CHEMICAL

FINANCIAL CORPORATIONSM

 

2008

Annual Report

to Shareholders

 

      

CHEMICAL FINANCIAL CORPORATION

 

 

2008 ANNUAL REPORT TO SHAREHOLDERS

 

 

SAFE HARBOR STATEMENT

 

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. All of the information concerning interest rate sensitivity in Management’s Discussion and Analysis under the subheadings “Liquidity Risk” and “Market Risk” is forward-looking. Management’s determination of the provision and allowance for loan losses involves judgments that are inherently forward-looking. 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, 2008, 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 (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 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’s branches are located and the areas immediately surrounding those communities. As of December 31, 2008, the Corporation operated through one subsidiary bank, Chemical Bank, headquartered in Midland, Michigan, serving 90 communities through 129 banking offices and 3 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. Chemical 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 72% of total revenue in 2008, 71% of total revenue in 2007 and 72% of total revenue in 2006. Interest on investment securities is also a significant source of revenue, accounting for 10% of total revenue in 2008, 2007 and 2006. Business volumes are influenced by overall economic factors including market interest rates, business and consumer spending, consumer confidence and competitive conditions in the marketplace.

 

RECENT MARKET DEVELOPMENTS

 

In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was signed into law. The EESA created the Troubled Asset Relief Program (TARP), under which the United States Department of the Treasury (Treasury) was given the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.

 

In October 2008, the Treasury announced that it would purchase equity stakes in a wide variety of banks and thrifts. Under the program, known as the Capital Purchase Program (CPP), the Treasury made $250 billion of the $700 billion authorized under TARP available to U.S. financial institutions through the purchase of preferred stock. In conjunction with the purchase of preferred stock, the Treasury received, from participating financial institutions, warrants to purchase common stock with an aggregate market price equal to 15% of the preferred stock investment. Participating financial institutions were required to agree to restrictions on future dividends and share repurchases during the period in which the preferred stock remained outstanding. On December 18, 2008, the Corporation announced that it had elected not to accept the $84 million capital investment approved by the Treasury as part of the CPP. The board of directors and management of the Corporation determined that the potential dilution to the Corporation’s shareholders and various restrictions outweighed any potential benefits from the Corporation’s participation in the CPP.

 

In November 2008, the Board of Directors of the Federal Deposit Insurance Corporation (FDIC) adopted a final rule relating to the Temporary Liquidity Guarantee Program (TLGP). The TLGP was announced by the FDIC on October 14, 2008, as an initiative to counter the system-wide crisis in the nation’s financial sector. Under the TLGP, the FDIC will (i) guarantee, through the earlier of maturity or June 30, 2012, certain newly-issued senior unsecured debt issued by participating institutions on or after October 14, 2008, and through June 30, 2009 and (ii) provide full FDIC deposit insurance coverage for noninterest bearing transaction deposit accounts, Negotiable Order of Withdrawal (NOW) accounts paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts held at participating FDIC-insured institutions through December 31, 2009. Coverage under the TLGP was available for the first 30 days without charge. The fee assessment for coverage of senior unsecured debt ranges from 50 basis points to 100 basis points per annum, depending on the initial maturity of the debt. The fee assessment for deposit insurance coverage is an annualized 10 basis points assessed quarterly on amounts in covered accounts exceeding $250,000. On December 4, 2008, the Corporation elected to participate in both guarantee programs.

 

At December 31, 2008, the Corporation held $16.2 million of Federal Home Loan Bank of Indianapolis (FHLB) stock and $116.1 million of senior bonds that were issued by all of the Federal Home Loan Banks. There are 12 regional banks that make up the Federal Home Loan Bank System (FHLBanks). There was no impairment of the FHLB stock or FHLBanks senior bonds held by the

Corporation at December 31, 2008. FHLBanks are government-sponsored enterprises created by Congress to ensure access to low-cost funding for their member financial institutions. During January 2009, a number of the regional banks in the Federal Home Loan Bank System publicly announced that they could incur significant other-than-temporary losses on their private-label mortgage-backed securities due to the dramatic decline in interest rates during 2008. In response, Moody’s issued a special comment in January 2009 indicating their rating of FHLBanks was “likely to remain unchanged” due to the expectation that these banks have a very high degree of government support. However, if the financial condition or results of operations of the FHLB or FHLBanks materially adversely changes, the Corporation could be subject to recording impairment of the recorded cost of $16.2 million of the FHLB stock and $116.1 million of FHLBanks senior bonds. The financial condition of the FHLB could also potentially impact the future liquidity available to the Corporation through its borrowings with the FHLB.

 

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) and follow general practices within the industry in which the Corporation operates. Application of these principles requires management to make estimates, assumptions and complex 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; accordingly, as this information changes, the consolidated financial statements could reflect different estimates, assumptions and judgments. Actual results could differ significantly from those estimates. 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 1 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, and the evaluation of goodwill impairment to be the 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. Management reviews its critical accounting policies with the Audit Committee of the board of directors at least annually.

 

In 2008, it was determined that the accounting estimates related to the capitalization and valuation of real estate mortgage loan servicing rights (MSRs) did not have a material impact on the Corporation’s financial condition or operating performance and, therefore, has been removed from this disclosure. See Note 9 to the consolidated financial statements for disclosures regarding MSRs.

 

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 (valuation allowances), (ii) allocations established for adversely-rated commercial, real estate commercial and real estate construction-commercial loans and nonaccrual real estate residential and nonaccrual consumer loans, (iii) allocations on all other loans based principally on the most recent three years of 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 defined methodology to quantify the necessary allowance and related provision for loan losses, but there can be no assurance that the methodology 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, 2008. Note 1 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, 2008, 2007 and 2006, 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, 2008, 2007 and 2006, the discount rate was established at 6.50%, 6.50% and 6.00%, respectively, 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 following rates of return by asset class were considered in setting the assumptions for long-term return on pension plan assets:

 

 

The assumed long-term return on pension plan assets is developed through an analysis of forecasted rates of return by asset class and forecasted asset allocations. It 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 Corporation’s projection of the long-term return on pension plan assets was 7% in 2008, 2007 and 2006.

