CHEMICAL

FINANCIAL CORPORATIONSM

 

2007

Annual Report

to Shareholders

 

      

 

CHEMICAL FINANCIAL CORPORATION

 

 

2007 ANNUAL REPORT TO SHAREHOLDERS

 

FORWARD-LOOKING STATEMENTS

 

This report contains forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and Chemical Financial Corporation itself. Words such as “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “judgment,” “plans,” “predicts,” “projects,” “should,” “will,” variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“risk factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. Chemical Financial Corporation undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise.

 

Risk factors include, but are not limited to, the risk factors described in Item 1A in Chemical Financial Corporation’s Annual Report on Form 10-K for the year ended December 31, 2007, included herein; the timing and level of asset growth; changes in banking laws and regulations; changes in tax laws; changes in prices, levies and assessments; the impact of technological advances and issues; governmental and regulatory policy changes; opportunities for acquisitions and the effective completion of acquisitions and integration of acquired entities; the possibility that anticipated cost savings and revenue enhancements from acquisitions, restructurings, reorganizations and bank consolidations may not be realized fully or at all or within expected time frames; the local and global effects of the ongoing war on terrorism and other military actions, including actions in Iraq; and current uncertainties and fluctuations in the financial markets and stocks of financial services providers due to concerns about credit availability and concerns about the Michigan economy in particular. These and other factors are representative of the risk factors that may emerge and could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.

 

 

 

 

 

BUSINESS OF THE CORPORATION

 

Chemical Financial Corporation (the Corporation) is a financial holding company with its business concentrated in a single industry segment — commercial banking. The Corporation, through its subsidiary bank, offers a full range of commercial banking services. These banking services include deposits, business and personal checking accounts, savings and individual retirement accounts, time deposit instruments, electronically accessed banking products, residential and commercial real estate financing, commercial lending, consumer financing, debit cards, safe deposit box services, money transfer services, automated teller machines, access to insurance products and corporate and personal trust and investment management services.

 

The principal markets for the Corporation’s commercial banking services are communities within Michigan in which the Corporation’s subsidiary bank branches are located and the areas immediately surrounding those communities. As of December 31, 2007, the Corporation operated through one subsidiary bank, Chemical Bank, headquartered in Midland, Michigan, serving 89 communities through 129 banking offices and 2 loan production offices located in 31 counties across Michigan’s lower peninsula. In addition to its banking offices, the Corporation operated 141 automated teller machines, both on- and off-bank premises. On December 31, 2005, a corporate internal consolidation was completed resulting in the consolidation of the Corporation’s three commercial bank charters into one commercial subsidiary bank, Chemical Bank. The Corporation’s sole subsidiary bank operates through an internal organizational structure of four regional banking units. The Corporation’s regional banking units are collections of branch banking offices organized by geographical regions within the state.

 

The principal source of revenue for the Corporation is interest and fees on loans, which accounted for 71% of total revenues in 2007, 72% of total revenues in 2006 and 69% of total revenues in 2005. Interest on investment securities is also a significant source of revenue, accounting for 10% of total revenues in 2007 and 2006 and 13% of total revenues in 2005. Business volumes are influenced by overall economic factors including market interest rates, business and consumer spending, consumer confidence and competitive conditions in the marketplace.

 

FINANCIAL HIGHLIGHTS

 

The following discussion and analysis is intended to cover the significant factors affecting the Corporation’s consolidated statements of financial position and income included in this report. It is designed to provide shareholders with a more comprehensive review of the consolidated operating results and financial position of the Corporation than could be obtained from an examination of the financial statements alone.

 

CRITICAL ACCOUNTING POLICIES

 

The Corporation’s consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (GAAP). Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements. As this information changes, the consolidated financial statements could reflect different estimates, assumptions and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value or when a decline in the value of an asset not carried at fair value on the financial statements warrants an impairment write-down or a valuation reserve to be established. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third-party sources, when available. When third-party information is not available, valuation adjustments are estimated by management primarily through the use of internal discounted cash flow analysis.

 

The most significant accounting policies followed by the Corporation are presented in Note A to the consolidated financial statements. These policies, along with the disclosures presented in the other notes to the consolidated financial statements and in “Management’s Discussion and Analysis,” provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, estimates and assumptions underlying those amounts, management has identified the determination of the allowance for loan losses, pension plan accounting, income and other taxes, capitalization and valuation of real estate mortgage loan servicing rights, and the evaluation of goodwill impairment to be the

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

CRITICAL ACCOUNTING POLICIES (CONTINUED)

 

accounting areas that require the most subjective or complex judgments, and as such, could be most subject to revision as new or additional information becomes available or circumstances change, including overall changes in the economic climate and/or market interest rates.

 

Allowance for Loan Losses

The allowance for loan losses (allowance) is calculated with the objective of maintaining a reserve sufficient to absorb inherent loan losses of the loan portfolio. The loan portfolio represents the largest asset type on the consolidated statements of financial position. The determination of the amount of the allowance is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected cash flows on impaired loans, estimated losses on commercial, real estate commercial and real estate construction-commercial loans and on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The principal assumption used in deriving the allowance is the estimate of a loss percentage for each type of loan. In determining the allowance and the related provision for loan losses, the Corporation considers four principal elements: (i) specific impairment reserve allocations based upon probable losses identified during the review of impaired commercial, real estate commercial and real estate construction-commercial loan portfolios, (ii) allocations established for adversely-rated commercial, real estate commercial and real estate construction-commercial loans, (iii) allocations on all other loans based principally on historical loan loss experience and loan loss trends, and (iv) an unallocated allowance based on the imprecision in the overall allowance methodology. It is extremely difficult to precisely measure the amount of losses that are inherent in the Corporation’s loan portfolio. The Corporation uses a modeling process to quantify the necessary allowance and related provision for loan losses, but there can be no assurance that the modeling process will successfully identify and estimate all of the losses that are inherent in the loan portfolio. As a result, the Corporation could record future provisions for loan losses that may be significantly different than the levels that have been recorded in the three-year period ended December 31, 2007. Note A to the consolidated financial statements describes the methodology used to determine the allowance. In addition, a discussion of the factors driving changes in the amount of the allowance is included under the subheading “Provision and Allowance for Loan Losses” in “Management’s Discussion and Analysis.”

 

Pension Plan Accounting

The Corporation has a defined benefit pension plan for certain salaried employees. Effective June 30, 2006, benefits under the defined benefit pension plan were frozen for approximately two-thirds of the Corporation’s salaried employees as of that date. Pension benefits continued unchanged for the remaining salaried employees. The Corporation’s pension benefit obligations and related costs are calculated using actuarial concepts and measurements. Benefits under the plan are based on years of vested service, age and compensation. Assumptions are made concerning future events that will determine the amount and timing of required benefit payments, funding requirements and pension expense.

 

The key actuarial assumptions used in the pension plan are the discount rate and long-term rate of return on plan assets. These assumptions have a significant effect on the amounts reported for net periodic pension expense, as well as the respective benefit obligation amounts. The Corporation evaluates these critical assumptions annually.

 

At December 31, 2007, December 31, 2006 and December 31, 2005, the Corporation calculated the discount rate for the pension plan using the results from a bond matching technique, which matched cash flows of the pension plan against both a bond portfolio derived from the Standard & Poors bond database of AA or better bonds and the Citigroup Pension Discount Curve, to determine the discount rate. As of December 31, 2007, the discount rate was established at 6.5% to reflect market interest rate conditions.

 

The assumed long-term rate of return on pension plan assets represents an estimate of long-term returns on an investment portfolio consisting primarily of equities and fixed income investments. When determining the expected long-term return on pension plan assets, the Corporation considers long-term rates of return on the asset classes in which the Corporation expects the pension funds to be invested. The expected long-term rate of return is based on both historical and forecasted returns of the overall stock and bond markets and the actual portfolio. The Corporation reduced its projection of forecasted returns on

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

the portfolio of pension plan assets during 2006. The following rates of return by asset class were considered in setting the long-term return on pension plan assets assumption:

 

 

The long-term return on pension plan assets is used to compute the subsequent year’s expected return on assets, using the “market-related value” of pension plan assets. The difference between the expected return and the actual return on pension plan assets during the year is either an asset gain or loss, which is deferred and amortized over future periods when determining net periodic pension expense. The actual average annual return on pension plan assets was 7.9% over the five years ended December 31, 2007.

 

Other assumptions made in the pension plan involve employee demographic factors such as retirement patterns, mortality, turnover and the rate of compensation increase.

