116 18,812 Retained earnings 79,107 71,253 Accumulated other comprehensive income 3,565 1,301 Treasury stock (3,604) (5,126) -------- -------- Total stockholders' equity 107,090 96,146 -------- -------- Total $174,358 $166,078 ======== ======== Income Statements for the Years Ended December 31, 2001 2000 1999 ------- ------ ------ Operating revenues: Dividends from subsidiaries $15,452 $21,768 $ 8,515 Security losses, (net) (246) - - Loss on trading account Securities (192) - - Impairment loss on equity Securities (773) - - Other 1,047 769 201 ------- ------- ------- Total operating revenues 15,288 22,537 8,716 ------- ------- ------- Operating expenses: Interest 4,807 4,934 2,087 Outside services 456 198 172 Other operating expenses 1,508 1,441 450 ------- ------- ------- Total operating expenses 6,771 6,573 2,709 ------- ------- ------- Equity in undistributed earnings 659 (8,322) 1,430 ------- ------- ------- Income before income tax benefit 9,176 7,642 7,437 Income tax benefit 2,238 1,944 788 ------- ------- ------- Net income $11,414 $ 9,586 $ 8,225 ======= ======= ======= Statements of Cash Flows For the Years Ended December 31, 2001 2000 1999 ------ ------ ------ Cash flows from operating activities: Net income $11,414 $ 9,586 $ 8,225 Adjustments to reconcile net income to net cash provided by operating activities: Undistributed earnings of subsidiaries (659) 8,322 (1,430) (Increase) decrease in due from subsidiaries 1,250 (9,200) (7,550) Increase (decrease) in other liabilities 601 1,183 (130) Increase in other assets (1,531) (410) (992) Increase in trading account securities (657) - - Noncash dividend from subsidiary (5,149) - - Other 1,282 88 (5) ------- ------- ------- Net cash provided (used) by operating activities 6,551 9,569 (1,882) ------- ------- ------- Cash flows from investing activities: Capital injections for subsidiaries (1,248) (4,150) (26,580) Receipts for sale of minority interest - 780 58 Payments for purchase of subsidiaries - (13,509) - Purchases of available for sale Securities (1,377) - - Sales of available for sale securities 1,917 - - ------- ------- ------- Net cash used by investing activities (708) (16,879) (26,522) ------- ------- ------- Cash flows from financing activities: Net increase (decrease) in short-term borrowings (10,075) 14,300 5,000 Proceeds from other borrowings 8,248 - 29,580 Payments on other borrowings (1,438) (1,449) (823) Cash dividends paid (3,560) (3,465) (3,247) Purchase of treasury stock (1,026) (5,197) (837) Sale of treasury stock 1,689 19 1,780 ------- ------- ------- Net cash provided (used) by financing activities (6,162) 4,208 31,453 ------- ------- ------- Net increase (decrease) in cash and cash equivalents (319) (3,102) 3,049 Cash and cash equivalents at beginning of year 642 3,744 695 ------- ------- ------- Cash and cash equivalents at end of year $ 323 $ 642 $ 3,744 ======= ======= ======= NINETEEN SUMMARY OF QUARTERLY FINANCIAL INFORMATION (UNAUDITED) 2001 December 31 September 30 ----------- ------------ Net interest income $ 13,636 $ 12,866 Provision for loan and lease losses 1,242 1,197 Net interest income after provision for loan and lease losses 12,394 11,669 Noninterest income 8,179 7,167 Noninterest expense 15,280 14,752 Provision for income taxes 1,811 1,422 Net income 3,482 2,662 Per share: Basic earnings per share $ 0.36 $ 0.28 Diluted earnings per share 0.36 0.27 Cash dividends declared on common stock 0.10 0.09 Book value per common share 11.06 10.82 Market price - high 13.50 13.80 low 12.78 13.15 Weighted average common shares outstanding 9,581,389 9,584,400 Weighted average diluted common shares outstanding 9,689,376 9,692,878 Ratios: Return on average assets 0.85% 0.67% Return on average equity 13.20 10.38 Net interest margin 3.79 3.67 Efficiency ratio 69.28 74.69 SUMMARY OF QUARTERLY FINANCIAL INFORMATION (UNAUDITED) 2001 June 30 March 31 ----------- ------------ Net interest income $ 12,131 $ 11,262 Provision for loan and lease losses 1,123 721 Net interest income after provision for loan and lease losses 11,008 10,541 Noninterest income 7,562 7,426 Noninterest expense 14,513 14,273 Provision for income taxes 1,243 1,238 Net income 2,814 2,456 Per share: Basic earnings per share $ 0.29 $ 0.26 Diluted earnings per