 

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 2009 pension expense for the defined benefit pension plan are a discount rate of 6.50%, a long-term rate of return on pension plan assets of 7% and a rate of compensation increase of 4.25%. Pension expense in 2009 is expected to be approximately $0.6 million, the same as 2008. In 2009, an increase in the discount rate of 50 basis points was estimated to reduce pension expense by less than $0.1 million and a decrease in the discount rate of 50 basis points was estimated to increase pension expense by $0.3 million.

 

There are uncertainties associated with the underlying key actuarial assumptions, and the potential exists for significant, and possibly material, impacts on either or both the results of operations and 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 is 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 projected 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 defined benefit pension plan incurred net unrealized losses during 2008 of $17 million, which was the primary reason for a decline in the value of pension plan assets of $17.5 million, or 22%, during the year. The adverse impact of the decline in the value of pension plan assets during 2008 had an adverse impact on shareholders’ equity at December 31, 2008. The impact of SFAS 158 on the statements of financial position at December 31, 2008 and 2007 is included in Note 17 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 subsidiaries 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 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 tax rate 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, 2008 and 2007, there were no federal income tax reserves recorded based on the regular reassessment of required tax accruals for these uncertain tax positions.

 

Goodwill

 

At December 31, 2008, the Corporation had $69.9 million of goodwill recorded on the consolidated statement of financial position. 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. In addition, the Corporation’s goodwill impairment assessment is reviewed annually, as of September 30, by an independent third-party appraisal firm 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 value of the Corporation’s subsidiary bank was measured utilizing the market and income approaches as prescribed in SFAS No. 157, “Fair Value Measurements” (SFAS 157), with a 75% weighting given to the income approach. SFAS 157 identifies the cost approach as another acceptable method; however, the cost approach was not deemed an effective method to value a financial institution. The cost approach estimates value by adjusting the reported values of assets and liabilities to their market values. It is the Corporation’s opinion that financial institutions cannot be liquidated in an efficient manner. Estimating the fair market value of loans is a very difficult process and subject to a wide margin of error unless done on a loan by loan basis. Voluntary liquidations of financial institutions are not typical. More commonly, if a financial institution is liquidated, it is due to being taken over by the FDIC. The value of the Corporation’s subsidiary bank was based on the going concern method and not as a liquidation. The income approach uses valuation techniques to convert future amounts (cash flows or earnings) to a single, discounted amount. The income approach includes present value techniques; option-pricing models, such as the Black-Scholes-Merton formula and lattice models, and the

multi-period excess-earnings method. In the valuation of the Corporation’s subsidiary bank, the income approach utilized the discounted cash flow method based upon a forecast of growth and earnings. Cash flows are measured by using projected earnings, projected dividends and dividend paying capacity over a five-year period. In addition to estimating periodic cash flows, an estimate of residual value is determined through the capitalization of earnings. The income approach assumed cost savings and earnings enhancements that a strategic acquiror would likely implement based upon typical market participant assumptions of market transactions. The discount rate is critical to the discounted cash flow analysis. The discount rate reflects the risk of uncertainty associated with the cash flows and a rate of return that investors would require from similar investments with similar risks. A discount rate of 13.5% was utilized in the income approach. The market approach uses observable prices and other relevant information that are generated by market transactions involving identical or comparable assets or liabilities. The fair value measure is based on the value that those transactions indicate utilizing both financial and operating characteristics of the companies sold or merged. Two of the more significant financial ratios analyzed in completed transactions included price to latest twelve months earnings and price to tangible book value. The market approach utilized a price to latest twelve months earnings ratio of 25 times and a price to tangible book value of 170%. The fair value of the Corporation’s subsidiary bank was determined to be slightly above the income approach and in the low to middle of the market approach to value range. The weighted average of the fair values determined under the income and market approaches was a discount compared to the market capitalization of the Corporation at the valuation date. The Corporation is publicly traded and, therefore, The Nasdaq Stock Market^® establishes the marketable minority value. This does not necessarily represent the fair value of the reporting unit as a whole. The results of the valuation analysis concluded that the fair value of the Corporation’s subsidiary bank was greater than its book value, including goodwill, and thus no goodwill impairment was evident at the valuation date of September 30, 2008. The Corporation determined that no triggering events occurred that indicated potential impairment of goodwill from the valuation date through December 31, 2008. The Corporation believes that the assumptions utilized were reasonable. 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, 2008, 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, 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.

 

NET INCOME

 

Net income in 2008 was $19.8 million, or $0.83 per diluted share, net income in 2007 was $39.0 million, or $1.60 per diluted share, and net income in 2006 was $46.8 million, or $1.88 per diluted share. Net income in 2008 represented a 49.1% decrease from 2007 net income, while 2007 net income represented a 16.7% decrease from 2006 net income. Net income per share in 2008 was 48.1% less than in 2007, while net income per share in 2007 was 14.9% less than in 2006. The decrease in net income in 2008 was primarily attributable to a significant increase in the provision for loan losses that was only partially offset by an increase in net interest income. 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 Corporation’s return on average assets was 0.52% in 2008, 1.03% in 2007 and 1.24% in 2006. The Corporation’s return on average shareholders’ equity was 3.9% in 2008, 7.7% in 2007 and 9.2% in 2006.

 

ASSETS

 

Average assets were $3.78 billion during 2008, a decrease of less than $1 million from average assets during 2007 of $3.79 billion. 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.

INVESTMENT SECURITIES

 

The Corporation’s investment securities portfolio historically has been relatively short-term in nature. Information about the Corporation’s investment securities portfolio is summarized in Tables 1 and 2.

 

TABLE 1. MATURITIES AND YIELDS* OF INVESTMENT SECURITIES AT DECEMBER 31, 2008

 

 

 

TABLE 2. SUMMARY OF INVESTMENT SECURITIES

 

 

The Corporation records all investment securities in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” (SFAS 115) under which the Corporation is required to assess equity securities with readily determinable fair values and debt securities that have fair values below amortized cost basis to determine whether the decline (impairment) is other-than-temporary. Impairment is other-than-temporary if the assessment concludes that it is probable that the holder will be unable to collect all amounts due according to the contractual terms of the debt instrument. SFAS 115 permits the use of reasonable management judgment of the probability that the holder will or will not be able to collect all amounts due. In addition, SFAS 115 also requires that the holder must have the intent and ability to hold the security to recovery for an impairment to be deemed temporary and not require a charge to earnings. In addition, FASB Staff Position (FSP) 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” clarified that an investor should recognize an impairment loss in the period that the impairment is deemed other-than-temporary.