 

The key actuarial assumptions that will be used to calculate 2008 pension expense for the defined benefit pension plan are a discount rate of 6.5%, a long-term rate of return on pension plan assets of 7% and a rate of compensation increase of 4.25%. Pension expense in 2008 is expected to be approximately $0.5 million, a decrease of $0.5 million from $1.0 million of pension expense in 2007. The projected decrease in 2008, compared to 2007, is mostly attributable to the Corporation’s implementation of a Voluntary Retirement Incentive Plan (VRIP) in 2007 at a cost of $0.3 million and an increase in the discount rate used to measure the present value of the pension plan’s obligations. A change in the discount rate of 50 basis points in 2008 was estimated to have an impact on pension expense of less than $0.1 million.

 

There are uncertainties associated with the underlying key actuarial assumptions, and the potential exists for significant, and possibly material, impacts on either the results of operations or cash flows (e.g., additional pension expense and/or additional pension plan funding, whether expected or required) from changes in the key actuarial assumptions. If the Corporation were to determine that more conservative assumptions are necessary, pension expense would increase and have a negative impact on results of operations in the period in which the increase occurs.

 

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 158, “Employers’ Accounting For Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (SFAS 158). The Corporation adopted SFAS 158 on December 31, 2006, as required. The purpose of SFAS 158 was to improve the overall financial statement presentation of pension and other postretirement plans, but did not impact the determination of the net periodic benefit cost or measurement of plan assets or obligations. SFAS 158 requires companies to recognize the over- or under-funded status of a plan as an asset or liability as measured by the difference between the fair value of the plan assets and the benefit obligation and requires any unrecognized prior service costs and actuarial gains and losses to be recognized as a component of accumulated other comprehensive income (loss). The impact of SFAS 158 on the statements of financial position at December 31, 2007 and December 31, 2006 is included in Note L to the consolidated financial statements.

 

Income and Other Taxes

The Corporation is subject to the income and other tax laws of the United States and the state of Michigan. These laws are complex and are subject to different interpretations by the taxpayer and the various taxing authorities. In determining the provisions for income and other taxes, management must make judgments and estimates about the application of these inherently complex laws, related regulations and case law. In the process of preparing the Corporation’s tax returns, management attempts to make reasonable interpretations of the tax laws. These interpretations are subject to challenge by the taxing authorities upon audit or to reinterpretation based on management’s ongoing assessment of facts and evolving case law.

 

The Corporation and its subsidiary file a consolidated federal income tax return. The provision for federal income taxes is based on income and expenses, as reported in the consolidated financial statements, rather than amounts reported on the Corporation’s federal income tax return. When income and expenses are recognized in different periods for tax purposes than for book purposes, applicable deferred tax assets and liabilities are recognized for the future tax consequences attributable to the

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

CRITICAL ACCOUNTING POLICIES (CONTINUED)

 

differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.

 

On a quarterly basis, management assesses the reasonableness of its effective federal and state tax rates based upon its current best estimate of net income and the applicable taxes expected for the full year. Deferred tax assets and liabilities are reassessed on an annual basis, or sooner, if business events or circumstances warrant. Reserves for uncertain tax positions are reviewed quarterly for adequacy based upon developments in tax law and the status of examinations or audits. For the years ended December 31, 2007 and 2006, net federal income tax benefits of $0 and $0.23 million, respectively, were recorded based on the regular reassessment of required tax accruals for these uncertain tax positions. The decline in 2007 was due to the adoption of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). See Note A to the consolidated financial statements for further discussion on FIN 48.

 

Real Estate Mortgage Loan Servicing Rights

At December 31, 2007, the Corporation had approximately $2.3 million of real estate mortgage loan servicing rights capitalized on the consolidated statement of financial position. The two critical assumptions involved in establishing the value of this asset are the estimated future prepayment speeds on the underlying real estate mortgage loans and the interest rate used to discount the net cash flows from the real estate mortgage loan portfolio being serviced. Other assumptions include the estimated amount of ancillary income that will be received in the future (such as late fees) and the estimated cost to service the real estate mortgage loans. The Corporation utilizes a third-party modeling software program to value mortgage servicing rights. The Corporation believes the assumptions utilized in the valuation are reasonable based upon market interest rates and accepted industry practices for valuing mortgage servicing rights and represent neither the most conservative nor the most aggressive assumptions. The Corporation adopted SFAS No. 156 “Accounting for Servicing of Financial Assets” (SFAS 156) on January 1, 2007. See Note A to the consolidated financial statements for further discussion on SFAS 156.

 

Goodwill

At December 31, 2007, the Corporation had $69.9 million of goodwill recorded on the consolidated statement of financial position. Goodwill decreased $0.2 million during 2007 due to the adoption of FIN 48. Under SFAS No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), amortization of goodwill ceased, and instead, goodwill is tested by management annually for impairment, or more frequently if triggering events occur and indicate potential impairment. The Corporation’s goodwill impairment review is additionally reviewed by an independent third-party appraisal firm, annually, utilizing the methodology and guidelines established in SFAS 142. This methodology involves assumptions regarding the valuation of the Corporation’s subsidiary bank that purchased the acquired entities and resulted in the recording of goodwill. The Corporation believes that the assumptions utilized are reasonable, and even utilizing more conservative assumptions on the valuation would not presently result in impairment in the amount of goodwill that has been recorded. However, the Corporation could incur impairment charges related to goodwill in the future due to changes in business prospects or other matters that could affect the valuation assumptions.

 

MERGERS AND ACQUISITIONS

 

The Corporation’s primary method of expansion into new banking markets has been through acquisitions of other financial institutions and bank branches. During the three years ended December 31, 2007, the Corporation completed the following acquisition:

 

In August 2006, the Corporation acquired two branch bank offices in Hastings and Wayland, Michigan from First Financial Bank, N.A., headquartered in Hamilton, Ohio, operating as Sand Ridge Bank. The Corporation acquired deposits of $47 million, loans of $64 million and other miscellaneous assets of $1.7 million. The Corporation recorded goodwill of $6.8 million and core deposit intangible assets of $2.7 million. The core deposit intangible assets are being amortized on an accelerated basis over ten years. The loans acquired were comprised of $6 million in commercial loans, $13 million in real estate commercial loans, $38 million in real estate residential loans and $7 million in consumer loans. During December 2006,

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

the Corporation sold $14 million of long-term fixed interest rate real estate residential loans that were acquired in this transaction and recognized gains totaling approximately $1 million.

 

On December 31, 2005, the Corporation completed an internal consolidation whereby two of its wholly-owned subsidiary banks, Chemical Bank Shoreline and Chemical Bank West, were consolidated into Chemical Bank and Trust Company (CBT). CBT’s name was changed to Chemical Bank on December 31, 2005.

 

NET INCOME

 

Net income in 2007 was $39.0 million, or $1.60 per diluted share, net income in 2006 was $46.8 million, or $1.88 per diluted share, and net income in 2005 was $52.9 million, or $2.10 per diluted share. Net income in 2007 represented a 16.7% decrease from 2006 net income, while 2006 net income represented an 11.4% decrease from 2005 net income. Net income per share in 2007 was 14.9% less than in 2006, while net income per share in 2006 was 10.5% less than in 2005. The decrease in net income in 2007 was attributable to a decrease in net interest income and increases in both the provision for loan losses and operating expenses. The decrease in net income in 2006 was primarily due to a decrease in net interest income.

 

The Corporation’s return on average assets was 1.03% in 2007, 1.24% in 2006 and 1.40% in 2005. The Corporation’s return on average shareholders’ equity was 7.7% in 2007, 9.2% in 2006 and 10.7% in 2005.

 

DEPOSITS

 

Total deposits at December 31, 2007 were $2.88 billion, a decrease of $22.5 million, or 0.8%, from total deposits at December 31, 2006 of $2.90 billion. Total deposits increased $78.2 million, or 2.8%, during 2006. In 2006, the acquisition of two branch banking offices from First Financial Bank, N.A. in Hastings and Wayland, Michigan added total deposits of $47 million.

 

The Corporation’s average deposit balances and average rates paid on deposits for the past three years are included in Table 1. Average total deposits in 2007 were $2.92 billion, which was $61.1 million, or 2.1%, higher than in 2006. Average deposits of $2.86 billion in 2006 were $24.3 million, or 0.8%, less than in 2005. The increase in average deposits in 2007, compared to 2006, was primarily attributable to an increase in deposits in a new money market deposit account, which the Corporation began offering in the latter part of 2006. This new account pays a variable rate of interest and was designed to compete with mutual fund money market accounts on balances greater than $100,000. The Corporation did not have any brokered deposits as of December 31, 2007 or December 31, 2006.