share 0.29 0.25 Cash dividends declared on common stock 0.09 0.09 Book value per common share 10.56 10.33 Market price - high 14.00 14.25 low 10.25 12.50 Weighted average common shares outstanding 9,600,801 9,618,210 Weighted average diluted common shares outstanding 9,695,351 9,724,761 Ratios: Return on average assets 0.73% 0.67% Return on average equity 11.32 10.24 Net interest margin 3.60 3.54 Efficiency ratio 73.95 77.58 SUMMARY OF QUARTERLY FINANCIAL INFORMATION (UNAUDITED) 2000 December 31 September 30 ----------- ------------ Net interest income $ 11,294 $ 11,398 Provision for loan and lease losses 696 779 Net interest income after provision for loan and lease losses 10,598 10,619 Noninterest income 7,211 6,932 Noninterest expense 13,737 13,723 Provision for income taxes 1,316 1,231 Net income 2,756 2,597 Per share: Basic earnings per share $ 0.29 $ 0.27 Diluted earnings per share 0.28 0.27 Cash dividends declared on common stock 0.09 0.09 Book value per common share 10.00 9.58 Market price - high 14.63 15.00 low 12.50 14.00 Weighted average common shares outstanding 9,615,392 9,619,934 Weighted average diluted common shares outstanding 9,724,766 9,745,536 Ratios: Return on average assets 0.77% 0.74% Return on average equity 11.78 11.44 Net interest margin 3.61 3.75 Efficiency ratio 73.38 74.55 SUMMARY OF QUARTERLY FINANCIAL INFORMATION (UNAUDITED) 2000 June 30 March 31 ----------- ------------ Net interest income $ 11,140 $ 10,709 Provision for loan and lease losses 1,007 819 Net interest income after provision for loan and lease losses 10,133 9,890 Noninterest income 6,645 6,453 Noninterest expense 13,709 13,510 Provision for income taxes 880 789 Net income 2,189 2,044 Per share: Basic earnings per share $ 0.23 $ 0.21 Diluted earnings per share 0.22 0.21 Cash dividends declared on common stock 0.09 0.09 Book value per common share 9.26 9.13 Market price - high 16.25 18.50 low 14.00 14.88 Weighted average common shares outstanding 9,626,131 9,518,805 Weighted average diluted common shares outstanding 9,759,418 9,673,493 Ratios: Return on average assets 0.65% 0.63% Return on average equity 10.01 9.41 Net interest margin 3.79 3.84 Efficiency ratio 75.82 78.58 INDEPENDENT AUDITORS' REPORT The Board of Directors Heartland Financial USA, Inc.: We have audited the accompanying consolidated balance sheets of Heartland Financial USA, Inc. and subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of income, changes in stockholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2001. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heartland Financial USA, Inc. and subsidiaries as of December 31, 2001 and 2000, and the results of their operations and their cash flows for each the years in the three-year period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America. KPMG LLP Des Moines, Iowa January 18, 2002 Representations of Management Management is responsible for the contents of the consolidated financial statements and other information contained in other sections of this annual report. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles appropriate to reflect, in all material respects, the substance of events and transactions that should be included. The consolidated financial statements reflect management's judgments and estimates as to the effects of events and transactions that are accounted for or disclosed. The company maintains accounting and reporting systems, supported by an internal accounting control system, which are adequate to provide reasonable assurance that transactions are authorized, assets are safeguarded, and reliable consolidated financial statements are prepared, recognizing the cost and expected benefits of internal accounting controls. A staff of internal auditors conducts ongoing reviews of accounting practices and internal accounting controls. The consolidated financial statements as of December 31, 2001, 2000 and 1999, of Heartland Financial USA, Inc. and its subsidiaries: Dubuque Bank and Trust Company; Galena State Bank and Trust Company; Riverside Community Bank; Wisconsin Community Bank; New Mexico Bank & Trust; First Community Bank, FSB; DB&T Insurance, Inc.; DB&T Community Development Corp.; Citizens Finance Co.; ULTEA, Inc.; Keokuk Bancshares, Inc. (dba