CHEMICAL FINANCIAL CORP - FORM 10-K - February 25, 2011

 

2010

Annual Report

to Shareholders

 

CHEMICAL FINANCIAL CORPORATION

 

 

2010 ANNUAL REPORT TO SHAREHOLDERS

 

 

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 (Chemical). Words such as “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “judgment,” “plans,” “predicts,” “projects,” “should,” “will,” and variations of such words and similar expressions are intended to identify such forward-looking statements. Such statements are based upon current beliefs and expectations and involve substantial risks and uncertainties which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These statements include, among others, statements related to real estate valuation, future levels of nonperforming loans, the rate of asset dispositions, future capital levels, future dividends, future growth and funding sources, future liquidity levels, future profitability levels, future deposit insurance premiums, the effects on earnings of future changes in interest rates and the future level of other revenue sources. All statements referencing future time periods are forward-looking. Management’s determination of the provision and allowance for loan losses; the carrying value of acquired loans, goodwill and mortgage servicing rights; the fair value of investment securities (including whether any impairment on any investment security is temporary or other-than-temporary and the amount of any impairment); and management’s assumptions concerning pension and other postretirement benefit plans involve judgments that are inherently forward-looking. There can be no assurance that future loan losses will be limited to the amounts estimated. All of the information concerning interest rate sensitivity is forward-looking. The future effect of changes in the financial and credit markets and the national and regional economy on the banking industry, generally, and on Chemical, specifically, are also inherently uncertain. 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 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 of this report. 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 headquartered in Midland, Michigan with its business concentrated in a single industry segment — commercial banking. The Corporation, through its subsidiary bank, Chemical Bank, offers a full range of traditional banking and fiduciary products and services. These products and 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 and investment products, corporate and personal wealth management services and other banking services.

 

The principal markets for the Corporation’s products and services are communities within Michigan in which the branches of Chemical Bank are located and the areas immediately surrounding those communities. As of December 31, 2010, Chemical Bank served 90 communities through 142 banking offices located in 32 counties across Michigan’s lower peninsula. In addition to its banking offices, Chemical Bank operated three loan production offices and 162 automated teller machines, both on- and off-bank premises. Chemical Bank operates through an internal organizational structure of four regional banking units. Chemical Bank’s regional banking units are collections of branch banking offices organized by geographical regions within the State of Michigan.

 

The principal source of revenue for the Corporation is interest and fees on loans, which accounted for 76% of total revenue in 2010, 74% of total revenue in 2009 and 72% of total revenue in 2008. Interest on investment securities is also a significant source of revenue, accounting for 6% of total revenue in 2010, 8% of total revenue in 2009 and 10% of total revenue in 2008. Revenue is influenced by overall economic factors including market interest rates, business and consumer spending, consumer confidence and competitive conditions in the marketplace.

 

BANK INDUSTRY DEVELOPMENTS

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) was signed into law by President Obama on July 21, 2010. The Dodd-Frank Act permanently increased the Federal Deposit Insurance Corporation (FDIC) insurance coverage to $250,000 per depositor. In addition, the Dodd-Frank Act resulted in a comprehensive overhaul of the financial services industry within the United States, established the new federal Bureau of Consumer Financial Protection (BCFP), and requires the BCFP and other federal agencies to implement many new and significant rules and regulations. At this time, it is difficult to predict the extent to which the Dodd-Frank Act or the resulting rules and regulations will impact the Corporation’s and Chemical Bank’s business. Compliance with these new laws and regulations will likely result in additional costs, which could be significant and could adversely impact the Corporation’s results of operations, financial condition or liquidity.

 

In November 2010, the FDIC, as mandated by the Dodd-Frank Act, issued a rule that provides unlimited insurance coverage on noninterest-bearing transaction accounts at all insured institutions beginning December 31, 2010 and expiring December 31, 2012. Under the rule, a noninterest-bearing transaction account is defined as a deposit account where interest is neither accrued nor paid, depositors are permitted to make an unlimited number of transfers and withdrawals and the institution does not reserve the right to advance notice of an intended withdrawal. Money market deposit accounts and Negotiable Orders of Withdrawal (NOW) accounts are not eligible for the unlimited insurance coverage, regardless of the interest rate. Further, there will not be a separate fee assessment on noninterest-bearing transaction accounts after December 31, 2010. Prior to December 31, 2010, unlimited insurance coverage was available on noninterest-bearing transaction accounts under the FDIC’s Transaction Account Guarantee Program (TAGP). The TAGP, which was adopted by the FDIC in November 2008 and expired December 31, 2010, provided full FDIC deposit insurance coverage for covered accounts, which were defined as noninterest-bearing transaction deposit accounts, NOW accounts paying less than 0.5% (0.25% after June 30, 2010) interest per annum and Interest on Lawyers Trust Accounts (IOLTA) held at participating FDIC-insured institutions through December 31, 2010. The fee assessment for deposit insurance coverage was an annualized 10 basis points assessed quarterly on amounts in covered accounts exceeding $250,000. The Corporation’s additional FDIC fee assessment related to the full deposit coverage for TAGP eligible accounts was $0.6 million in 2010 and $0.1 million in 2009.

 

In February 2011, the FDIC adopted a rule which changes the assessment base and assessment rates used to compute quarterly FDIC insurance assessments beginning April 1, 2011. Under the rule, the assessment base for all insured institutions, as mandated by the Dodd-Frank Act, will change to average consolidated total assets less average tangible equity. In addition, the initial base assessment rates for Risk Category 1 institutions will range from 5 to 9 basis points, on an annualized basis, and from 2.5 to 9 basis points after the effect of potential base-rate adjustments. Chemical Bank was, by definition, a Risk Category 1 institution during 2010 and 2009.