 

It is the Corporation’s strategy to develop customer relationships that will drive core deposit growth and stability. The Corporation has historically gathered deposits from the local markets of its subsidiary bank, although rising market interest rates and strong competition impeded the Corporation’s ability to internally generate deposits during the three years ended December 31, 2007.

 

The growth of the Corporation’s deposits is also impacted by competition from other investment products, such as brokerage accounts, mutual funds and various annuity products. These investment products are sold by a wide spectrum of organizations, such as brokerage and insurance companies, as well as by financial institutions. The Corporation also competes with credit unions in most of its markets. These institutions are challenging competitors, as credit unions are exempt from federal income taxes, allowing them to potentially offer higher deposit rates and lower loan rates to customers.

 

In response to the competition for other investment products, the Corporation’s subsidiary bank, through “CFC Investment Center,” offers a wide array of mutual funds, annuity products and market securities through an alliance with an independent, registered broker/dealer. During 2007 and 2006, customers purchased $82 million and $73 million, respectively, of annuity and mutual fund investments through “CFC Investment Center.”

 

ASSETS

 

Average assets were $3.79 billion during 2007, an increase of $22.0 million, or 0.6%, from average assets during 2006 of $3.76 billion. The increase in average assets during 2007 was primarily attributable to an increase in short-term investments that resulted from slightly higher average deposits. Average assets of $3.76 billion in 2006 were $25.4 million, or 0.7%, less

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

ASSETS (CONTINUED)

 

than average assets in 2005. The Corporation acquired two branch banking offices on August 18, 2006, increasing total assets by $75.2 million as of the acquisition date. The increase in average assets from the branch acquisitions was more than offset by a reduction in average assets that was largely due to the Corporation utilizing a portion of investment securities that matured during 2006 to reduce Federal Home Loan Bank advances — long-term that also matured during 2006.

 

CASH DIVIDENDS

 

The Corporation’s annual cash dividends paid per share over the past five years, adjusted for all stock dividends, were as follows:

 

 

During 2007, cash dividends paid per share were $1.14, up 3.6% over cash dividends paid per share in 2006 of $1.10.

 

The Corporation has paid regular cash dividends every quarter since it began operating as a bank holding company in 1973. The compound annual growth rate of the Corporation’s cash dividends paid per share over the past five- and ten-year periods ended December 31, 2007 was 5.5% and 7.5%, respectively. The earnings of the Corporation’s subsidiary bank are the principal source of funds to pay cash dividends to shareholders. Cash dividends are dependent upon the earnings of the Corporation’s subsidiary bank, as well as capital requirements, regulatory restraints and other factors affecting the Corporation’s subsidiary bank.

 

Interest income is the total amount earned on funds invested in loans, investment and other securities, other interest-bearing deposits and federal funds sold. Interest expense is the amount of interest paid on interest-bearing checking and savings accounts, time deposits, short-term borrowings and FHLB advances — long-term. Net interest income, on a fully taxable equivalent (FTE) basis, is the difference between interest income and interest expense adjusted for the tax benefit received on tax-exempt commercial loans and investment securities. Net interest margin is calculated by dividing net interest income (FTE) by average interest-earning assets. Net interest spread is the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Because noninterest-bearing sources of funds, or free funds (principally demand deposits and shareholders’ equity), also support earning assets, the net interest margin exceeds the net interest spread.

 

The presentation of net interest income on a FTE basis is not in accordance with United States generally accepted accounting principles (GAAP) but is customary in the banking industry. This non-GAAP measure ensures comparability of net interest income arising from both taxable and tax-exempt loans and investment securities. The adjustments to determine tax equivalent net interest income were $2.25 million, $2.11 million and $1.61 million for 2007, 2006 and 2005, respectively. These adjustments were computed using a 35% tax rate.

 

Net interest income is the most important source of the Corporation’s earnings and thus is critical in evaluating the results of operations. Changes in the Corporation’s net interest income are influenced by a variety of factors, including changes in the level of interest-earning assets, changes in the mix of interest-earning assets and interest-bearing liabilities, the level and direction of interest rates, the difference between short-term and long-term interest rates (the steepness of the yield curve), and the general strength of the economies in the Corporation’s markets. Risk management plays an important role in the Corporation’s level of net interest income. The ineffective management of credit risk, and more significantly interest rate risk, can adversely impact the Corporation’s net interest income. Management monitors the Corporation’s consolidated statement of financial position to reduce the potential adverse impact on net interest income caused by significant changes in interest rates. The Corporation’s policies in this regard are further discussed under the subheading “Market Risk.”

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

 

 

 

Table 1 presents for 2007, 2006 and 2005 average daily balances of the Corporation’s major categories of assets and liabilities, interest income and expense on a FTE basis, average interest rates earned and paid on the assets and liabilities, net interest income (FTE), net interest spread and net interest margin.

 

Net interest income (FTE) in 2007, 2006 and 2005 was $132.3 million, $134.3 million and $143.5 million, respectively. Net interest income (FTE) in 2007 was $2.0 million, or 1.5%, lower than 2006 net interest income (FTE) of $134.3 million, and net interest income (FTE) in 2006 was $9.1 million, or 6.4%, lower than 2005 net interest income (FTE) of $143.5 million. The decrease in net interest income (FTE) in 2007 was primarily attributable to the average cost of interest-bearing liabilities increasing more than the average yield on loans and investments that resulted primarily from a change in the mix of interest-bearing deposits, and the impact of higher nonaccrual loans. These unfavorable items were partially offset by the positive effect of slightly higher average interest-earning assets in 2007 and the reduction of short-term market interest rates during the fourth quarter of 2007.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

NET INTEREST INCOME (CONTINUED)

 

 

 

 

In 2007, the Federal Open Market Committee (FOMC) lowered the Federal Funds rate three times during the last four months of the year, a total of 100 basis points, which resulted in an equal decline each time in the prime rate. The Federal Funds rate was 4.25% on December 31, 2007, compared to 5.25% on December 31, 2006. The prime rate was 7.25% on December 31, 2007, compared to 8.25% on December 31, 2006. While short-term interest rates were generally stable through the first half of 2007, long-term interest rates declined to produce an inverted interest yield curve in the two-to-five year segment of the curve through most of the first three quarters of the year. The ten-year U.S. Treasury note, which is generally used to price both 15- and 30-year residential mortgage loans, was 4.04% at the end of 2007, compared to 4.71% at the end of 2006.

 

Net interest margin was 3.73% in 2007, compared to 3.82% in 2006. The decrease in net interest margin during 2007, compared to 2006, was primarily attributable to the increase in the average yield on interest-earning assets not keeping pace with the increase in the average cost of interest-bearing liabilities. The average yield on interest-earning assets increased 19 basis points to 6.42% in 2007. In comparison, the average cost of interest-bearing liabilities increased 36 basis points to 3.52% in 2007. The significant increase in the cost of interest-bearing liabilities was attributable to a combination of factors, including the overall increase in short-term market interest rates in 2006 and the continued migration of consumer funds from lower yielding deposit products into higher yielding money market and time deposits during 2007. The yield on the Corporation’s loan portfolio increased only twelve basis points in 2007, compared to 2006, due to the loan portfolio being comprised predominately of fixed interest rate loans or loans with interest rates fixed for at least five years. In addition, the competition for loan volume remained strong in the Corporation’s local markets, resulting in heightened pricing competition for new loan originations, and lower than expected yields on new and refinanced loans, considering the overall increase in market interest rates during the prior two years. The net interest margin was also adversely impacted in 2007 due to an increase in nonaccrual loans of $35.4 million, or 175%, during the year to $55.6 million at December 31, 2007.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

Table 2 allocates the dollar change in net interest income (FTE) between the portion attributable to changes in the average volume of interest-earning assets and interest-bearing liabilities, including changes in the mix of assets and liabilities, and changes in average interest rates earned and paid.

 

The $2.0 million reduction in net interest income (FTE) in 2007, as compared to 2006, is analyzed in detail in Table 2. The decrease in net interest income (FTE) during 2007 was almost entirely attributable to an adverse change in the mix of customer deposits and higher nonaccrual loans that were only partially offset by a favorable change in the mix of average interest-earning assets. The favorable effect of a $38.8 million, or 1.4%, increase in average loans was more than offset by the impact of a change in the mix of customer deposit accounts from lower cost transaction and savings accounts to higher-cost money market savings, time and municipal customer accounts and a $35.4 million increase in nonaccrual loans. The Corporation’s balance sheet was liability sensitive throughout 2007, with a higher percentage of interest-bearing liabilities repricing than interest-earning assets.

 

The Corporation’s competitive position within many of its market areas limits its ability to materially increase deposits without adversely impacting the weighted average cost of core deposits.