 

The accounting guidance does not provide for an automatic conclusion that a security does not have other-than-temporary impairment (OTTI) because all of the scheduled payments to date have been received. Further analysis and judgment are required to assess whether a decline in fair value is temporary and that it is probable that the holder will collect all of the contractual or estimated cash flows from the investment security. Further, the Securities and Exchange Commission (SEC) Staff Accounting Bulletin Topic 5M, “Other-than-Temporary Impairment of Certain Investments in Debt and Equity Securities,” states that the length of time and extent to which the fair value has been less than cost can indicate a decline is other-than-temporary. The longer and/or the more severe the decline in fair value, the more persuasive the evidence that is needed to overcome the premise that the holder will not collect all of the contractual or estimated cash flows from the investment security. Accordingly, in making an OTTI assessment, the holder is to consider all available information relevant to the collectibility of the investment security, including information about past events, current conditions and reasonable and supportable forecasts, when developing the estimate of future cash flows. The accounting literature also recommends the holder consider industry analyst reports and forecasts, sector credit ratings and other market data that are relevant to the collectibility of the investment security.

 

The Corporation’s investment securities portfolio had a carrying value of $547.5 million at December 31, 2008, with gross impairment of $10.8 million as of that date. The Corporation concluded that at December 31, 2008 the impairment was temporary. A further discussion of the impairment and the Corporation’s process that resulted in the conclusion that the impairment was temporary follows.

 

At December 31, 2008, the Corporation’s investment securities portfolio included U.S. Treasury and government sponsored agency securities that had no impairment, state and political subdivisions securities with gross impairment of $1.17 million, mortgage-backed securities and collateralized mortgage obligations, combined, with gross impairment of $0.59 million, corporate bonds with gross impairment of $2.40 million and trust preferred securities with gross impairment of $6.67 million. The carrying values and fair values of investment securities are disclosed in Note 4 to the consolidated financial statements.

The state and political subdivisions held-to-maturity investment securities portfolio totaling $85.5 million at December 31, 2008 was recorded at amortized cost. The majority of these investment securities are from issuers primarily located in the state of Michigan and are general obligations of the issuer, meaning that the Corporation has the first claim on taxes collected for the repayment of the investment securities. Of the total $85.5 million, investment securities totaling $34.1 million had gross impairment of $1.17 million at December 31, 2008. The majority of the investment securities with impairment mature beyond 2016 and, due to the steepness of the interest yield curve at December 31, 2008, the Corporation determined that the impairment of $1.17 million at December 31, 2008 was attributable to the change in market interest rates and that the impairment was temporary in nature. The Corporation has the intent and ability to hold these impaired investment securities to maturity.

 

The mortgage-backed securities and collateralized mortgage obligations, combined in the available-for-sale investment securities portfolio, had an amortized cost of $204.7 million, with gross impairment of $0.59 million at December 31, 2008. Virtually all of the impaired investment securities in these two categories are backed by an explicit guarantee of the U.S. government. The Corporation assessed the impairment on these investment securities at December 31, 2008 and determined the impairment was attributable to the general decline in market interest rates and the impairment on these investment securities at that date was temporary in nature. The Corporation has the intent and ability to hold these impaired investment securities to maturity.

 

At December 31, 2008, the Corporation’s corporate bond portfolio had an amortized cost of $47.5 million, with gross impairment of $2.40 million. Fair values of 90% of the corporate bonds were below amortized cost at December 31, 2008. All of the corporate bonds held at December 31, 2008 were of an investment grade, except one single issue investment security, Lehman Brothers Holdings Inc., for which the Corporation recognized an OTTI loss of $0.4 million in the third quarter of 2008. The Corporation’s remaining amortized cost of the Lehman Brothers Holdings Inc. bond was less than $0.1 million at December 31, 2008. The investment grade ratings obtained for the balance of the corporate bond portfolio indicated that the obligors’ capacities to meet their financial commitments was “strong.” The majority of the impairment existing at December 31, 2008 was attributable to two corporate bonds from one issuer with a combined amortized cost/par value of $2.7 million that had impairment of $1.6 million, or 68%, of the total impairment on corporate bonds at that date. Both corporate bonds are senior unsecured obligations of American General Finance Corporation (AGFC), a wholly-owned subsidiary of American General Finance Inc. (AGFI), which is wholly-owned indirectly by American International Group (AIG). The amortized cost/par value amounts of the bonds were $0.2 million and $2.5 million with maturity dates of September 1, 2010 and December 15, 2011, respectively.

 

The Corporation performed an assessment of the probability that it would collect all of the contractual amounts due under the two AGFC corporate bonds at December 31, 2008. Ratings from Moody’s, Standard & Poor’s and Fitch were Baa1, BBB and BBB, respectively, at December 31, 2008. AGFC was downgraded by each of these rating services twice during 2008 (the most recent downgrade occurred on November 10, 2008), although all of these rating services indicated, through the assignment of their ratings, that the issuer appeared to have a strong ability to pay its financial obligations in the intermediate term and supports an investment grade rating.

 

The public filing of AGFC’s Form 10-Q with the SEC for the period ended September 30, 2008 indicated AGFC had suffered a financial loss of $496 million in the third quarter of 2008 and $558 million during the nine months ended September 30, 2008; however, AGFC’s total equity at September 30, 2008 was $2.8 billion, or 9.6% of total assets. AGFC’s own assessment of its financial condition at September 30, 2008 indicated that, after consideration of many factors, although primarily due to its ability to obtain funding from its parent company and its ability to severely reduce originations of finance receivables, AGFC believed it would have adequate liquidity to finance and operate its businesses and repay its obligations for at least the next twelve months. However, it is possible that the actual outcome of one or more of AGFC’s significant judgments or estimates could prove to be materially incorrect and AGFC may not have sufficient cash to meet its obligations in the future. A $0.1 million AGFC bond owned by the Corporation that matured on October 15, 2008 was paid in full on that date.