Chemical Bank’s FDIC insurance assessments totaled $7.4 million in 2010, $7.0 million in 2009 and $0.9 million in 2008. Based upon the adopted rule that takes effect April 1, 2011 and the Corporation’s average assessment base (under the adopted rule) at December 31, 2010, the Corporation’s FDIC premiums are expected to be lower in 2011 than in 2010.

 

In February 2009, the FDIC issued rules to amend the Deposit Insurance Fund (DIF) restoration plan, change the risk-based assessment system and set increased assessment rates for Risk Category 1 institutions beginning in the second quarter of 2009. Effective April 1, 2009, for Risk Category 1 institutions, the assessment rate methodology was established to determine the initial base assessment rate by using a weighted combination of weighted-average regulatory examination component ratings, long-term debt issuer ratings (converted to numbers and averaged) and certain financial ratios. The initial base assessment rates for Risk Category 1 institutions ranged from 12 to 16 basis points, on an annualized basis, and from 7 to 24 basis points after the effect of potential base-rate adjustments. In May 2009, the FDIC issued a rule which levied a special assessment applicable to all FDIC insured depository institutions totaling 5 basis points of each institution’s total assets less Tier 1 capital as of June 30, 2009, not to exceed 10 basis points of domestic deposits. The special assessment was part of the FDIC’s efforts to restore the DIF reserves. The Corporation recognized $1.8 million of additional deposit insurance expense in the second quarter of 2009 related to the special assessment. Deposit insurance expense during 2009 totaled $7.0 million, including the $1.8 million recognized in the second quarter related to the special assessment. In November 2009, the FDIC issued a rule that required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The prepayment calculation was based on an institution’s assessment rate in effect on September 30, 2009 and assumed a 5% annual growth rate in the assessment base. On December 30, 2009, the Corporation prepaid $19.7 million in risk-based assessments. In conjunction with the adoption of the prepaid assessment, the FDIC adopted a uniform 3 basis point increase in assessment rates effective on January 1, 2011. In October 2010, the FDIC adopted a new DIF restoration plan to ensure the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. Under the new restoration plan, the FDIC elected to forego the uniform 3 basis point increase scheduled to take place on January 1, 2011. As previously discussed, in February 2011, the FDIC adopted a rule that further changed future assessment rates beginning April 1, 2011.

 

At December 31, 2010, the Corporation held $18.7 million of Federal Home Loan Bank of Indianapolis (FHLB) stock. The Corporation carries FHLB stock at cost, or par value, and evaluates FHLB stock for impairment based on the ultimate recoverability of par value rather than by recognizing temporary declines in value. As part of the impairment assessment of FHLB stock, management considers, among other things, (i) the significance and length of time of any declines in net assets of the FHLB compared to its capital stock, (ii) commitments by the FHLB to make payments required by law or regulations and the level of such payments in relation to its operating performance, (iii) the impact of legislative and regulatory changes on financial institutions and, accordingly, the customer base of the FHLB and (iv) the liquidity position of the FHLB. The Corporation received $0.3 million of cash dividend payments on its FHLB stock during 2010, down from $0.5 million received during 2009. The FHLB was profitable through the first three quarters of 2010, with net income of $70 million, despite recognizing $68 million of other-than-temporary impairment losses on the credit-loss portion of its private-label residential mortgage-backed securities portfolio. At September 30, 2010, the FHLB was considered well-capitalized in accordance with regulatory requirements and its capital was 4.2% of total assets, compared to 3.7% at December 31, 2009. Standard & Poor’s has given the FHLB a rating of AAA since December 2009. Given all of the factors available, it was the Corporation’s assessment that the overall financial condition of the FHLB did not indicate an impairment of its FHLB stock at December 31, 2010.

 

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was signed into law in response to the financial crisis affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions. 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, residential 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. EESA also temporarily increased the amount of deposit insurance coverage available on customer deposit accounts from $100,000 per depositor to $250,000 per depositor until December 31, 2009. In May 2009, the Helping Families Save Their Homes Act was signed into law, which extended the temporary deposit insurance increase of $250,000 per depositor through December 31, 2013. With the passage of the Dodd-Frank Act in 2010, the deposit insurance increase to $250,000 per depositor was made permanent.

 

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 FDIC adopted the Temporary Liquidity Guarantee Program (TLGP). The TLGP, an initiative to counter the system-wide crisis in the nation’s financial sector, was amended by the FDIC in August 2009 and again in April 2010 to extend maturity dates originally adopted. Under the TLGP, the FDIC guaranteed, through the earlier of maturity or December 31, 2012, certain newly-issued senior unsecured debt issued by participating institutions on or after October 14, 2008 and through April 30, 2010. The fee assessment for coverage of senior unsecured debt ranged from 50 basis points to 300 basis points per annum, depending on the initial maturity of the debt. The Corporation did not issue any FDIC guaranteed debt during the three years ended December 31, 2010.

 

ACQUISITION OF O.A.K. FINANCIAL CORPORATION

 

On April 30, 2010, the Corporation acquired 100% of O.A.K. Financial Corporation (OAK) for total consideration of $83.7 million. The total consideration consisted of the issuance of 3,529,772 shares of the Corporation’s common stock with a total value of $83.7 million based upon a market price per share of the Corporation’s common stock of $23.70 at the acquisition date, the exchange of 26,425 stock options for the outstanding vested stock options of OAK with a value of the exchange equal to approximately $41,000 at the acquisition date, and approximately $8,000 of cash in lieu of fractional shares.