KBS Investment Corp); DBT Investment Corporation; Heartland Capital Trust I; and Heartland Statutory Trust II were audited by independent certified public accountants. Their role is to render independent professional opinions of the fairness of the consolidated financial statements based upon performance of procedures they deem appropriate under generally accepted auditing standards. The Audit Committees of the Boards of Directors of member banks meet periodically with the internal auditors to review matters relating to internal accounting controls and the nature, extent and results of audit efforts. The internal auditors and independent certified public accountants have free access to the Audit Committees. /s/ Lynn B. Fuller ----------------------------- Lynn B. Fuller President and CEO, Heartland Financial USA, Inc. /s/ John K. Schmidt ------------------------------ John K. Schmidt Executive Vice President and CFO, Heartland Financial USA, Inc. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS The information in the Heartland Proxy Statement for the 2002 annual meeting of stockholders dated April 10, 2002 (the "2002 Proxy Statement") under the caption "Election of Directors" and under the caption, "Security Ownership of Directors and Executive Officers and Certain Beneficial Owners" is incorporated by reference. The information regarding executive officers is included pursuant to Instruction 3 to Item 401 (b) and (c) of Regulation S-K and is noted below. EXECUTIVE OFFICERS The term of office for the executive officers of Heartland is from the date of election until the next annual organizational meeting of the board of directors. The names and ages of the executive officers of Heartland as of December 31, 2001, offices held by these officers on that date and other positions held with Heartland and its subsidiaries are set forth below. Position with Heartland and Subsidiaries Name Age and Principal Occupation Lynn B. Fuller 52 Chairman, President and Chief Executive Officer of Heartland; Vice Chairman of Dubuque Bank and Trust; Director of Galena State Bank, First Community Bank, Riverside Community Bank, Wisconsin Community Bank, New Mexico Bank & Trust, Keokuk Bancshares, and Citizens Finance; Director and President of Citizens Finance; Chairman and Director of ULTEA. John K. Schmidt 42 Executive Vice President, Chief Financial Officer and Treasurer of Heartland; Director, President and Chief Executive Officer of Dubuque Bank and Trust; Treasurer of Citizens Finance; Director of Keokuk Bancshares; Treasurer of ULTEA Kenneth J. Erickson 50 Executive Vice President, Credit Administration, of Heartland; Executive Vice President, Lending of Dubuque Bank and Trust; Senior Vice President of Citizens Finance; Director of ULTEA Edward H. Everts 50 Senior Vice President, Heartland, Operations and Retail Banking; Senior Vice President of Operations and Retail Banking of Dubuque Bank and Trust Douglas J. Horstmann 48 Senior Vice President, Lending of Heartland; Executive Vice President, Head of Lending of Dubuque Bank and Trust Paul J. Peckosh 56 Senior Vice President, Trust of Heartland; Executive Vice President, Trust, of Dubuque Bank and Trust Mr. Lynn B. Fuller is the brother-in-law of Mr. James F. Conlan. There are no other family relationships among any of the directors or executive officers of Heartland. Lynn B. Fuller has been a director of Heartland and of DB&T since 1984 and has been President of Heartland since 1987. He has been a director of Galena State Bank since its acquisition by Heartland in 1992 and of Keokuk Bancshares and First Community Bank since the merger in 1994. Mr. Fuller joined Dubuque Bank and Trust in 1971 as a consumer loan officer and was named Dubuque Bank and Trust's Executive Vice President and Chief Executive Officer in 1985. He was named Director of Riverside Community Bank in conjunction with the opening of the de novo operation in 1995, Director of Wisconsin Community Bank in conjunction with the purchase of Cottage Grove State Bank in 1997 and Director of New Mexico Bank & Trust in conjunction with the opening of the de novo bank in 1998. Mr. Fuller was President of DB&T from 1987 until 1999 at which time he was named Chief Executive Officer of Heartland. John