 

At December 31, 2008, the Corporation believed it was probable, as defined by SFAS 115, that it would receive all contractual cash flows of its corporate bond portfolio and determined that the impairment on the corporate bond portfolio at that date was temporary in nature. The Corporation has the intent and ability to hold these impaired investment securities to maturity.

 

At December 31, 2008, the Corporation owned $10.5 million of trust preferred securities that had gross impairment of $6.67 million. Of the $10.5 million balance, $10 million represented a 100% interest in a trust preferred security (TRUP) of a small non-public bank holding company in Michigan (issuer) that was purchased in the second quarter of 2008. At December 31, 2008, the Corporation determined the fair value of the TRUP was $3.65 million. The fair value measurement was developed based upon market pricing observations of much larger banking institutions in an illiquid market adjusted by risk measurements. The fair value of the TRUP was based on a calculation of discounted cash flows, based upon both observable inputs and appropriate risk adjustments that market participants would make for performance, liquidity and issuer specifics. See the additional discussion of the development of the fair value of the TRUP in Note 14 to the consolidated financial statements.

Management reviewed non-audited financial information of the issuer of the TRUP at December 31, 2008, including nonperforming asset information and Tier I capital/risk-weighted assets ratios. Based on this review, the Corporation concluded that the significant decline in fair value of the TRUP, compared to its amortized cost, was not attributable to adverse conditions specifically related to the issuer. At December 31, 2008, it was the Corporation’s opinion that the issuer appeared well positioned to continue to realize positive net income in 2009. The issuer had consistent earnings in 2007 and 2008 and, at December 31, 2008, had equity capital of $50 million, a liquidity position of $160 million in investment securities held as available-for-sale and additional borrowing capacity of approximately $100 million through the FHLB. Based on the Corporation’s analysis at December 31, 2008, it was the Corporation’s opinion that the issuer appeared to be a financially sound institution with ample liquidity to meet all of its financial obligations in 2009. This TRUP is not independently rated and, therefore, there was no published downgrade of the investment during 2008. Industry bank ratings, obtained from the issuer, indicated the issuer was defined as “sound.” Common stock cash dividends were paid throughout 2008 by the issuer and the issuer’s management anticipates cash dividends to be paid in 2009 and beyond. All scheduled interest payments on the TRUP were made on a timely basis in 2008. The principal of $10 million of the TRUP matures in 2038, with interest payments due quarterly.

 

Based on the information provided by the issuer, as of December 31, 2008, it was the Corporation’s opinion that there had been no adverse changes in the issuer’s financial performance since the TRUP was issued and purchased by the Corporation and no indication that any adverse trends were developing that would suggest that the TRUP would be unable to make all future principal and interest payments. Further, based on the information provided, the issuer appeared to be a financially viable financial institution with both the credit quality and liquidity necessary to meet all financial obligations in 2009. At December 31, 2008, the Corporation was not aware of any regulatory issues, memorandums of understanding or cease and desist orders that had been issued to the issuer or its subsidiaries. In reviewing all available information regarding the issuer reflecting past performance and its financial and liquidity position, it was the Corporation’s opinion that the future cash flows of the issuer supported the carrying value of the TRUP at its original cost of $10 million at December 31, 2008. There can be no assurance that other-than-temporary impairment losses will not be recognized on TRUPs or any other investment security in the future. While the fair value of the TRUP was $6.35 million below the Corporation’s carrying value (original cost) at December 31, 2008 and the TRUP was impaired, it was the Corporation’s assessment that the overall financial condition of the issuer did not indicate permanent or other-than-temporary impairment of the TRUP and that the unrealized loss was temporary at December 31, 2008. The Corporation has the intent and ability to hold this impaired investment security to maturity.

 

DEPOSITS

 

Total deposits at December 31, 2008 were $2.98 billion, an increase of $103.2 million, or 3.6%, from total deposits at December 31, 2007 of $2.88 billion. Total deposits increased $22.5 million, or 0.8%, during 2007. The increase in total deposits in 2008 was primarily attributable to a fourth quarter increase in business and non-retail money market deposit accounts with no defined maturities.

 

The Corporation’s average deposit balances and average rates paid on deposits for the past three years are included in Table 3. Average total deposits in 2008 were $2.92 billion, an increase of $1.4 million over average deposits in 2007. Average total deposits in 2007 were $2.92 billion, an increase of $61.1 million, or 2.1%, over average deposits in 2006. There was no significant growth or change in the mix of average deposits during 2008 or 2007, nor did the Corporation have any brokered deposits as of December 31, 2008 or 2007.

 

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 strong competition impeded the Corporation’s ability to internally generate deposits during the three years ended December 31, 2008. As was publicized nationwide during 2008, many of the Corporation’s competitor banks in its local markets faced liquidity issues and concerns that resulted in their necessity to increase deposits by offering above market interest rates. This activity created a difficult environment for the Corporation to increase deposits without adversely impacting the weighted average cost of deposits. The Corporation had ample liquidity in 2008, and therefore, did not seek new deposits at above market interest rates.

 

The growth of the Corporation’s deposits is also impacted by competition from other investment products, such as 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 its CFC Investment Center program, offers a wide array of mutual funds, annuity products and marketable securities through an alliance with an independent, registered broker/dealer. During 2008 and 2007, customers purchased $106 million and $82 million, respectively, of annuity products, mutual fund and other investments through the CFC Investment Center program.

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 2008, cash dividends paid per share were $1.18, up 3.5% over cash dividends paid per share in 2007 of $1.14.

 

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, 2008 was 4.4% and 6.5%, respectively. The earnings of the Corporation’s subsidiary bank, Chemical Bank, have been the principal source of funds to pay cash dividends to shareholders. Over the long-term, cash dividends to shareholders are dependent upon earnings, as well as capital requirements, regulatory restraints and other factors affecting Chemical Bank. Due to the strength of the Corporation’s capital position, the parent company has the ability to continue to pay cash dividends to shareholders in excess of the earnings of Chemical Bank. The length of time the parent company can sustain cash dividends to shareholders in excess of the current earnings of Chemical Bank is dependent on the magnitude of any earnings shortfall and the capital levels of both Chemical Bank and the Corporation.