 

OAK, a bank holding company, owned Byron Bank, which provided traditional banking services and products through 14 banking offices serving communities in Ottawa, Allegan and Kent counties in west Michigan. Byron Bank owned two operating subsidiaries, Byron Investment Services, which offered mutual fund products, securities, brokerage services, retirement planning services, and investment management and advisory services, and O.A.K. Title Insurance Agency, which offered title insurance to buyers and sellers of residential and commercial properties. At April 30, 2010, OAK had total assets of $820 million, total loans of $627 million and total deposits of $693 million. The Corporation operated Byron Bank as a separate subsidiary from the acquisition date until July 23, 2010, the date Byron Bank was consolidated with and into Chemical Bank, and at which time Byron Investment Services and O.A.K. Title Insurance Agency became subsidiaries of Chemical Bank. O.A.K. Title Insurance Agency was subsequently dissolved effective August 31, 2010 and Byron Investment Services is expected to be dissolved in 2011.

 

In connection with the acquisition of OAK, the Corporation recorded $43.5 million of goodwill. Goodwill recorded was primarily attributable to the synergies and economies of scale expected from combining the operations of the Corporation and OAK. In addition, the Corporation recorded $9.8 million of other intangible assets in conjunction with the acquisition. The other intangible assets represent the value attributable to core deposits of $8.4 million, mortgage servicing rights of $0.7 million and non-compete agreements of $0.7 million.

 

The Corporation developed exit plans for involuntary employee terminations associated with the OAK acquisition, of which the Corporation recognized $0.6 million during 2010 for these exit costs and employee termination benefits. In addition to these costs, the Corporation incurred other acquisition related transaction expenses of $3.7 million in 2010. Acquisition-related transaction expenses associated with the OAK acquisition totaled $4.3 million during 2010, which reduced net income per common share by $0.12 in 2010.

 

Additional information regarding the acquisition of OAK can be found in the notes to the consolidated financial statements contained in this Report and the Corporation’s Current Reports on Form 8-K filed with the Securities and Exchange Commission (SEC) on May 7, 2010, May 3, 2010 and January 8, 2010.

 

CRITICAL ACCOUNTING POLICIES

 

The Corporation’s consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (GAAP), SEC rules and interpretive releases and 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 analyses.

 

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 of Financial Condition and Results of Operations,” 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, accounting for loans acquired in business combinations, pension plan accounting, income and other taxes, the evaluation of goodwill impairment and fair value measurements 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.

 

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 in 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 and collateral values on impaired loans, estimated losses on commercial, real estate commercial, real estate construction and land development 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 (valuation allowances) based upon probable losses identified during the review of impaired commercial, real estate commercial, real estate construction and land development loan portfolios, (ii) allocations established for adversely-rated commercial, real estate commercial, real estate construction and land development loans and nonaccrual real estate residential and 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 accurately 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, 2010. Notes 1 and 4 to the consolidated financial statements further describe 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 “Allowance for Loan Losses” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

The Corporation has a loan review function that is independent of the loan origination function and that reviews management’s evaluation of the allowance at least annually. The Corporation’s loan review function performs a detailed credit quality review at least annually on commercial, real estate commercial, real estate construction and land development loans, particularly focusing on larger balance loans and loans that have deteriorated below certain levels of credit risk.

 

Accounting for Loans Acquired in Business Combinations

 

Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (ASC 310-30), provides the GAAP guidance for accounting for loans acquired in a business combination that have experienced a deterioration of credit quality from origination to acquisition for which it is probable that the investor will be unable to collect all contractually required payments receivable, including both principal and interest.

 

Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered to be impaired. In the assessment of credit quality deterioration, the Corporation must make numerous assumptions, interpretations and judgments using internal and third-party credit quality information to determine whether it is probable that the Corporation will be able to collect all contractually required payments. This is a point in time assessment and inherently subjective due to the nature of the available information and judgment involved. Evidence of credit quality deterioration as of the purchase date may include statistics such as past due and nonaccrual status, recent borrower credit scores and loan-to-value percentages. Those loans that qualify under ASC 310-30 are recorded at fair value at acquisition, which involves estimating the expected cash flows to be received. Accordingly, the associated allowance for loan losses related to these loans is not

carried over at the acquisition date. ASC 310-30 also allows investors to aggregate loans acquired into loan pools that have common risk characteristics and thereby use a composite interest rate and expectation of cash flows to be collected for the loan pools. The Corporation understands, as outlined in the American Institute of Certified Public Accountants’ open letter to the Office of the Chief Accountant of the SEC dated December 18, 2009 and pending further standard setting, that for acquired loans that do not meet the scope criteria of ASC 310-30, a company may elect to account for such acquired loans pursuant to the provisions of either ASC 310-20, Nonrefundable Fees and Other Costs, or ASC 310-30. The Corporation elected to apply ASC 310-30 by analogy to loans acquired in the OAK transaction that were determined not to have deteriorated credit quality, and therefore, did not meet the scope criteria of ASC 310-30. Accordingly, the Corporation will follow the accounting and disclosure guidance of ASC 310-30 for these loans.

 

The excess of cash flows of a loan, or pool of loans, expected to be collected over the estimated fair value is referred to as the accretable yield and is recognized into interest income over the remaining life of the loan, or pool of loans, on a level-yield basis. The difference between the contractually required payments of a loan, or pool of loans, and the cash flows expected to be collected at acquisition, considering the impact of prepayments and estimates of future credit losses expected to be incurred over the life of the loan, or pool of loans, is referred to as the nonaccretable difference.