 

In 2006, the Federal Open Market Committee (FOMC) raised the Federal Funds rate by twenty-five basis points four times during the year that resulted in an equal increase each time in the prime rate. The Federal Funds rate was 5.25% on December 31, 2006, compared to 4.25% on December 31, 2005. The prime rate was 8.25% on December 31, 2006, compared to 7.25% on December 31, 2005. While short-term interest rates increased 100 basis points during 2006, long-term interest rates rose only slightly to produce an inverted interest yield curve at December 31, 2006. The ten-year U.S. Treasury note, which is generally used to price both 15- and 30-year residential mortgage loans, was 4.71% at the end of 2006, compared to 4.35% at the end of 2005.

 

Net interest margin was 3.82% in 2006, compared to 4.04% in 2005. The decrease in net interest margin during 2006, compared to 2005, was primarily attributable to the increase in the average yield on interest-earning assets not keeping pace with the increase in the average cost of interest-bearing liabilities. The average yield on interest-earning assets increased 57 basis points to 6.23% in 2006. In comparison, the average cost of interest-bearing liabilities increased 105 basis points to 3.16% in 2006. The increase in the cost of interest-bearing liabilities was attributable to a combination of factors, including the overall increase in market interest rates, the migration of customer funds from lower yielding deposit products into higher yielding time deposits and a slight change in the mix of deposits, with a slight decline in lower cost consumer deposits being offset by increases in higher cost business and municipal customer deposits. The yield on the Corporation’s loan portfolio increased only moderately during a two-year period of rising interest rates due to the loan portfolio being comprised predominately of fixed interest rate loans or loans with interest rates fixed for at least five years. In addition, the competition for loan volume was strong in the Corporation’s local markets, resulting in heightened pricing competition for new loan originations, and lower than expected yields on new and refinanced loans, considering the overall increase in market interest rates.

 

The $9.1 million reduction in net interest income (FTE) in 2006, as compared to 2005, is analyzed in detail in Table 2. The net impact on net interest income (FTE) in 2006 from the favorable effect of a $126 million, or 4.8%, increase in average loans and the unfavorable effects of a $29 million decrease in the level of interest-earning assets and a change in the composition of deposit accounts, was an increase in net interest income (FTE) of $1.3 million. This increase was more than offset by the Corporation experiencing a $10.4 million reduction in net interest income (FTE) due to the effect of the rising interest rate environment and the flattening of the interest yield curve. Interest income on loans, investment securities and other investable funds increased $16.4 million due to rising interest rates and the repricing of loans and investment securities, although interest expense on deposits and borrowings increased $26.8 million, as market interest rates increased and deposits and wholesale borrowings repriced in 2006. The Corporation’s balance sheet was liability sensitive throughout 2006, with a higher percentage of interest-bearing liabilities repricing than interest-earning assets.

 

In 2005, the FOMC raised the Federal Funds rate by twenty-five basis points eight times that resulted in an equal increase each time in the prime rate. The prime rate was 5.25% on January 1, 2005 and 7.25% on December 31, 2005. While short-term interest rates increased throughout 2005, long-term interest rates rose only slightly to produce a virtually flat interest yield curve at December 31, 2005. The ten-year U.S. Treasury note, which is generally used to price both 15- and 30-year residential mortgage loans, was 4.24% at the end of 2004 compared to 4.35% at the end of 2005.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

The Corporation’s subsidiary bank is a full-service commercial bank and, therefore, the acceptance and management of credit risk is an integral part of the Corporation’s business. The Corporation maintains conservative loan policies and credit underwriting standards. These standards include the granting of loans generally only within the Corporation’s market areas. The Corporation’s lending markets generally consist of small communities across the middle to southern and western sections of the lower peninsula of Michigan. The Corporation’s lending market areas do not include the southeastern portion of Michigan. The average size of commercial loan transactions is generally relatively small, which decreases the risk of loss within the commercial loan portfolio due to the lack of loan concentration. The Corporation’s commercial loan portfolio, defined as commercial, real estate commercial and real estate construction-commercial loans, is well diversified across business lines and has no concentration in any one industry. While the average commercial loan transaction is relatively small, the commercial loan portfolio of $1.37 billion at December 31, 2007 included approximately sixty loans that exceeded $2.5 million. These sixty borrowing relationships totaled $291.4 million and represented approximately 21% of the commercial loan portfolio at December 31, 2007. Further, at December 31, 2007, only six of these borrowing relationships were $10 million or higher, totaling $73.2 million or 5.3% of the commercial loan portfolio as of that date. The Corporation has no foreign loans or any loans to finance highly leveraged transactions. The Corporation’s lending philosophy is implemented through strong administrative and reporting controls at the subsidiary bank level, with additional oversight at the corporate level. The Corporation maintains a centralized independent loan review function, which monitors asset quality of the loan portfolio.

 

The Corporation’s subsidiary bank has extended loans to its directors, executive officers and their affiliates. The loans were made in the ordinary course of business upon normal terms, including collateralization and interest rates prevailing at the time and did not involve more than the normal risk of repayment by the borrower or present other unfavorable features. Note F to the consolidated financial statements includes more information on loans to the Corporation’s directors, executive officers and their affiliates.

 

The Corporation experiences competition for commercial loans primarily from larger regional banks located both within and outside of the Corporation’s market areas, and from other community banks located within the Corporation’s lending markets. The Corporation’s competition for real estate residential loans primarily includes community banks, larger regional banks, savings associations, credit unions and mortgage companies. The competition for real estate residential loans has increased over the last five years as mortgage lending companies have expanded their sales and marketing efforts. The Corporation experiences competition for consumer loans mostly from captive automobile finance companies, larger regional banks, community banks and local credit unions. The Corporation’s loan portfolio is generally diversified along industry lines and, therefore, the Corporation believes that its loan portfolio is reasonably sheltered from material adverse local economic impact.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

Table 3 includes the composition of the Corporation’s loan portfolio, by major loan category, as of December 31, 2007, 2006, 2005, 2004 and 2003.

 

 

Total loans at December 31, 2007 were $2.80 billion, a decrease of $8.2 million, or 0.3%, from total loans at December 31, 2006.

 

Commercial loans totaled $525.9 million at December 31, 2007, a decrease of $19.7 million, or 3.6%, from total commercial loans at December 31, 2006 of $545.6 million. The decrease of commercial loans during 2007 was a result of a slower than average economic climate within the Corporation’s market areas during the year. Commercial loans increased $27.7 million, or 5.4%, in 2006 from $517.9 million at December 31, 2005. The increase in commercial loans in 2006 was partially attributable to the 2006 branch transaction. Commercial loans represented 18.8%, 19.4% and 19.1% of total loans outstanding at December 31, 2007, 2006 and 2005, respectively.

 

Real estate loans include real estate commercial loans, real estate construction loans and real estate residential loans. At December 31, 2007, 2006 and 2005, real estate loans totaled $1.72 billion, $1.71 billion and $1.65 billion, respectively. Real

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

LOANS (CONTINUED)

 

estate loans increased $15.4 million, or 0.9%, in 2007. Real estate loans increased $59.5 million, or 3.6%, in 2006. Real estate loans as a percentage of total loans at December 31, 2007, 2006 and 2005 were 61.6%, 60.9% and 60.9%, respectively.

 

Real estate commercial loans increased $20.8 million, or 2.9%, during 2007 to $747.4 million at December 31, 2007. Real estate commercial loans increased $21.9 million, or 3.1%, during 2006 to $726.6 million at December 31, 2006. The modest internal growth in this category of loans in 2007 and 2006 was largely due to minimal economic expansion in the majority of the Corporation’s market areas in each of these years. At December 31, 2007, 2006 and 2005, real estate commercial loans as a percentage of total loans were 26.7%, 25.9% and 26.0%, respectively.

 

Commercial lending and real estate commercial lending are generally considered to involve a higher degree of risk than one- to four-family residential lending. Such lending typically involves larger loan balances concentrated in a single borrower. In addition, the payment experience on loans secured by income-producing properties is typically dependent on the success of the operation of the related project and is typically affected by adverse conditions in the real estate market and in the economy. The Corporation generally attempts to mitigate the risks associated with commercial lending by, among other things, lending primarily in its market areas, lending across industry lines, not developing a concentration in any one line of business and using conservative loan-to-value ratios in the underwriting process.