K. Schmidt has been Heartland's Executive Vice President and Chief Financial Officer since 1991. He has been employed by Dubuque Bank and Trust since September, 1984 and became Dubuque Bank and Trust's Vice President, Finance in 1986, Senior Vice President and Chief Financial Officer in January, 1991 and President and Chief Executive Officer in 1999. Mr. Schmidt is a certified public accountant and worked at KPMG LLP in Des Moines, Iowa, from 1982 until joining DB&T. Mr. Schmidt has been a director of Heartland since February, 2001. Kenneth J. Erickson was named Executive Vice President, Credit Administration, of Heartland in 1999 and has served as Executive Vice President since 2000, Senior Vice President since 1992 and Senior Vice President, Lending of Dubuque Bank and Trust since 1989. Mr. Erickson joined DB&T in 1975 and was appointed Vice President, Commercial Loans in 1985. Edward H. Everts was appointed as Senior Vice President of Heartland in 1996. Mr. Everts joined Dubuque Bank and Trust as Senior Vice President, Operations and Retail Banking in 1992. Prior to his service with Dubuque Bank and Trust, Mr. Everts was Vice President and Lead Retail Banking Manager of First Bank, Duluth, Minnesota. Douglas J. Horstmann was named as Senior Vice President of Heartland in 1999, and has been Executive Vice President, Lending since 2000 and Senior Vice President, Lending, of Dubuque Bank and Trust since 1989. Mr. Horstmann joined Dubuque Bank & Trust in 1980 and was appointed Vice President, Commercial Loans in 1985. Prior to joining Dubuque Bank and Trust, Mr. Horstmann was an examiner for the Iowa Division of Banking. Paul J. Peckosh was appointed Senior Vice President of Heartland in 1999, and has been Executive Vice President, Trust, since 2000 and Senior Vice President, Trust, of Dubuque Bank and Trust since 1991. Mr. Peckosh joined Dubuque Bank and Trust in 1975 as Assistant Vice President, Trust and was appointed Vice President, Trust in 1980. Mr. Peckosh is an attorney and graduated from the Marquette University of Law School in 1970. ITEM 11. EXECUTIVE COMPENSATION The information in the 2002 Proxy Statement, under the caption "Executive Compensation" is incorporated by reference, except for the information contained under the heading "Compensation Committee Report on Executive Compensation" and "Stockholder Return Performance Presentation." ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information in the 2002 Proxy Statement, under the caption "Security Ownership of Certain Beneficial Owners and Management" is incorporated by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information in the 2002 Proxy Statement under the caption "Transactions with Management" is incorporated by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The documents filed as a part of this report are listed below: 3. Exhibits The exhibits required by Item 601 of Regulation S-K are included along with this Form 10-K and are listed on the "Index of Exhibits" immediately following the signature page. (b) Reports of Form 8-K: There were no reports on Form 8-K filed during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 19, 2002. Heartland Financial USA, Inc. By: /s/ Lynn B. Fuller /s/ John K. Schmidt ------------------------ ------------------------ Lynn B. Fuller John K. Schmidt Principal Executive Officer Executive Vice President and Principal Financial and Accounting Officer Date: March 19, 2002 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 19, 2002. /s/ Lynn B. Fuller /s/ John K. Schmidt ----------------------------- ----------------------------- Lynn B. Fuller John K. Schmidt President, CEO, Chairman Executive Vice President, CFO and Director and Director /s/ James F. Conlan /s/ Mark C. Falb ----------------------------- ----------------------------- James F. Conlan Mark C. Falb Director Director /s/ Thomas L. Flynn /s/ Robert Woodward ----------------------------- ----------------------------- Thomas L. Flynn Robert Woodward Director Director 3. Exhibits 3.1 Certificate of Incorporation of Heartland Financial USA, Inc. (Filed as Exhibit 3.1 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 3.2 Bylaws of Heartland Financial USA, Inc. (Filed as Exhibit 3.2 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 