 

Subsequent to acquisition, the Corporation is required to quarterly evaluate its estimates of cash flows expected to be collected. These evaluations require the continued usage of key assumptions and estimates, similar to the initial estimate of fair value. Given the current economic environment, the Corporation must apply judgment to develop its estimates of cash flows for acquired loans given the impact of changes in property values, default rates, loss severities and prepayment speeds. Decreases in the estimates of expected cash flows will generally result in a charge to the provision for loan losses and a resulting increase to the allowance for loan losses. Increases in the estimates of expected cash flows will generally result in adjustments to the accretable yield which will increase amounts recognized in interest income in subsequent periods. Disposals of loans, which may include sales of loans to third parties, receipt of payments in full or in part by the borrower and foreclosure of the collateral, result in removal of the loan from the acquired loan portfolio at its carrying amount. As a result of the significant amount of judgment involved in estimating future cash flows expected to be collected for acquired loans, the adequacy of the allowance for loan losses is particularly sensitive to changes due to decreases in expected cash flows resulting from changes in loan credit quality.

 

Acquired loans that were classified as nonperforming loans prior to being acquired are not classified as nonperforming at acquisition because the loans are recorded in pools at fair value based on the principal and interest the Corporation expects to collect on such loans. Accordingly, at the acquisition date, the Corporation expects to fully collect the carrying value of acquired loans. Judgment is required to classify acquired loans as performing and is dependent on having a reasonable expectation about the timing and amount of cash flows expected to be collected, even if the loans are contractually past due.

 

Loans acquired in the acquisition of OAK (“acquired loans”) were initially recorded at fair value without a carryover of OAK’s allowance for loan losses. The calculation of fair value of the acquired loans entailed estimating the amount and timing of cash flows attributable to both principal and interest expected to be collected on such loans and then discounting those cash flows at market interest rates. The Corporation aggregated acquired loans into 14 pools based upon common risk characteristics and estimated the cash flows expected to be collected at acquisition using its internal credit risk grading model, interest rate risk and prepayment models, which incorporated its best estimate of current key assumptions, such as property values, default rates, loss severity and prepayment speeds. The fair value of the acquired loans included discounts attributable to both credit quality and market interest rates, which were recorded as a reduction of the loans’ outstanding principal balance at the acquisition date. Upon acquisition, the acquired loan portfolio had contractually required principal and interest payments of $683 million and $97 million, respectively, expected principal and interest cash flows of $636 million and $88 million, respectively, and a fair value of $627 million. The difference between the contractually required payments receivable and the expected cash flows represents the nonaccretable difference, which totaled $56 million at the acquisition date, with $47 million attributable to expected credit losses. The difference between the expected cash flows and the fair value represents the accretable yield, which totaled $97 million at the acquisition date.

 

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. At December 31, 2010, 257 employees, or 16% of total employees, on a full-time equivalent basis, were earning pension benefits under the defined benefit pension plan. 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 amount of 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, 2010, 2009 and 2008, 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 a portfolio of bonds of Aa quality to determine the discount rate. At December 31, 2010, 2009 and 2008, the discount rate was established at 5.65%, 6.15% and 6.50%, 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 equity 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 2010, 2009 and 2008.

 

Other assumptions made in the pension plan calculations 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 pension expense in 2011 for the defined benefit pension plan are a discount rate of 5.65%, a long-term rate of return on pension plan assets of 7% and a rate of compensation increase of 3.50%. Pension expense in 2011 is expected to be approximately $0.7 million, a decrease of approximately $0.1 million from 2010. In 2011, a decrease in the discount rate of 50 basis points was estimated to increase pension expense by $0.4 million, while an increase of 50 basis points was estimated to decrease pension expense by the same amount.

 

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.

 

The Corporation accounts for its defined benefit pension and other postretirement plans in accordance with FASB ASC Topic 715, Compensation-Retirement Benefits, which 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 impact of pension plan accounting on the statements of financial position at December 31, 2010 and 2009 is further discussed in Note 16 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 applicable 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 regulations and 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 more frequently, if warranted by business events or circumstances. Reserves for uncertain tax positions are reviewed quarterly for adequacy based upon developments in tax law and the status of examinations or audits. As of December 31, 2010 and 2009, there were no federal income tax reserves recorded for uncertain tax positions.

 

Goodwill

 

At December 31, 2010, the Corporation had $113.4 million of goodwill, which was originated through the acquisition of various banks and bank branches, recorded on the consolidated statement of financial position. Goodwill is not amortized, but rather is tested by management annually for impairment, or more frequently if triggering events occur and indicate potential impairment, in accordance with FASB ASC Topic 350-20, Goodwill. 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 GAAP, including assumptions regarding the valuation of Chemical Bank.

 

The value of Chemical Bank was measured utilizing the income and market approaches as prescribed in FASB ASC Topic 820, Fair Value Measurements and Disclosures (ASC 820). GAAP 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 Chemical Bank was based as a going concern 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 formula and lattice models, and the multi-period excess-earnings method. In the valuation of Chemical 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 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. At the valuation date of September 30, 2010, a discount rate of 14% 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 acquired companies. Two of the more significant financial ratios analyzed in completed transactions included price to latest twelve months earnings and price to tangible book value. At the valuation date of September 30, 2010, the market approach utilized a price to latest twelve months earnings ratio of 35 times and a price to tangible book value of 145%.

 

The fair value of Chemical Bank was determined to be slightly above the income approach and within the range of values in the market approach value range. The results of the valuation analysis concluded that the fair value of Chemical Bank was greater than its book value, including goodwill, and thus no goodwill impairment was evident at the valuation date of September 30, 2010. 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 price per share of its common stock as reported on The Nasdaq Stock Market^® establishes the marketable minority value. Given the volatility of the financial markets, particularly in the equity markets in 2010, it is management’s opinion that the marketable minority value does not always represent the fair value of the reporting unit as a whole and that an adjustment to the marketable minority value for the

acquiror’s control is generally considered in the assessment of fair value. The Corporation determined that no triggering events occurred that indicated potential impairment of goodwill from the valuation date through December 31, 2010. 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 financial results or other matters that could affect the valuation assumptions.