 

Real estate construction loans are originated for both business, including land development, and residential properties. These loans often convert to a real estate loan at the completion of the construction or development period. Real estate construction loans were $137.3 million at December 31, 2007, a decrease of $8.7 million, or 5.9%, from December 31, 2006. The decrease in real estate construction loans during 2007 was largely reflective of the continued slow economic climate within Michigan in 2007 and a corresponding reduction in business expansion and development throughout most of the Corporation’s market areas. Real estate construction loans decreased $12.4 million, or 7.9%, during 2006 from $158.4 million at December 31, 2005, as the economic climate was slow in 2006. At December 31, 2007, 2006 and 2005, real estate construction loans as a percentage of total loans were 4.9%, 5.2% and 5.9%, respectively.

 

Construction lending involves a higher degree of risk than one- to four-family residential lending because of the uncertainties of construction, including the possibility of costs exceeding the initial estimates and the need to obtain a tenant or purchaser of the property if it will not be owner-occupied. The Corporation generally attempts to mitigate the risks associated with construction lending by, among other things, lending primarily in its market areas, using conservative underwriting guidelines, and closely monitoring the construction process. The Corporation’s risk in this area increased during 2007 as the sale of units in residential real estate development projects slowed as customer demand decreased and the inventory of unsold units increased across the state of Michigan.

 

Table 4 presents the maturity distribution of commercial, real estate commercial, and real estate construction loans. These loans represented 50% of total loans at December 31, 2007 and 51% at December 31, 2006. The percentage of these loans maturing within one year was 38% at December 31, 2007, compared to 33% at December 31, 2006. The percentage of these loans maturing beyond five years remained low at 9% at December 31, 2007 and December 31, 2006. Of those loans with maturities beyond one year, the percentage of loans with variable interest rates was 14% at December 31, 2007, compared to 17% at December 31, 2006. The decrease in variable interest rate loans with maturities greater than one year was due to a continuation in customer preference to secure fixed interest rate financing and equally strong competitive conditions.

 

Real estate commercial loans are generally written as balloon-type mortgages at fixed interest rates for balloon time periods ranging from three to ten years. As of December 31, 2007, the Corporation held $129 million in commercial, real estate commercial and real estate construction loans that had maturities extending beyond five years, with the majority of these loans having fixed interest rates.

 

Real estate residential loans increased $3.3 million, or 0.4%, during 2007 to $838.5 million. The internal growth of real estate residential loans was low as the housing market across much of the state of Michigan was weak throughout the year. Real estate residential loans increased $50.1 million, or 6.4%, during 2006 to $835.3 million. The increase in real estate residential loans during 2006 was partially attributable to the branch transaction during the year which added $24 million in real estate residential loans, after a portion of the loans acquired were sold in December 2006. At December 31, 2007, 2006 and 2005, real estate residential loans as a percentage of total loans were 30.0%, 29.8% and 29.0%, respectively.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

 

 

 

The Corporation’s real estate residential loans primarily consist of one- to four-family residential loans with original terms of less than fifteen years. The loan-to-value ratio at the time of origination is generally 80% or less. Loans with more than an 80% loan-to-value ratio generally require private mortgage insurance.

 

The Corporation’s general practice is to sell real estate residential loan originations with maturities of fifteen years and longer in the secondary market. The Corporation originated $311 million of real estate residential loans during 2007 and sold $136 million of these originations in the secondary market, compared to the sale of $118 million of real estate residential loans during 2006, excluding $14 million of loans sold that were acquired in the 2006 branch transaction.

 

At December 31, 2007, the Corporation was servicing $570 million of real estate residential loans that had been originated by the Corporation in its market areas and subsequently sold in the secondary mortgage market. At December 31, 2006 and December 31, 2005, the Corporation was servicing real estate residential loans for others in the amounts of $552 million and $544 million, respectively.

 

Consumer loans totaled $550.3 million at December 31, 2007, a decrease of $4.0 million, or 0.7%, from total consumer loans at December 31, 2006 of $554.3 million. Consumer loans increased $13.7 million, or 2.5%, during 2006. The decrease in 2007 and minimal increase in 2006 were largely attributable to increased competition from captive auto finance companies on new personal vehicle loans and slow economic conditions in the Corporation’s market areas, as evidenced by the unemployment level in Michigan that was above the national average at December 31, 2007. Consumer loans represented 19.6%, 19.7% and 20.0% of total loans outstanding at December 31, 2007, 2006 and 2005, respectively.

 

Consumer loans generally have shorter terms than mortgage loans but generally involve more credit risk than one- to four-family residential lending because of the type and nature of the collateral. Collateral values, particularly those of automobiles, are negatively impacted by many factors, such as new car promotions, vehicle condition and a slow economy. Consumer lending collections are dependent on the borrowers’ continuing financial stability, and thus are more likely to be affected by adverse personal situations.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

Nonperforming assets consist of nonperforming loans, which are defined as loans for which the accrual of interest has been discontinued and loans that are past due as to principal or interest by ninety days or more and are still accruing interest, and assets obtained through foreclosures and repossessions. There were no restructured loans at December 31, 2007, 2006, 2005, 2004 or 2003. The Corporation transfers a loan that is ninety days or more past due to nonaccrual status, unless it believes the loan is both well secured and in the process of collection. Accordingly, the Corporation has determined that the collection of accrued and unpaid interest on any loan that is ninety days or more past due and still accruing interest is probable. Nonperforming assets were $74.5 million as of December 31, 2007, compared to $35.8 million as of December 31, 2006, and $26.5 million at December 31, 2005 and represented 2.0%, 0.9% and 0.7% of total assets, respectively. It is management’s opinion that the increase in nonperforming assets is, in part, attributable to the recessionary type economic climate within Michigan which has resulted in cash flow difficulties being encountered by many commercial loan customers. The increase in the Corporation’s nonperforming assets is not concentrated in any one industry or any one geographical area within Michigan. The Corporation’s lending market does not include the southeastern portion of Michigan and at December 31, 2007, the Corporation did not have any nonperforming assets in that portion of the state. In addition, the sizes of the loan transactions are generally relatively small, which further decreases the risk of loss within the commercial loan portfolio due to the lack of loan concentration. While it has been well publicized nationwide throughout 2007 that appraisal values of residential real estate have generally declined, the Corporation has also experienced some declines in commercial real estate appraisals due to the weakness in the economy in Michigan. It is management’s assessment as of December 31, 2007, for both commercial and residential real estate loans, that the discounted loan to value ratios within the Corporation’s lending market areas are generally still within an acceptable underwriting range. Based on the declines in both commercial and residential real estate values, management continues to discount appraised values to compute estimated fair market values of real estate secured loans.

 

The Corporation considers a loan as impaired when management determines it is probable that all of the principal and interest due under the contractual terms of the loan will not be collected. The Corporation measures impairment on commercial, real estate commercial and real estate construction-commercial loans. In most instances, the impairment is measured based on the fair value of the underlying collateral. Impairment may also be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate.

 

Impaired loans were $45.9 million as of December 31, 2007, $19.8 million as of December 31, 2006 and $9.8 million as of December 31, 2005. All nonaccrual commercial, real estate commercial and real estate construction-commercial loans, which totaled $43.6 million at December 31, 2007, met the definition of an impaired loan. The Corporation also identified loans in each of these loan types totaling $2.3 million that were in an accrual status as of December 31, 2007 that met the definition of an impaired loan. After analyzing the various components of the customer relationships and evaluating the underlying collateral of impaired loans, it was determined that impaired loans totaling $22.2 million at December 31, 2007, required a specific allocation of the allowance for loan losses (impairment reserve), compared to $3.8 million of impaired loans at December 31, 2006 and $5.1 million of impaired loans at December 31, 2005 requiring a specific allocation of the allowance. The specific allocation of the allowance for loan losses on impaired loans was $4.6 million at December 31, 2007, $0.9 million at December 31, 2006 and $1.3 million at December 31, 2005. At December 31, 2007, $7.7 million of impaired loans, that did not require a specific allocation of the allowance for loan losses as of that date, were partially charged off, totaling $2.2 million over 2006 and 2007, primarily as a result of declining real estate values. The process of measuring impaired loans and the allocation of the allowance for loan losses requires judgment and estimation; therefore, the eventual outcome may differ from the estimates used on these loans.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

The following table provides a five-year history of nonperforming assets and the composition of nonperforming loans by major loan category:

 

 

Total nonperforming loans were $63.4 million, or 2.26%, of total loans at December 31, 2007, compared to $26.9 million, or 0.96%, of total loans at December 31, 2006. The level and composition of nonperforming loans in 2007 were adversely affected by economic conditions in the state of Michigan and in the Corporation’s local markets. The majority of the increase in nonperforming loans during 2007 occurred in commercial, real estate commercial and real estate construction loans.