 

NET INTEREST INCOME

 

Interest income is the total amount earned on funds invested in loans, investment and other securities, federal funds sold and other interest-bearing deposits. Interest expense is the amount of interest paid on interest-bearing checking and savings accounts, time deposits, short-term borrowings and FHLB advances. 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 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 $2.37 million, $2.25 million and $2.11 million for 2008, 2007 and 2006, respectively. These adjustments were computed using a 35% federal income 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 both credit risk and 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.”

 

Table 3 presents for 2008, 2007 and 2006 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 2008, 2007 and 2006 was $147.6 million, $132.3 million and $134.3 million, respectively. Net interest income (FTE) in 2008 was $15.3 million, or 11.6%, higher than 2007 net interest income (FTE) of $132.3 million, although net interest income (FTE) in 2007 was $2.0 million, or 1.5%, lower than 2006 net interest income (FTE) of $134.3 million. The increase in net interest income (FTE) in 2008 was primarily attributable to the positive impact of lower short-term interest rates reducing interest expense more than interest income and to a lesser extent attributable to the growth in loans. The decrease in short-term market interest rates reduced the average cost of interest-bearing liabilities significantly more than the average yield on loans and investment securities throughout 2008, as the loan portfolio is comprised primarily of fixed interest rate loans. At December 31, 2008 and 2007, approximately 79% and 81%, respectively, of the Corporation’s loans were at fixed interest rates.

TABLE 3. AVERAGE BALANCES, TAX EQUIVALENT INTEREST AND EFFECTIVE YIELDS AND RATES* (Dollars in thousands)

 

 

 

In 2008, the Federal Open Market Committee (FOMC) lowered the Federal Funds rate seven times throughout the year for a total reduction of 425 basis points, which resulted in an equal decline each time in the prime rate, except for the last decline which lowered the effective Federal Funds rate 25 basis points more than the prime rate. The Federal Funds rate was effectively near 0% on December 31, 2008, compared to 4.25% on December 31, 2007. The prime rate was 3.25% on December 31, 2008, compared to 7.25% on December 31, 2007. The ten-year U.S. Treasury note, which is generally used to price both 15- and 30-year residential mortgage loans, was 2.25% at the end of 2008, compared to 4.04% at the end of 2007.

 

Net interest margin was 4.16% in 2008, compared to 3.73% in 2007. The increase in net interest margin during 2008, compared to 2007, was primarily attributable to the decrease in the average cost of interest-bearing liabilities significantly exceeding the decrease in the average yield on interest-earning assets. During 2008, the average cost of interest-bearing liabilities decreased 119 basis points to 2.33%, while the average yield on interest-earning assets decreased 49 basis points to 5.93%. The significant decrease in the cost of interest-bearing liabilities was attributable to the overall decrease in short-term market interest rates in 2008. The yield on the Corporation’s loan portfolio decreased only 54 basis points in 2008, compared to 2007, due to the loan portfolio being comprised predominately of fixed interest rate loans or loans with interest rates fixed for at least five years. The increase in the net interest margin was also positively impacted by an increase in average loans of $67.3 million, or 2.4%, during 2008. The net interest margin was slightly adversely impacted in 2008 due to an increase in nonaccrual loans of $20.9 million, or 37.5%, during the year to $76.5 million at December 31, 2008.

 

Table 4 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.

TABLE 4. VOLUME AND RATE VARIANCE ANALYSIS* (In thousands)

 

 

 

The $15.3 million increase in net interest income (FTE) in 2008, as compared to 2007, is analyzed in detail in Table 4. The increase in net interest income (FTE) during 2008 was mostly attributable to the reduction in the average cost of interest-bearing liabilities significantly exceeding the reduction in the average yield on interest-earning assets. The favorable effect of an increase in average loans of $67.3 million represents the majority of the increase in net interest income (FTE) attributable to average volume. The positive impact attributable to the increase in loans was partially offset by the adverse impact of modest changes in the mix of customer deposit accounts from lower-cost transaction and savings accounts to higher-cost money market savings accounts. The Corporation’s balance sheet was liability sensitive throughout 2008, with a significantly 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 2007, the 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, resulting from the lagging impact of short-term market interest rates increasing in 2006. 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 increase in the cost of interest-bearing liabilities was attributable to a combination of factors, including the lagging impact of the increase in market interest rates during 2006 on certificates of deposit, 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 changed only moderately 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 during 2007 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.

 

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. At December 31, 2008, the Corporation’s loan portfolio was $2.98 billion and consisted of loans to commercial borrowers (commercial, real estate commercial and real estate construction-commercial) totaling $1.46 billion, or 49% of total loans, loans to consumer borrowers for the purpose of acquiring residential real estate (real estate construction-residential and real estate residential) totaling $869 million, or 29% of total loans, and loans to consumer borrowers secured by various types of collateral totaling $649 million, or 22% of total loans, at that date. Loans at fixed interest rates comprised 79% of the Corporation’s loan portfolio at December 31, 2008, compared to 81% at December 31, 2007. The Corporation maintains loan policies and credit underwriting standards as part of the process to manage credit risk. Underwriting standards are designed to promote relationship banking rather than transactional banking. These standards include providing 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. The total commercial loan portfolio of $1.46 billion at December 31, 2008 included 63 loan relationships of $2.5 million and greater. These 63 borrowing relationships totaled $320 million and represented 22% of the total commercial loan portfolio at December 31, 2008. Further, at December 31, 2008, only four of these borrowing relationships were $10 million or higher, totaling $53.3 million, or 3.6%, of the commercial loan portfolio as of that date. The remaining commercial loan portfolio totaling $1.14 billion at December 31, 2008 consisted of approximately 5,900 relationships. 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 5 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 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 a material adverse economic impact in any one industry.

 

Table 5 includes the composition of the Corporation’s loan portfolio, by major loan category, as of December 31, 2008, 2007, 2006, 2005 and 2004.

 

TABLE 5. SUMMARY OF LOANS

 

 

Total loans at December 31, 2008 were $2.98 billion, an increase of $182 million, or 6.5%, from total loans at December 31, 2007, compared to a slight decrease in loans of $8 million, or 0.3%, during 2007 and a $101 million, or 3.7%, increase in total loans during 2006.