 

Fair Value Measurements

 

The Corporation determines the fair value of its assets and liabilities in accordance with ASC 820. ASC 820 establishes a standard framework for measuring and disclosing fair value under GAAP. A number of valuation techniques are used to determine the fair value of assets and liabilities in the Corporation’s financial statements. The valuation techniques include quoted market prices for investment securities, appraisals of real estate from independent licensed appraisers and other valuation techniques. Fair value measurements for assets and liabilities where limited or no observable market data exists are based primarily upon estimates, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the valuation results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. Significant changes in the aggregate fair value of assets and liabilities required to be measured at fair value or for impairment are recognized in the income statement under the framework established by GAAP. See Note 13 to the Corporation’s consolidated financial statements for more information on fair value measurements.

 

PENDING ACCOUNTING PRONOUNCEMENTS

 

Fair Value Measurements and Disclosures:  In January 2010, the FASB issued Accounting Standards Update (ASU) No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements (ASU 2010-06). ASU 2010-06 requires reporting entities to make new disclosures about recurring and nonrecurring fair value measurements, including significant transfers into and out of Level 1 and Level 2 fair value measurements and information on purchases, sales, issuances and settlements, on a gross basis, in the reconciliation of Level 3 fair value measurements. ASU 2010-06 also requires disclosure of fair value measurements by “class” instead of by “major category” as well as any changes in valuation techniques used during the reporting period. For disclosures of Level 1 and Level 2 activity, fair value measurements by “class” and changes in valuation techniques, ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009, with disclosures for previous comparative periods prior to adoption not required. The adoption of this portion of ASU 2010-06 on January 1, 2010 did not have a material impact on the Corporation’s consolidated financial condition or results of operations. For the reconciliation of Level 3 fair value measurements, ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2010. The adoption of this portion of ASU 2010-06 on January 1, 2011 did not have a material impact on the Corporation’s consolidated financial condition or results of operations.

 

Goodwill Impairment Testing:  In December 2010, the FASB issued ASU No. 2010-28, Intangibles (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts (ASU 2010-28). ASU 2010-28 provides guidance on (i) the circumstances under which step 2 of the goodwill impairment test must be performed for reporting units with zero or negative carrying amounts, and (ii) the qualitative factors to be taken into account when performing step 2 in determining whether it is more likely than not that an impairment exists. ASU 2010-28 is effective for public entities with fiscal years beginning after December 15, 2010, with early adoption prohibited. Upon initial application, all entities having reporting units with zero or negative carrying amounts are required to assess whether it is more likely than not that impairment exists and any resulting goodwill impairment should be recognized as a cumulative-effect adjustment to opening retained earnings in the period of adoption. The adoption of ASU 2010-28 on January 1, 2011 did not have a material impact on the Corporation’s consolidated financial condition or results of operations.

 

Pro Forma Disclosure Requirements for Business Combinations:  In December 2010, the FASB issued ASU No. 2010-29, Business Combinations (Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations (ASU 2010-29). ASU 2010-29 clarifies that pro forma revenue and earnings for a business combination occurring in the current year should be presented as though the business combination occurred as of the beginning of the year or, if comparative financial statements are presented, as though the business combination took place as of the beginning of the comparative year. ASU 2010-29 also amends existing guidance to expand the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring adjustments directly attributable to the business combination included in the pro forma revenue and earnings. ASU 2010-29 is effective prospectively for business combinations consummated on or after the start of the first annual reporting period beginning after December 15, 2010, with early adoption permitted. The adoption of ASU 2010-29 on January 1, 2011 did not have a material impact on the Corporation’s consolidated financial condition or results of operations.

Deferral of Troubled Debt Restructuring Disclosures:  In January 2011, the FASB issued ASU No. 2011-01, Receivables (Topic 310): Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20 (ASU 2011-01). For public entities, ASU 2011-01 delays the effective date for certain disclosures about loans modified under troubled debt restructurings included in ASU No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses (ASU 2010-20). The new effective date for the loans modified under troubled debt restructuring disclosures will be concurrent with the effective date of FASB’s proposed ASU, Receivables (Topic 310): Clarifications to Accounting for Troubled Debt Restructurings by Creditors. ASU 2011-01 does not change the effective date for other disclosures required by public entities in ASU 2010-20. The adoption of ASU 2011-01 once effective is not expected to have a material impact on the Corporation’s consolidated financial condition or results of operations.

 

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.

 

NET INCOME

 

Net income in 2010 was $23.1 million, or $0.88 per diluted share, compared to net income in 2009 of $10.0 million, or $0.42 per diluted share, and net income in 2008 of $19.8 million, or $0.83 per diluted share. Net income in 2010 represented a 131% increase from 2009 net income, while 2009 net income represented a 50% decrease from 2008 net income. Net income per share in 2010 was 110% more than in 2009, while net income per share in 2009 was 49% less than in 2008. The increases in net income and net income per share in 2010, compared to 2009, were primarily attributable to a decrease in the provision for loan losses and the acquisition of OAK. The decreases in net income and net income per share in 2009, compared to 2008, were primarily attributable to increases in the provision for loan losses and operating expenses.

 

The Corporation’s return on average assets was 0.47% in 2010, 0.25% in 2009 and 0.52% in 2008. The Corporation’s return on average shareholders’ equity was 4.3% in 2010, 2.1% in 2009 and 3.9% in 2008.

 

ASSETS

 

Total assets were $5.25 billion at December 31, 2010, an increase of $1.00 billion, or 23%, from total assets at December 31, 2009 of $4.25 billion. Average assets were $4.91 billion during 2010, an increase of $847.1 million, or 21%, from average assets during 2009 of $4.07 billion. Average assets were $4.07 billion during 2009, an increase of $281.6 million, or 7%, from average assets during 2008 of $3.78 billion. The increases in total assets and average assets during 2010 were primarily attributable to the acquisition of OAK.