 

Nonperforming commercial loans of $12.9 million at December 31, 2007 were up $7.0 million, or 119%, from nonperforming commercial loans at December 31, 2006 of $5.9 million. At December 31, 2007, the Corporation had one nonperforming commercial loan over $1 million, with the customer’s loan relationship totaling $1.7 million. This customer is a retailer of mobile and modular homes, with the loan secured primarily by an inventory of mobile homes. The Corporation has initiated legal proceedings against the borrower for payment and expects a lengthy workout of this credit relationship. A $0.5 million impairment reserve was established on this loan in the fourth quarter of 2007. In addition, the Corporation has a customer with a nonperforming commercial loan balance of $0.5 million that also has a nonperforming real estate commercial loan with a balance of $0.5 million at December 31, 2007, resulting in $1.0 million of total nonperforming loans with this customer at December 31, 2007. This customer’s business is an excavating company and the loans are secured by construction equipment, accounts receivable and commercial property, primarily a gravel pit. Business has been slow for this customer, which has created cash flow difficulties, although the customer’s business has recently slightly improved. At December 31, 2007, the Corporation assessed the fair value of the underlying collateral to be in excess of the principal balances of the loans.

 

The Corporation’s real estate commercial loan portfolio is comprised of four segments: commercial real estate, land development and vacant land loans that are combined within the real estate commercial loan category and also real estate construction loans. The following definitions are provided to clarify the types of loans included in each of the real estate commercial loan segments. Commercial real estate loans are secured by real estate occupied by the owner for ongoing operations and by non-owner occupied real estate leased to one or more tenants. Land development loans are secured by land

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

NONPERFORMING ASSETS (CONTINUED)

 

that has been developed in terms of infrastructure improvements to create finished marketable lots for commercial or residential construction. Vacant land loans are secured by undeveloped land which has been acquired for future development. Real estate construction loans are secured by commercial, retail and residential real estate in the construction phase with the intent to be sold or become an income producing property and land development loans that are secured by land that is in the process of actively being developed in terms of infrastructure improvements to create finished marketable lots for future development.

 

Nonperforming real estate commercial loans totaled $23.9 million at December 31, 2007 and were comprised of $21.0 million of real estate commercial loans, $1.4 million of land development loans and $1.5 million of vacant land loans. Nonperforming real estate construction loans totaled $13.0 million at December 31, 2007 and were comprised primarily of residential real estate development loans. At December 31, 2007, $15.1 million of the nonperforming real estate commercial and construction loans were in various stages of foreclosure with 22 borrowers. At December 31, 2007, the Corporation’s nonperforming real estate commercial loans were comprised of a diverse mix of commercial lines of business and were also geographically disbursed throughout the Company’s market areas. The Michigan economy remains weak, thus creating a difficult business environment for many lines of business across the state. In addition, the economy in Michigan has adversely impacted housing demand throughout the state and, accordingly, the Corporation has experienced an increase in the number of its residential real estate development borrowers with cash flow difficulties associated with a significant decline in sales of residential real estate. The following discussion of the Corporation’s nonperforming real estate commercial loans has been segregated into the four real estate commercial loan segments, described above, to provide more detail on the risk associated with these type loans.

 

The Corporation’s nonperforming real estate commercial loans of $21.0 million at December 31, 2007 were comprised of approximately 60 borrowers with loan relationships from $5,000 to $2.3 million, with seven borrowers having loan relationships exceeding $1 million and comprising $10.7 million, or 51%, of these loans as of that date. A description of these seven loan relationships follows. One loan relationship involves two loans to related borrowers totaling $2.3 million that are secured by the same non-owner occupied real estate, with foreclosure proceedings commenced. A loan relationship in the amount of $1.7 million is secured by a hotel. The carrying value of this loan was written down $0.2 million in the fourth quarter of 2007. A loan relationship in the amount of $1.2 million is secured by interests in three hotels. While the business cash flows appear to be adequate to service the debt on the loan, the customer has not kept the loan payments current and, therefore, foreclosure proceedings are probable. At December 31, 2007, the Corporation assessed the fair market value of the underlying collateral of the above described three loan relationships and determined it was in excess of the remaining carrying values of the loans. A loan in the amount of $1.3 million is secured by a restaurant that closed operations in January 2008. Based on the nature of the collateral, declining real estate values and limited market interest in this property, the Corporation partially charged off this loan in the amount of $1.4 million ($0.3 million in 2007 and $1.1 million in 2006). In addition, during the fourth quarter of 2007 an impairment reserve of $0.25 million was established on this loan. The Corporation received title to this property in January 2008 and the restaurant is for sale. A loan relationship in the amount of $1.3 million is secured by an automobile dealership and is also secured with a seventy-five percent guarantee by a federal governmental agency. A $0.26 million impairment reserve was established on this loan in the third quarter of 2007 attributable to the unguaranteed portion of the loan. A loan relationship in the amount of $1.6 million is secured by a hotel. Foreclosure proceedings have begun on this loan. A $0.15 million impairment reserve was established on this loan during the third quarter of 2007. A loan relationship in the amount of $1.3 million is secured by a sixty-unit apartment complex where the borrower has a pending sale in process. If the pending sale does not occur, the Corporation will commence foreclosure proceedings. A $0.2 million impairment reserve was established during the third quarter of 2007 on this loan.

 

The Corporation’s nonperforming land development loans were $1.4 million and nonperforming vacant land loans were $1.5 million at December 31, 2007. These loans represented amounts due primarily from one customer. The carrying value of this customer’s loan relationship totaled $2.5 million at December 31, 2007 and was secured by forty-three residential lots and multiple parcels of vacant land, zoned both commercial and residential. Foreclosure proceedings have begun with this borrower. Due to declining real estate values, the Corporation partially charged off this loan in the amount of $0.4 million in the fourth quarter of 2007. The Corporation determined that the fair value of the underlying collateral exceeded the remaining carrying value of this loan relationship at December 31, 2007.

 

The Corporation’s $13.0 million of nonperforming construction loans at December 31, 2007 were comprised of 12 borrowers, with three borrowers having loan relationships exceeding $1 million and comprising 81% of total nonperforming construction loans as of that date. The first loan relationship has a principal balance of $6.1 million and is secured by a condominium hotel

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

project on waterfront property. The project is complete, although there were no sales in 2007. This loan is secured by twelve unsold units and adjacent property. A $0.27 million impairment reserve was established on this loan during the fourth quarter of 2007. The second loan relationship has a principal balance of $3.2 million and is secured by a residential condominium project consisting of 129 sites, with 69 units sold, four units that have been completed and offered for sale and 56 sites available for construction. There were no sales in 2007 in this project. A $1 million impairment reserve was established on this loan during the fourth quarter of 2007. The third loan relationship is comprised of a nonperforming construction loan with a carrying value of $1.2 million and a nonperforming real estate commercial loan of $0.3 million at December 31, 2007 that are both secured by two residential condominium projects with eleven total units, with construction complete on three of the units and offered for sale by the borrower, and residential real estate. The construction loan was partially charged off in the amount of $0.5 million ($0.1 million in 2007 and $0.4 million in 2006). Judicial foreclosure proceedings have commenced on this loan. The Corporation determined that the fair value of the underlying collateral exceeded the remaining carrying value of this loan relationship at December 31, 2007.

 

Nonperforming real estate residential loans were $10.0 million at December 31, 2007, an increase of $6.0 million, or 147%, over total nonperforming real estate residential loans of $4.0 million at December 31, 2006. Nonperforming real estate residential loans represented 15.8% of nonperforming loans at December 31, 2007, compared to 15.0% at December 31, 2006. The increase in nonperforming real estate residential loans was primarily due to a rise in delinquencies, bankruptcies and foreclosures reflective of weak economic conditions in Michigan.

 

Nonperforming consumer loans were $3.6 million at December 31, 2007, compared to $2.4 million at December 31, 2006. The increase in nonperforming consumer loans during 2007 was reflective of the weak economic conditions within Michigan.