The Corporation’s lending markets are all within the state of Michigan where the economy has been in a recession for a number of years. The recession in Michigan during most of 2008 has been characterized as severe and was exacerbated by the economic impact of a struggling automotive industry. However, the Corporation’s lending opportunities were strong throughout 2008 and resulted in the largest amount of loan growth measured in both dollars and percentages during the four years ended December 31, 2008. A significant portion of the loan growth in 2008 was attributable to the Corporation’s competitor banks intentionally reducing their lending efforts due to liquidity concerns. Additionally, during the second half of 2008, as the captive automotive finance companies largely exited the leasing business and significantly changed their underwriting standards, the Corporation experienced a significant increase in new auto loan origination opportunities. A summary of the changes in the loan portfolio by category follows.

 

Commercial loans totaled $587.5 million at December 31, 2008, an increase of $72.2 million, or 14.0%, from total commercial loans at December 31, 2007 of $515.3 million. The growth in commercial loans during 2008 was attributable to a combination of an increase in loan balances of existing customers and loans to new customers. These increases arose throughout the Corporation’s lending markets and across a range of different industries. Commercial loans decreased $30.3 million, or 5.5%, during 2007 from total commercial loans at December 31, 2006 of $545.6 million. Commercial loans represented 19.7%, 18.4% and 19.4% of total loans outstanding at December 31, 2008, 2007 and 2006, respectively.

 

Real estate loans include real estate commercial loans, real estate construction loans and real estate residential loans. At December 31, 2008, 2007 and 2006, real estate loans totaled $1.74 billion, $1.73 billion and $1.71 billion, respectively. Real estate loans increased $11.2 million, or 0.6%, in 2008 and $26.0 million, or 1.5%, in 2007. Real estate loans as a percentage of total loans at December 31, 2008, 2007 and 2006 were 58.5%, 62.0% and 60.9%, respectively.

 

Real estate commercial loans increased $26.0 million, or 3.4%, during 2008 to $786.4 million at December 31, 2008. Real estate commercial loans increased $33.8 million, or 4.7%, during 2007 to $760.4 million at December 31, 2007. At December 31, 2008, 2007 and 2006, real estate commercial loans as a percentage of total loans were 26.4%, 27.2% and 25.9%, 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. Real estate commercial loans are loans secured by real estate occupied by the borrower for ongoing operations and non-owner occupied real estate leased to one or more tenants. At December 31, 2008, approximately 74% of the outstanding balance of the Corporation’s real estate commercial loans were secured by owner-occupied properties. Real estate commercial lending also includes loans to residential and commercial developers for the purchase of vacant land that is intended to be developed and land development loans. Land development loans are loans made to residential and commercial developers for infrastructure improvements to create finished marketable lots for residential or commercial construction. Vacant land loans are also made to borrowers for investment purposes. Commercial and real estate commercial lending typically involves larger loan balances concentrated in a single borrower. In addition, the payment experience on loans secured by income-producing properties, vacant land and land development loans are typically dependent on the success of the operation of the related project and are 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 prudent loan-to-value ratios in the underwriting process.

 

Real estate construction loans are originated for both business and residential properties, including development. These loans often convert to a real estate commercial or real estate residential loan at the completion of the construction period, however, most development loans are originated with the intention that the loans will be paid through the sale of finished properties by the developers within twelve months of the completion date. The severe recession in Michigan has resulted in the inability of most developers to sell their finished developed lots and units within their original expected time frames. Further, few of the Corporation’s development borrowers sold developed lots or units during 2008 due to the poor economic environment. Real estate construction loans made to consumers are for the construction of single family residences and are secured by these properties. Real estate construction loans to consumers at December 31, 2008 and December 31, 2007 were $29.3 million and $42.0 million, respectively. Total real estate construction loans were $119.0 million at December 31, 2008, a decrease of $15.9 million, or 11.7%, from December 31, 2007. The decrease in real estate construction loans was partially attributable to the lack of residential housing development lending during 2008, as it has been well publicized nationwide that this industry over expanded during the last few years. Business expansion and development continued at a historically low rate during 2008 across all of the Corporation’s market areas due to the recessionary economic environment within the state of Michigan. Real estate construction loans were $134.8 million at December 31, 2007, a decrease of $11.1 million, or 7.6%, from December 31, 2006. At December 31, 2008, 2007 and 2006, real estate construction loans as a percentage of total loans were 4.0%, 4.8% and 5.2%, respectively.

 

Real estate 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 prudent underwriting guidelines and closely

monitoring the construction process. The Corporation’s risk in this area increased during 2008 as the sale of units in residential real estate development projects slowed significantly, as customer demand significantly decreased and the inventory of unsold housing units increased across the state of Michigan.

 

Table 6 presents the maturity distribution of commercial, real estate commercial and real estate construction loans. These loans totaled $1.49 billion at December 31, 2008, compared to $1.41 billion at December 31, 2007 and represented 50% of total loans at December 31, 2008 and 2007. The percentage of these loans maturing within one year was 36% at December 31, 2008, compared to 38% at December 31, 2007. The percentage of these loans maturing beyond five years remained low at 9% at both December 31, 2008 and 2007. At December 31, 2008 and 2007, commercial, real estate commercial and real estate construction loans with maturities beyond one year totaled $962 million and $875 million, respectively, and were comprised of 91% and 90%, respectively, of loans at fixed interest rates.

 

TABLE 6. COMPARISON OF LOAN MATURITIES AND INTEREST SENSITIVITY (Dollars in thousands)

 

 

 

Real estate residential loans increased $1.1 million, or 0.1%, during 2008 to $839.6 million at December 31, 2008. The increase in real estate residential loans was low, compared to the growth in other loan categories, as the housing market across the state of Michigan was extremely weak throughout 2008. Real estate residential loans increased $3.3 million, or 0.4%, during 2007 to $838.5 million at December 31, 2007. At December 31, 2008, 2007 and 2006, real estate residential loans as a percentage of total loans were 28.1%, 30.0% and 29.8%, respectively.

 

The Corporation’s real estate residential loans primarily consist of one- to four-family residential loans with original fixed interest rates of fifteen years or less. 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 have private mortgage insurance. At December 31, 2008, the Corporation had $52.2 million in real estate residential loans, or 6.2%, of the real estate residential loan portfolio that had private mortgage insurance.