INVESTMENT SECURITIES

 

Information about the Corporation’s investment securities portfolio is summarized in Tables 1 and 2. The following table summarizes the maturities and yields of the carrying value of investment securities by investment category and fair value by investment category, at December 31, 2010:

 

TABLE 1. MATURITIES AND YIELDS* OF INVESTMENT SECURITIES AT DECEMBER 31, 2010

 

 

 

The following table summarizes the carrying value of investment securities at December 31, 2010, 2009 and 2008:

 

TABLE 2. SUMMARY OF INVESTMENT SECURITIES

 

 

The carrying value of investment securities at December 31, 2010 totaled $744.0 million, an increase of $20.2 million, or 2.8%, from investment securities at December 31, 2009 of $723.8 million. The increase in investment securities was attributable to the acquisition of OAK’s investment securities portfolio, which was partially offset by the Corporation not reinvesting all of its maturing investment securities. At December 31, 2010, the Corporation’s investment securities portfolio consisted of $117.5 million in government sponsored agency debt obligations comprised primarily of senior bonds that were issued by the twelve regional Federal Home Loan Banks that make up the Federal Home Loan Bank System (FHLBanks); $201.0 million in state and political subdivisions debt obligations comprised primarily of general debt obligations of issuers primarily located in the State of Michigan; $136.9 million in residential mortgage-backed securities comprised primarily of fixed rate instruments backed by a U.S. government agency (Government National Mortgage Association) or government sponsored enterprises (Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae)); $233.9 million of collateralized mortgage obligations comprised primarily of variable rate instruments with average maturities of less than three years backed by the same U.S. government agency and government sponsored enterprises as the residential mortgage-backed securities; $42.8 million in corporate bonds comprised primarily of debt obligations of large national financial organizations; preferred stock securities of $1.4 million comprised of preferred stock securities of two large banks; and $10.5 million of trust preferred securities (TRUPs) comprised primarily of a 100% interest in a TRUP of a small non-public bank holding company in Michigan.

 

The acquisition of OAK increased the Corporation’s investment securities portfolio by $69.6 million at the acquisition date and slightly changed the mix of the investment securities portfolio by increasing the amount of state and political subdivisions investment securities by $46.3 million, of which $46.0 million remained at December 31, 2010 in the available-for-sale portfolio. In addition, the preferred stock securities of $1.4 million at December 31, 2010 were acquired in the OAK acquisition. The Corporation has re-invested a portion of funds from maturing government sponsored agencies and residential mortgage-backed securities in 2010 into state and political subdivisions investment securities, as opportunities in local municipal markets remained available due to a reduction in demand nationally for local municipal securities. State and political subdivisions investment securities, which consist primarily of issuers located in the State of Michigan and are general obligations of the issuers, totaled $201.0 million, or 27.0%, of investment securities at December 31, 2010, compared to $124.0 million, or 17.1%, of investment securities at December 31, 2009. The Corporation also invested maturing funds from its investment securities portfolio into corporate bonds during 2010 due to an improvement in that market related to credit risk. The corporate bond portfolio totaled $42.7 million, or 5.7% of investment securities, at December 31, 2010, compared to $19.0 million, or 2.6% of investment securities, at December 31, 2009. The remaining investment securities that matured in 2010 were primarily held in interest bearing deposits at the Federal Reserve Bank of Chicago (FRB) due to the lack of investment options that meet the Corporation’s investment strategy, which is primarily centered on investing in relatively short-term investment securities with average maturities of two years or less or variable rate investment securities with limited exposure to credit risk.

 

The Corporation records all investment securities in accordance with FASB ASC Topic 320, Investments-Debt and Equity Securities (ASC 320), under which the Corporation is required to assess equity and debt securities that have fair values below their amortized cost basis to determine whether the decline (impairment) is other-than-temporary. An assessment is performed quarterly by the Corporation to determine whether unrealized losses in its investment securities portfolio are temporary or other-than-temporary by carefully considering all available information. The Corporation reviews factors such as financial statements, credit ratings, news releases and other pertinent information of the underlying issuer or company to make its determination.

 

Effective April 1, 2009, in accordance with FASB Staff Position FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (later codified in ASC 320), if the Corporation intends to sell a security or it is more-likely- than-not that the Corporation will be required to sell the security prior to the recovery of its amortized cost, an other-than-temporary impairment (OTTI) write down is recognized in earnings equal to the entire difference between the security’s amortized cost basis and its fair value. If the Corporation does not intend to sell a security and it is not more-likely-than-not that the Corporation would be required to sell a security before the recovery of its amortized cost basis, then the recognition of the impairment is bifurcated. For a security where the impairment is bifurcated, the impairment is separated into an amount representing credit loss, which is recognized in earnings, and an amount related to all other factors, which is recognized in other comprehensive income. Prior to April 1, 2009, all declines in fair value deemed to be other-than-temporary were reflected in earnings as realized losses. In assessing whether OTTI exists, management considers, among other things, (i) the length of time and the extent to which the fair value has been less than amortized cost, (ii) the financial condition and near-term prospects of the issuer, (iii) the potential for impairments in an entire industry or sub-sector and (iv) the potential for impairments in certain economically depressed geographical locations.

 

The Corporation’s investment securities portfolio with a carrying value of $744.0 million at December 31, 2010, had gross impairment of $9.4 million at that date. Management believed that the unrealized losses on investment securities were temporary in nature and due primarily to changes in interest rates on the investment securities and market illiquidity and not as a result of credit-related issues. Accordingly, at December 31, 2010, the Corporation believed the impairment in its investment securities portfolio was temporary in nature and, therefore, no impairment loss was realized in the Corporation’s consolidated statement of income for 2010.