 

Other real estate and repossessed assets totaled $11.1 million at December 31, 2007, and consisted of commercial real estate of $5.4 million, residential real estate of $5.5 million and other repossessions, mostly automobiles, boats and recreational vehicles, of $0.2 million. Other real estate and repossessed assets totaled $8.9 million at December 31, 2006, and consisted of commercial real estate of $5.5 million, residential real estate of $3.0 million and other repossessions, mostly automobiles, boats and recreational vehicles, of $0.4 million. A significant portion, or 34%, of other real estate at December 31, 2007 was represented by two commercial real estate properties totaling $3.7 million. One of these properties with a book value of $1.2 million was sold on a land contract, although the purchaser’s down-payment was not sufficient to account for the transaction as a sale in accordance with generally accepted accounting principles. Payments on the land contract are reducing the book value balance, with scheduled payments current as of December 31, 2007. The second property with a book value of $2.5 million is a high rise mixed use condominium property with eleven residential units in various stages of completion and six retail business condominium units offered for sale. There had been only one residential unit sold on this project as of December 31, 2007 and this unit was sold in 2005. The Corporation obtained an updated appraisal of the condominium property during the first quarter of 2007, which assessed the time to sell the remaining units at approximately thirty months. In addition, the Corporation held seventeen other commercial real estate properties for sale at December 31, 2007, totaling $1.7 million with book values of $22,000 to $0.32 million, with three of these properties having an individual book value greater than $0.25 million. The residential real estate component of other real estate of $5.5 million at December 31, 2007 was comprised of forty-eight properties with four properties having an individual book value greater than $0.25 million. The inventory of real estate properties for sale across the state of Michigan has resulted in an increase in the Corporation’s carrying time of holding other real estate. Excluding the property sold on a land contract, $4.5 million, or 47%, of the remaining other real estate held at December 31, 2007 had been held in excess of one year as of that date.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

The provision for loan losses (provision) is the amount added to the allowance for loan losses (allowance) to absorb inherent loan losses (charge-offs) in the loan portfolio. A summary of the activity in the allowance for years 2007 back through 2003 is included in Table 3. Management quarterly evaluates the allowance to ensure the level is adequate to absorb losses inherent in the loan portfolio. This evaluation is based on a continuous review of the loan portfolio, both individually and by category, and includes consideration of changes in the mix and volume of the loan portfolio, actual loan loss experience and loan loss trends, the financial condition of the borrowers, industry and geographical exposures within the portfolio, economic conditions and employment levels of the Corporation’s local markets, and special factors affecting business sectors. A formal evaluation of the allowance is prepared quarterly to assess the risk in the loan portfolio and to determine the adequacy of the allowance. The Corporation’s loan review function is independent of the loan origination function and reviews this evaluation. The Corporation’s loan review function was performed by internal staff in 2007 and a combination of internal staff and third-party consulting firms during 2006 and 2005. Loan review performs a detailed credit quality review at least annually on commercial, real estate commercial and real estate construction-commercial loans, particularly focusing on larger balance loans and loans that have deteriorated below certain levels of credit risk.

 

The allowance provides for probable losses that have been identified with specific customer relationships and for probable losses believed to be inherent in the remainder of the loan portfolio but that have not been specifically identified. The allowance for loan losses is comprised of specific impairment reserve allocations (assessed for loans that have known credit weaknesses), allowances based on assigned risk ratings, general allowances on the remainder of the loan portfolio based primarily on historical loan loss experience and loan loss trends, and an unallocated allowance for the imprecision in the subjective nature of the specific and general allowance methodology. Factors contributing to the determination of specific impairment reserve allocations include the financial condition of the borrower, changes in the value of pledged collateral and general economic conditions. The Corporation establishes the allowance allocations by the application of projected loss percentages to adversely-graded commercial, real estate commercial and real estate construction-commercial loans by grade categories. General allowances are allocated to all other loans by loan category, based on a defined methodology that focuses on loan loss experience and trends. Allowance allocations to loan categories are developed based on historical loss and past due trends, management’s judgment concerning those trends and other relevant factors, including delinquency, default, and loss rates, as well as general economic conditions. Some loans will not be repaid in full. Therefore, an allowance for loan losses is maintained at a level that represents management’s best estimate of inherent losses within the loan portfolio.

 

In determining the allowance and the related provision for loan losses, the Corporation considers four principal elements: (i) specific impairment reserve allocations based upon probable losses identified during the review of impaired commercial, real estate commercial and real estate construction-commercial loan portfolios, (ii) allocations established for adversely-rated commercial, real estate commercial and real estate construction-commercial loans, (iii) allocations on all other loans based principally on historical loan loss experience and loan loss trends, and (iv) an unallocated allowance based on the imprecision in the overall allowance methodology.

 

The first element reflects the Corporation’s estimate of probable losses based upon the systematic review of impaired commercial, real estate commercial and real estate construction-commercial adversely-graded loans. These estimates are based upon a number of objective factors, such as payment history, financial condition of the borrower, and discounted collateral exposure. The Corporation measures the investment in an impaired loan based on one of three methods: the loan’s observable market price, the fair value of the collateral, or the present value of expected future cash flows discounted at the loan’s effective interest rate.

 

The second element reflects the application of the Corporation’s loan grading system. This grading system is similar to those employed by state and federal banking regulators. Commercial, real estate commercial and real estate construction-commercial loans that are risk rated below a certain predetermined risk grade are assigned a loss allocation factor that is based upon a historical analysis of losses incurred within the specific risk grade category. The lower the grade assigned to a loan or category, the greater the allocation percentage that is generally applied.

 

The third element is determined by assigning allocations based principally upon the three-year average of loss experience for each type of loan. Average losses may be adjusted based on current loan loss and delinquency trends and for the projected impact of loans acquired in branch and bank acquisitions. Loan loss analyses are performed quarterly.

 

The fourth element is based on factors that cannot be associated with a specific credit or loan category and reflects an attempt to ensure that the overall allowance for loan losses appropriately reflects a margin for the imprecision necessarily inherent in

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

the estimates of expected loan losses. Management maintains an unallocated allowance to recognize the uncertainty and imprecision underlying the process of estimating projected loan losses. Determination of the probable losses inherent in the portfolio, which are not necessarily captured by the allocation methodology discussed above, involves the exercise of judgment. The unallocated allowance associated with the imprecision in the risk rating system is based on a historical evaluation of the accuracy of the risk ratings associated with loans. This unallocated portion of the allowance is judgmentally determined and generally serves to compensate for the uncertainty in estimating losses, particularly in times of changing economic conditions, and also considers the possibility of improper risk ratings. The unallocated allowance considers the lagging impact of historical charge-off ratios in periods where future loan charge-offs are expected to increase, trends in delinquencies and nonaccrual loans, the changing portfolio mix in terms of collateral, average loan balance, loan growth, the degree of seasoning in the various loan portfolios, and loans recently acquired through acquisitions. The unallocated portion of the allowance also takes into consideration economic conditions within the state of Michigan and nationwide, including unemployment levels, industry-wide loan delinquency rates and in 2007 declining commercial and residential real estate values and historically high inventory levels of residential lots, condominiums and single family houses held for sale.

 

The underlying credit quality of the Corporation’s real estate residential and consumer loan portfolios is dependent primarily on each borrower’s ability to continue to make required loan payments and, in the event a borrower is unable to continue to do so, the value of the collateral, if any, securing the loan. A borrower’s ability to pay typically is dependent primarily on employment and other sources of income, which in turn is impacted by general economic conditions, although other factors may also impact a borrower’s ability to pay. At December 31, 2007, the unemployment rate in the state of Michigan was approximately 7.6%, compared to the national average of approximately 5.0%.

 

The provision for loan losses was $11.5 million in 2007, $5.2 million in 2006 and $4.29 million in 2005. The Corporation experienced net loan charge-offs of $6.18 million in 2007, $5.65 million in 2006 and $4.30 million in 2005. Net loan charge-offs as a percentage of average loans were 0.22% in 2007, 0.20% in 2006 and 0.16% in 2005. The increase in net loan charge-offs in 2007 occurred primarily in the commercial loan types. The ten largest commercial loan charge-offs were primarily real estate based loans and totaled $2.1 million. These ten loan charge-offs represented 45% of total gross commercial loan type charge-offs in 2007. The Corporation’s allowance was $39.4 million at December 31, 2007 and represented 1.41% of total loans, compared to $34.1 million and 1.21% of total loans at December 31, 2006.

 

The Corporation’s provision for loan losses was $6.3 million higher in 2007 than in 2006. The increase in the provision for loan losses in 2007 was largely driven by an increase in the impairment reserve (specific allocation of the allowance) on impaired loans and also by increases in nonperforming loans, loan delinquencies, and the overall average risk grade of the commercial and real estate-commercial loan portfolios.

 

The level of the provision for loan losses reflects management’s assessment of the allowance for loan losses. During 2007, the provision for loan losses of $11.5 million exceeded net loan charge-offs by $5.3 million. The excess was reflective of credit deterioration in 2007. Nonperforming loans increased $36.5 million, or 135%, in 2007 to $63.4 million, or 2.26% of total loans at December 31, 2007. The increase in nonperforming loans in 2007 occurred in all loan categories, although the majority of the increase occurred in the commercial loan categories. During 2007, the Corporation’s total impairment reserve increased $3.7 million to $4.6 million at December 31, 2007, and represented $3.7 million of the $5.3 million excess of the provision for loan losses over net loan charge-offs during 2007. A further increase in the provision for loan losses of $1.6 million was required in 2007 in accordance with the Corporation’s defined methodology of assessing the adequacy of the allowance, which included consideration of the upward trends during 2007 in nonperforming loans, higher loan delinquencies, an increase in the average risk of the graded portion of the loan portfolio and the downward trend in the economy in Michigan.