4.1 Specimen Stock Certificate of Heartland Financial USA, Inc. (Exhibit 4.1 to the Registration Statement on Form S- 4 filed with the Commission May 4, 1994, as amended (SEC File No. 33-76228) 10.1 Heartland Financial USA, Inc. 1993 Stock Option Plan (Filed as Exhibit 10.1 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.2 Heartland Financial USA, Inc. Executive Restricted Stock Purchase Plan (Filed as Exhibit 10.2 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.3 Dubuque Bank and Trust Management Incentive Compensation Plan (Filed as Exhibit 10.3 to Registrant's Form S-4 for the fiscal year ended December 31, 1993, and incorporated by reference herein.) 10.4 Heartland Financial Money Purchase Pension Plan and Defined Contribution Master Plan and Trust Agreement dated January 1, 1995. (Filed as Exhibit 10.21 to Registrant's Form 10-K for the fiscal year ended December 31, 1995, and incorporated by reference herein.) 10.5 Form of Split-Dollar Life Insurance Plan effective November 13, 2001, between the Heartland subsidiaries and their selected officers who have met the three years of service requirement. These plans are in place at Dubuque Bank and Trust Company, Galena State Bank and Trust Company, First Community Bank, FSB, Riverside Community Bank, Wisconsin Community Bank, New Mexico Bank & Trust and ULTEA. 10.6 Heartland Financial USA, Inc. Employee Stock Purchase Plan effective January 1, 1996. (Filed in conjunction with Form S-8 on June 18, 1996, and incorporated by reference herein.) 10.7 License and Service Agreement, Software License Agreement, and Professional Services Agreement between Fiserv and Heartland Financial USA, Inc. dated June 21, 1996. (Filed as Exhibit 10.43 to Registrant's form 10Q for the quarter ended June 30, 1996, and incorporated by reference herein.) 10.8 Stockholder Agreement between Heartland Financial USA, Inc. and Investors in the Proposed New Mexico Bank dated November 5, 1997. (Filed as Exhibit 10.23 to Registrant's Form 10K for the fiscal year ended December 31, 1997, and incorporated by reference herein.) 10.9 Heartland Financial USA, Inc. Health Care Plan dated January 1, 1999. (Filed as Exhibit 10.13 to Registrant's Form 10K for the fiscal year ended December 31, 1998, and incorporated by reference herein.) 10.10 Second Amended and Restated Credit Agreement between Heartland Financial USA, Inc. and The Northern Trust Company dated September 28, 2000. (Filed as Exhibit 10.19 to Registrant's Form 10Q for the nine months ended September 30, 2000, and incorporated by reference herein.) 10.11 See Exhibit 10.10 for substantially the same form of a Credit Agreement between Heartland Financial USA, Inc. and Harris Trust and Savings Bank dated September 28, 2000, except that the lender is Harris Trust and Savings Bank and the commitment is $20 million. (Filed as Exhibit 10.20 to Registrant's Form 10Q for the nine months ended September 30, 2000, and incorporated by reference herein.) 10.12 Change of Control Agreements including Golden Parachute Payment Adjustments and Restrictive Covenants between Heartland Financial USA, Inc. and Executive Officers dated January 1, 2002. 10.13 Change of Control Agreements between Heartland Financial USA, Inc. and Executive Officers dated January 1, 2002. 10.14 Third Amendment to Second Amended and Restated Credit Agreement between Heartland Financial USA, Inc. and The Northern Trust Company dated as of December 13, 2001. 10.15 See Exhibit 10.14 for substantially the same form of a Third Amendment to Credit Agreement between Heartland Financial USA, Inc. and Harris Trust and Savings Bank dated as of December 13, 2001, except that the lender is Harris Trust and Savings Bank and the commitment is $20 million 10.16 Indenture between Heartland Financial USA, Inc. and First Union Trust Company, National Association, dated as of October 21, 1999 (filed as Exhibit 4.1 to Form S-3 dated September 16, 1999, and incorporated by reference herein.) 10.17 Indenture between Heartland Financial USA, Inc. and State Street Bank and Trust Company of Connecticut, National Association, dated as of December 18, 2001. 11. Statement re Computation of Per Share Earnings 21.1 Subsidiaries of the Registrant 23.1 Consent of KPMG LLP