 

The Corporation’s general practice is to sell real estate residential loan originations with interest rates fixed for time periods greater than ten years in the secondary market. The Corporation originated $344 million of real estate residential loans during 2008 and sold $145 million of these originations in the secondary market, compared to the origination of $311 million in real estate residential loans during 2007 and the sale of $136 million of these originations in the secondary market.

 

At December 31, 2008, the Corporation was servicing $604 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, 2007 and December 31, 2006, the Corporation was servicing real estate residential loans for others in the amounts of $576 million and $558 million, respectively.

 

Consumer loans totaled $649.2 million at December 31, 2008, an increase of $98.9 million, or 18.0%, from total consumer loans at December 31, 2007 of $550.3 million. Consumer loans decreased $4.0 million, or 0.7%, during 2007. Consumer loans represented 21.8%, 19.6% and 19.7% of total loans outstanding at December 31, 2008, 2007 and 2006, 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. The Corporation originates consumer loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. Consumer loans are generally relatively small loan amounts that are spread across many individual borrowers, which minimizes the risk per loan transaction. Collateral values, particularly those of automobiles, recreational vehicles and boats, are negatively impacted by many factors, such as new car promotions, vehicle condition and even more significantly, overall economic conditions. Consumer loans also include home equity loans, whereby consumers utilize equity in their personal residence, generally through a second mortgage, as collateral to secure the loan. Credit risk in these types of loans has historically been low as property values of residential real estate have historically increased year over year. Credit risk on home equity loans increased during 2008 as property values declined an average of 15% throughout the state of Michigan, thus increasing the risk of insufficient collateral, and in some cases, no collateral available on these loans when the consumer is no longer able to make payments. At December 31, 2008, approximately 40% of consumer loans were secured by the borrowers’ personal residences, 25% by automobiles, 15% by recreational vehicles, 10% by marine vehicles and the remaining 10% was mostly unsecured. Consumer lending collections are dependent on the borrowers’ continuing financial stability, and thus are more likely to be affected by adverse personal situations. Overall, credit risk on these loans increases as the unemployment rate increases. The unemployment rate in the state of Michigan was over 10% at December 31, 2008, which was significantly higher than the national average of 7% at that date.

 

NONPERFORMING ASSETS

 

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. 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 $113.3 million at December 31, 2008, compared to $74.5 million at December 31, 2007, and $35.8 million at December 31, 2006 and represented 2.9%, 2.0% and 0.9%, respectively, of total assets. It is management’s opinion that the increase in nonperforming assets is largely attributable to the severe recessionary economic climate within Michigan, which has resulted in cash flow difficulties being encountered by many business and consumer loan customers. The unemployment rate in Michigan was over 10% at December 31, 2008, compared to 7% nationwide. The increase in the Corporation’s nonperforming assets was not concentrated in any one industry or any one geographical area within Michigan. In addition, the sizes of the commercial loan transactions are generally relatively small, which mitigates somewhat the risk of loss within the commercial loan portfolio due to the lack of loan concentration. At December 31, 2008, the Corporation had 63 commercial loan relationships of $2.5 million and greater that totaled $320 million and comprised 22% of commercial, real estate commercial and real estate construction-commercial loans at that date, with four loan relationships exceeding $10 million and totaling $53 million. The remaining commercial, real estate commercial and real estate construction-commercial loans totaling $1.14 billion at December 31, 2008 consisted of approximately 5,900 loan relationships. While it has been well publicized nationwide throughout 2008 that appraisal values of residential real estate have generally declined, the Corporation has also experienced declines in commercial real estate appraisals due to the weakness in the economy in Michigan. It is management’s assessment that as of December 31, 2008, for both real estate commercial and residential loans, the discounted loan-to-value ratios within the Corporation’s loan portfolio 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. Consistent with this definition, all nonaccrual loans (with the exception of nonaccrual real estate residential and nonaccrual consumer loans) are impaired. 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 $59.0 million at December 31, 2008, compared to $45.9 million at December 31, 2007 and $19.8 million at December 31, 2006. After analyzing the various components of the customer relationships and evaluating the underlying collateral of impaired loans, it was determined that impaired loans totaling $30.3 million at December 31, 2008 required a valuation allowance compared to $22.2 million of impaired loans at December 31, 2007 and $3.8 million of impaired loans at December 31, 2006. The valuation allowance on impaired loans was $9.2 million at December 31, 2008 compared to $4.6 million at December 31, 2007 and $0.9 million at December 31, 2006.

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

 

TABLE 7. NONPERFORMING ASSETS

 

 

Total nonperforming loans were $93.3 million, or 3.13%, of total loans at December 31, 2008, compared to $63.4 million, or 2.26%, of total loans at December 31, 2007. The increase in nonperforming loans occurred across all loan categories. The increase in the level of nonperforming loans in 2008 was largely attributable to the recessionary economic conditions in the state of Michigan and in the Corporation’s local markets that have been existent in the state of Michigan since 2006, only to have worsened in 2008 with no economic indications of improving in 2009. Commercial, real estate commercial and real estate construction nonperforming loans totaled $71.4 million at December 31, 2008, or 76%, of total nonperforming loans at that date. The majority of the Corporation’s net loan charge-offs during 2008 also occurred within these three loan categories, with 80% of net loan charge-offs in 2008 attributable to these three loan categories.

 

The following schedule provides the composition of nonperforming loans, by major loan category, as of December 31, 2008 and 2007.

 

Nonperforming real estate residential loans were $15.5 million at December 31, 2008, an increase of $5.5 million, or 56%, from total nonperforming real estate residential loans of $10.0 million at December 31, 2007. Nonperforming real estate residential loans represented 17% of nonperforming loans at December 31, 2008, compared to 16% at December 31, 2007. The increase in nonperforming real estate residential loans was attributable to a rise in delinquencies, bankruptcies and foreclosures primarily reflective of an increase in the unemployment rate in the state of Michigan.

 

Nonperforming consumer loans were $6.4 million at December 31, 2008, an increase of $2.8 million, or 76%, from total nonperforming consumer loans of $3.6 million at December 31, 2007. The increase in nonperforming consumer loans during 2008 was also primarily reflective of an increase in the unemployment rate in the state of Michigan.