However, due to market and economic conditions, OTTI may occur as a result of material declines in the fair value of investment securities in the future. A further discussion of the assessment of potential impairment and the Corporation’s process that resulted in the conclusion that the impairment was temporary in nature follows.

 

At December 31, 2010, the Corporation’s investment securities portfolio included government sponsored agencies securities with gross impairment of $0.04 million, state and political subdivisions securities with gross impairment of $1.99 million, residential mortgage-backed securities and collateralized mortgage obligations, combined, with gross impairment of $0.38 million, corporate bonds with gross impairment of $0.47 million and trust preferred securities with gross impairment of $6.56 million. The amortized costs and fair values of investment securities are disclosed in Note 3 to the consolidated financial statements.

 

The government sponsored agencies securities, included in the available-for-sale investment securities portfolio, had an amortized cost totaling $117.2 million, with gross impairment of $0.04 million, at December 31, 2010. This gross impairment was attributable to impaired government sponsored agencies securities with an amortized cost of $20.2 million. All of the impaired investment securities are backed by the full faith and credit of the U.S. government. The Corporation determined that the impairment on these investment securities was attributable to the recent increase in interest rates for these investments and was temporary in nature at December 31, 2010. At December 31, 2010, the Corporation’s government sponsored agencies securities included $48.9 million of senior bonds at fair value that were issued by the twelve FHLBanks. There was no impairment in these FHLBanks’ investment securities at December 31, 2010. FHLBanks are government-sponsored enterprises created by Congress to ensure access to low-cost funding for their member financial institutions. FHLBanks overall experienced declines in profitability during the fourth quarter of 2008 and first quarter of 2009, primarily due to a number of the FHLBanks incurring significant OTTI losses on their portfolios of private-label residential mortgage-backed securities and home equity loans due to the dramatic decline in interest rates that occurred in 2008. However, the capital of FHLBanks improved throughout 2009 and by September 30, 2009, the FHLBanks were categorized as well-capitalized under applicable regulatory requirements and continued to be well-capitalized in 2010.

 

The state and political subdivisions securities, included in the available-for-sale and the held-to-maturity investment securities portfolios, had an amortized cost totaling $200.9 million, with gross impairment of $1.99 million, at December 31, 2010. 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. The gross impairment of $1.99 million at December 31, 2010 was attributable to $77.7 million of investment securities at amortized cost, with two-thirds of these investment securities maturing beyond 2013. The Corporation determined that the impairment of $1.99 million at December 31, 2010 was attributable to the recent change in market interest rates for these investment securities and the market’s perception of the Michigan economy causing illiquidity in the market for these investment securities. The Corporation determined that the impairment on these investment securities at December 31, 2010 was temporary in nature.

 

The residential mortgage-backed securities and collateralized mortgage obligations, included in the available-for-sale investment securities portfolio, had a combined amortized cost of $365.9 million, with gross impairment of $0.38 million, at December 31, 2010. Virtually all of the impaired investment securities in these two categories are backed by a guarantee of a U.S. government agency or government sponsored enterprise and are AAA rated. The Corporation assessed the impairment on these investment securities and determined that the impairment was attributable to the low level of market interest rates and the volatility of prepayment speeds and that the impairment on these investment securities at December 31, 2010 was temporary in nature.

 

At December 31, 2010, the Corporation’s corporate bond portfolio, included in the available-for-sale investment securities portfolio, had an amortized cost of $43.1 million, with gross impairment of $0.47 million. All of the corporate bonds held at December 31, 2010 were of an investment grade, except a single issue investment security of Lehman Brothers Holdings Inc. (Lehman) and a corporate bond of American General Finance Corporation (AGFC). During the third quarter of 2008, the Corporation recognized an OTTI loss of $0.4 million related to the write-down of the Lehman bond to fair value as the impairment was deemed to be other-than-temporary and entirely credit related. The Corporation’s remaining amortized cost of the Lehman bond was less than $0.1 million at December 31, 2010. AGFC was a wholly-owned subsidiary of Fortress Investment Group, LLC, which was rated BBB by Fitch at December 31, 2010. AGFC had previously been owned by American General Finance Inc. (AGFI), which was wholly-owned indirectly by American International Group (AIG). At December 31, 2010, the AGFC corporate bond had an amortized cost of $2.5 million with gross impairment of $0.15 million and a maturity date of December 15, 2011. At December 31, 2010, the Corporation’s assessment was that it was probable that it would collect all of the contractual amounts due on the AGFC corporate bond. The impairment at December 31, 2010 on the AGFC corporate bond of $0.15 million improved from $0.46 million of impairment at December 31, 2009. Ratings from Moody’s, Standard & Poor’s and Fitch were B2, BB+ and BB, respectively, at December 31, 2010. The investment grade ratings obtained for the balance of the corporate bond portfolio, with a gross impairment of $0.32 million at December 31, 2010, indicated that the obligors’ capacities to meet their financial commitments was “strong.” The Corporation assessed the gross impairment of $0.47 million on the corporate bond portfolio at December 31, 2010 and determined that the impairment was attributable to the low level of market interest rates, and not due to credit-related issues, and that the impairment on the corporate bond portfolio at December 31, 2010 was temporary in nature.

At December 31, 2010, the Corporation held two TRUPs in the held-to-maturity investment securities portfolio, with a combined amortized cost of $10.5 million that had gross impairment of $6.56 million. One TRUP, with an amortized cost of $10.0 million, represented a 100% interest in a TRUP of a small non-public bank holding company in Michigan that was purchased in the second quarter of 2008. At December 31, 2010, the Corporation determined that the fair value of this TRUP was $3.80 million. The second TRUP, with an amortized cost of $0.5 million, represented a 10% interest in the TRUP of another small non-public bank holding company in Michigan. At December 31, 2010, the Corporation determined the fair value of this TRUP was $0.14 million. The fair value measurements of the two TRUP investments were developed based upon market pricing observations of much larger banking institutions in an illiquid market adjusted by risk measurements. The fair values of the TRUPs were based on calculations of discounted cash flows, and further 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 values of the TRUPs in Note 3 to the consolidated financial statements.