 

Impaired loans were $45.9 million as of December 31, 2007, $19.8 million as of December 31, 2006 and $9.8 million as of December 31, 2005. After analyzing the various components of the customer relationships and evaluating the underlying collateral of impaired loans, it was determined that impaired loans totaling $22.2 million required a specific allocation of the allowance for loan losses at December 31, 2007, compared to $3.8 million of impaired loans at December 31, 2006 and $5.1 million of impaired loans at December 31, 2005. The allowance for loan losses allocated to impaired loans was as follows: $4.6 million at December 31, 2007, $0.9 million at December 31, 2006 and $1.3 million at December 31, 2005. Accordingly, at December 31, 2007, the Corporation, after individually reviewing its impaired loans, determined that $23.7 million of nonperforming commercial and commercial real estate-based loans as of that date were deemed to have sufficient collateral

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

PROVISION AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)

 

values so as not to require a specific allocation of the allowance for loan losses to these loans. The carrying value of impaired loans of $45.9 million at December 31, 2007 was net of $3.7 million in partial loan write-downs (charge-offs) on these loans in 2007 and 2006, with $1.5 million of write-downs attributable to impaired loans that had an impairment reserve at December 31, 2007 and $2.2 million of write-downs attributable to $7.7 million of the total $23.7 million of impaired loans that did not require an impairment reserve at December 31, 2007. The process of measuring impaired loans and the allocation of the allowance for loan losses requires judgment and estimation, therefore the eventual outcome may differ from the estimates used on these loans.

 

Economic conditions in the Corporation’s markets, all within Michigan, were generally less favorable than those nationwide during 2007. Forward-looking indicators suggest these economic conditions will continue into 2008.

 

The allocation of the allowance in Table 6 is based upon ranges of estimates and is not intended to imply either limitations on the usage of the allowance or exactness of the specific amounts. The entire allowance is available to absorb future loan losses without regard to the categories in which the loan losses are classified. The allocation of the allowance is based upon a combination of factors, including historical loss factors, credit-risk grading, past-due experiences, and the trends in these, as well as other factors, as discussed above.

 

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

NONINTEREST INCOME

 

Noninterest income totaled $43.3 million in 2007, $40.1 million in 2006 and $39.2 million in 2005. Noninterest income increased $3.2 million, or 7.8%, in 2007 and increased $0.9 million, or 2.4%, in 2006 compared to the prior year. Noninterest income as a percentage of net revenue (net interest income plus noninterest income) was 25.0% in 2007, 23.3% in 2006 and 21.7% in 2005.

 

The following schedule includes the major components of noninterest income during the past three years:

 

TABLE 7. NONINTEREST INCOME

 

 

Service charges on deposit accounts were $20.5 million in 2007, $21.0 million in 2006 and $20.4 million in 2005. The decline of $0.5 million, or 2.1%, in 2007 was primarily attributable to a lower level of customer activity in areas where fees and service charges are applicable and customers choosing alternative non-fee based accounts. The increase of $0.6 million, or 3.1%, in 2006 was primarily attributable to increases in fees assessed and a higher level of customer activity in areas where fees and service charges are applicable.

 

Trust and investment services revenue (trust services revenue) was $8.3 million in 2007, $7.9 million in 2006 and $7.9 million in 2005. Trust services revenue increased 5.6% in 2007 over the prior year as assets under management were higher than in the prior year. Positive investment returns in the equity markets were largely responsible for the year over year increase in assets under management. Trust services revenue was unchanged in 2006 compared to 2005. While growth in the equity markets produced additional trust services revenue in 2006, it was offset by the effect of modest changes in the composition of assets under management.

 

Other fees for customer services were $3.0 million in 2007, $3.1 million in 2006 and $2.4 million in 2005. The 2006 increase of $0.7 million, or 29.8%, was primarily attributable to $0.6 million of float income earned on the sale of bank money orders to customers that was recognized in noninterest income in 2006, as compared to being recognized in interest income in 2005, as a result of the transfer of the bank money order process to a third-party vendor.

 

ATM and network user fees were $3.0 million in 2007, $2.7 million in 2006 and $2.7 million in 2005. ATM and network user fees increased $0.3 million, or 9.6%, in 2007 due primarily to a $0.3 million, or 53.6%, decline in the reserve for debit card reward points that was attributable to the retirement of inactive points. ATM and network user fees in 2006 were virtually unchanged from 2005. Management believes that the expansion of ATMs by non-banking institutions was the primary reason for the lack of growth in ATM fee revenue in 2006.

 

Investment fees in 2007 were $3.0 million, up $0.5 million, or 20.5%, compared to investment fees of $2.5 million in 2006. This follows an increase in investment fees in 2006 of $0.6 million, or 31.7%, compared to investment fees of $1.9 million in 2005. The increase in investment fees between 2007 and 2006 resulted from higher sales of investment products under the Corporation’s “CFC Investment Center” program. The increase in investment fees in 2006 over 2005 was largely a result of a broader mix of products and services being offered to customers through the “CFC Investment Center” program.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

NONINTEREST INCOME (CONTINUED)

 

Insurance commissions were $0.8 million in 2007, $0.8 million in 2006 and $0.9 million in 2005. The virtually unchanged insurance commissions in 2007, compared to 2006, were due to lower title insurance commissions being partially offset by higher credit life insurance income.

 

Mortgage banking revenue (MBR) was $2.1 million in 2007, $1.7 million in 2006 and $1.7 million in 2005. During 2007, the Corporation sold $136 million of real estate residential loans in the secondary market, compared to $118 million in 2006 and $111 million in 2005. During 2007, generally all fifteen-year and longer term mortgages were sold in the secondary market. The increase in MBR in 2007, compared to 2006, was primarily attributable to an increase in the amount of loans sold and in net gains on sales of loans. Based on similar market conditions and the amount of loans sold, MBR in 2006, compared to 2005, was unchanged.

 

During the third quarter of 2007, the Corporation recognized a $1.1 million nonrecurring gain from an insurance settlement due to damage to a branch building from a fire in an adjacent structure on February 13, 2007. In addition, during the second quarter of 2007, the Corporation realized $0.9 million of gains on the sales of a branch office building and a parcel of excess land contiguous to an existing branch office.

 

During the fourth quarter of 2006, the Corporation recognized $1.1 million in gains on the sale of $14 million in long-term fixed interest rate real estate residential mortgage loans that were acquired in the 2006 branch transaction. There was no such sale of loans from acquisitions in 2007 or 2005.

 

The Corporation recognized losses on the sale of investment securities of $1.3 million in 2006 and net gains of $0.5 million in 2005. During the fourth quarter of 2006, the Corporation sold $68 million of U.S. Treasury and government sponsored agency investment securities scheduled to mature in 2007 and 2008 that had an average yield of 3.12% and realized a $1.3 million loss. The Corporation had a significant volume of investment securities maturing in 2007 and management deemed it prudent to sell and reinvest a portion of these securities during 2006 as part of its interest rate risk management program. The proceeds from the sale were reinvested in U.S. Treasury and government sponsored agency investment securities with an average life of 3 years and an average yield of 4.81%. In 2005, the Corporation extended the average life of the investment securities portfolio and funded loan growth by selling $109 million of short-term investment securities for a net gain of $0.5 million.

 

Noninterest income, excluding the gain on an insurance settlement, gains on sales of branch bank properties, investment securities net gains and losses and the gains on the sale of acquired loans in 2006, was $41.2 million in 2007, $40.4 million in 2006 and $38.7 million in 2005. Noninterest income, excluding these non-recurring items, increased $0.8 million, or 2.0%, in 2007 and increased $1.7 million, or 4.5%, in 2006. The increase in 2007, compared to 2006, was primarily attributable to increases in trust and investment services revenue, ATM and network user fees, investment fees and mortgage banking revenue being partially offset by a decline in service charges on deposit accounts and other miscellaneous income. The increase in 2006, compared to 2005, was primarily attributable to increases in service charges on deposit accounts, other fees for customer services and investment fees.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

OPERATING EXPENSES

 

Total operating expenses were $104.7 million in 2007, $97.9 million in 2006 and $98.5 million in 2005.

 

The following schedule includes the major categories of operating expenses during the past three years:

 

TABLE 8. OPERATING EXPENSES