 

The following schedule presents additional data related to nonperforming commercial, real estate commercial and real estate construction loans by dollar amount as of December 31, 2008 and 2007.

 

 

Nonperforming commercial loans of $18.0 million at December 31, 2008 were up $5.1 million, or 39%, from nonperforming commercial loans at December 31, 2007 of $12.9 million. The nonperforming commercial loans at December 31, 2008 were not concentrated in any single industry and it is management’s opinion that the increase in 2008 was primarily reflective of the recessionary economic conditions in Michigan.

 

The Corporation’s real estate commercial loan portfolio is comprised of commercial real estate, land development and vacant land loans. Real estate commercial loans are secured by real estate occupied by the borrower for ongoing operations and by non-owner occupied real estate leased to one or more tenants. Land development loans are secured by land that is being developed in terms of infrastructure improvements to create finished marketable lots for commercial or residential construction. Vacant land loans are secured by undeveloped land that has been acquired for future development or investment purposes. Nonperforming real estate commercial loans totaled $37.3 million at December 31, 2008, up $13.5 million, or 57%, from $23.8 million at December 31, 2007. At December 31, 2008, the Corporation’s nonperforming real estate commercial loans included a diverse mix of commercial lines of business and were also geographically disbursed throughout the Corporation’s market areas. The largest concentrations of the $37.3 million in nonperforming real estate commercial loans at December 31, 2008 were $3.5 million in loans secured by residential development real estate and loans totaling $5.7 million to one customer that were secured primarily by vacant land, which combined comprised 25% of nonperforming real estate commercial loans at that date. At December 31, 2008, $7.9 million of the nonperforming real estate commercial loans were in various stages of foreclosure with 27 borrowers. The Michigan economy remains weak, thus creating a difficult business environment for many lines of business across the state.

 

Real estate construction loans are comprised of loans in the construction phase to both commercial and consumer customers. Real estate construction loans made to commercial customers are secured by commercial real estate and includes commercial and residential real estate development projects that the customer intends to sell and commercial real estate that the customer intends to convert to income producing property or become owner-occupied. These loans also include 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. Real estate construction loans made to consumers are for the construction of single family residences and are secured by these properties.

 

Nonperforming real estate construction loans at December 31, 2008 were $16.1 million, up $3.1 million, or 24%, from $13.0 million at December 31, 2007. At December 31, 2008, $14.3 million of nonperforming real estate construction loans were secured by residential development real estate comprised of a combination of vacant land, improved lots and housing units. The economy in Michigan has significantly 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 lots and units.

 

At December 31, 2008, the Corporation had $68.9 million in residential development loans in various stages of completion, collateralized by a combination of vacant land, improved lots and housing units. These loans are included in the real estate commercial and real estate construction loan categories. At December 31, 2008, $17.7 million, or 26%, of residential development loans were nonperforming and are included in the nonperforming real estate commercial and nonperforming real estate construction loans discussed above.

 

Other real estate and repossessed assets is a component of nonperforming assets that primarily includes real property acquired through foreclosure or by acceptance of a deed in lieu of foreclosure, and also personal and commercial property held for sale. Other real estate and repossessed assets totaled $19.9 million at December 31, 2008, up $8.8 million, or 79%, from $11.1 million at December 31, 2007. The increase during 2008 was the result of the migration of nonperforming loans secured by real estate into other real estate as the foreclosure processes were completed, including the expiration of the redemption periods.

 

At December 31, 2008, other real estate and repossessed assets of $19.9 million was comprised of 29 commercial properties totaling $6.2 million, commercial development properties obtained from four developers totaling $1.6 million, 75 residential real estate properties totaling $7.0 million, 13 residential development projects totaling $4.7 million and other repossessions, including commercial equipment, automobiles, boats and recreational vehicles totaling $0.4 million.

 

The commercial properties totaling $6.2 million at December 31, 2008 included six properties with carrying values greater than $0.25 million that totaled $4.3 million, with two of these properties having carrying values exceeding $1.0 million that totaled $2.3 million. The residential properties totaling $7.0 million at December 31, 2008 included four properties with carrying values greater than $0.25 million that totaled $3.0 million, with one of these properties having a carrying value of $1.6 million. The residential development projects totaling $4.7 million were primarily concentrated in five projects totaling $4.1 million, or 87% of the total. These residential development projects are unfinished in varying stages of completion. The largest residential development project is a high-rise mixed use condominium building with eleven unsold residential units and a carrying value of $1.8 million. Only one unit has been sold in this project and that unit was sold in 2005. The carrying value of $1.8 million on the high-rise mixed use condominium building at December 31, 2008 was net of $1.2 million in fair value write-downs, including $0.7 million that occurred during 2008.

 

The historically large inventory of other real estate properties held for sale across the state of Michigan has resulted in an increase in the Corporation’s carrying time for other real estate. Consequently, the Corporation had $5.1 million in other real estate properties at December 31, 2008 that had been held in excess of one year as of that date. Due to severe economic conditions in the state of Michigan, management estimated that less than 50% of the other real estate held at December 31, 2008 will be sold during 2009. Additionally, due to the redemption period on foreclosures being relatively long in Michigan (nine months to one year) and the Corporation having a significant number of nonperforming loans that were in the process of foreclosure at December 31, 2008, management anticipates that the level of other real estate will continue to rise during 2009 and will likely remain at elevated levels for some period of time. Other real estate properties are carried at the lower of cost or fair value less estimated cost to sell. At December 31, 2008, all of the other real estate properties, except four properties totaling $0.6 million, had been written down to fair value through a combination of a loan charge-off at the transfer of the loan to other real estate and/or as an operating expense write-down due to further market value decline of the property after the initial transfer date. Accordingly, at December 31, 2008, the carrying value of other real estate of $19.5 million was reflective of $10.9 million in write-downs, which represents a 36% average write-down from the contractual loan balance remaining at the time the property was transferred to other real estate.

 

There were 68 other real estate properties sold during 2008. Net proceeds from these sales totaled $8 million and on an average basis represented 72% of the remaining contractual loan balance at the time the Corporation received title to the properties.

 

TABLE 8. ANALYSIS OF ALLOWANCE FOR LOAN LOSSES