 

Management reviewed financial information of the issuers of the TRUPs at December 31, 2010. Based on this review, the Corporation concluded that the significant decline in fair values of the TRUPs, compared to their amortized cost, was not attributable to materially adverse conditions specifically related to the issuers. The issuer of the $10.0 million TRUP reported net income in each of the three years ended December 31, 2010. At December 31, 2010, the issuer was categorized as well-capitalized under applicable regulatory requirements and had a liquidity position which included over $100 million in investment securities held as available-for-sale. Based on the Corporation’s analysis at December 31, 2010, it was the Corporation’s opinion that this issuer appeared to be a financially sound financial institution with sufficient liquidity to meet its financial obligations in 2011. This TRUP is not independently rated. Bank industry ratings as of September 30, 2010, obtained from Bauer Financial at www.bauerfinancial.com (Bauer) for subsidiaries of this issuer were rated good and excellent. Common stock cash dividends were paid throughout 2010 and 2009 by the issuer and the Corporation understands that the issuer’s management anticipates cash dividends to continue to be paid in the future. All scheduled interest payments on this TRUP were made on a timely basis in 2009 and 2010. The principal of $10.0 million of this TRUP matures in 2038, with interest payments due quarterly.

 

Based on the information provided by the issuer of the $10.0 million TRUP, it was the Corporation’s opinion that, as of December 31, 2010, there had been no material adverse changes in the issuer’s financial performance since the TRUP was issued and purchased by the Corporation and no indication that any material adverse trends were developing that would suggest that the issuer would be unable to make all future principal and interest payments under the TRUP. Further, based on the information provided by the issuer, the issuer appeared to be a financially viable financial institution with both the credit quality and liquidity necessary to meet its financial obligations in 2011. At December 31, 2010, 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, including 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 $10.0 million at December 31, 2010. While the total fair value of the TRUP was $6.2 million below the Corporation’s amortized cost at December 31, 2010, it was the Corporation’s assessment that, based on the overall financial condition of the issuer, the impairment was temporary in nature at December 31, 2010.

 

The issuer of the $0.5 million TRUP reported a net loss in 2010 that was significantly greater than a small net loss reported in 2009. At December 31, 2010, the issuer was categorized as well-capitalized under applicable regulatory requirements and its subsidiary bank was rated adequate by Bauer based on September 30, 2010 financial data. All scheduled interest payments on this TRUP were made on a timely basis in 2010 and 2009. The principal of $0.5 million of this TRUP matures in 2033, with interest payments due quarterly. At December 31, 2010, the Corporation was not aware of any regulatory issues, memorandums of understanding or cease and desist orders that had been issued to the issuer of this TRUP or any subsidiary. In reviewing all financial information regarding the $0.5 million TRUP, it was the Corporation’s opinion that the carrying value of this TRUP at its original cost of $0.5 million was supported by the issuer’s financial position at December 31, 2010, even though the fair value of the TRUP was $0.3 million below the Corporation’s amortized cost at December 31, 2010. It was the Corporation’s assessment that the impairment was temporary in nature at December 31, 2010.

 

At December 31, 2010, the Corporation expected to fully recover the entire amortized cost basis of each impaired investment security in its investment securities portfolio at that date. Furthermore, at December 31, 2010, the Corporation did not have the intent to sell any of its impaired investment securities and believed that it was more likely-than-not that the Corporation would not have to sell any of its impaired investment securities before a full recovery of amortized cost. However, there can be no assurance that OTTI losses will not be recognized on the TRUPs or on any other investment security in the future.

 

The Corporation did not realize any investment securities impairment losses in 2010 or 2009. In 2008, the Corporation recorded a $0.4 million loss related to the write-down of a specific investment debt security to fair value as the impairment was deemed to be other-than-temporary in nature and entirely credit related.

LOANS

 

Chemical 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, 2010, the Corporation’s loan portfolio was $3.68 billion and consisted of loans to commercial borrowers (commercial, real estate commercial and real estate construction and land development) totaling $2.04 billion, or 55.4% of total loans, loans to borrowers for the purpose of acquiring residential real estate totaling $798 million, or 21.7% of total loans, and loans to consumer borrowers secured by various types of collateral totaling $845 million, or 22.9% of total loans, at that date. Loans at fixed interest rates comprised approximately 72% of the Corporation’s total loan portfolio at December 31, 2010, compared to 80% at December 31, 2009.

 

The Corporation maintains loan policies and credit underwriting standards as part of the process of managing credit risk. These standards include making loans generally only within the Corporation’s market areas. The Corporation’s lending markets generally consist of 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 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. The Corporation maintains a centralized independent loan review function that monitors the approval process and ongoing asset quality of the loan portfolio.

 

Table 3 includes the composition of the Corporation’s loan portfolio, by major loan category, as of December 31, 2010, 2009, 2008, 2007 and 2006.

 

TABLE 3. SUMMARY OF LOANS

 

 

Table 4 presents the maturity distribution of commercial, real estate commercial and real estate construction and land development loans. These loans totaled $2.04 billion and represented 55% of total loans at December 31, 2010. The percentage of these loans maturing within one year was 41% at December 31, 2010, while the percentage of these loans maturing beyond five years remained low at 6% at December 31, 2010. At December 31, 2010, commercial, real estate commercial and real estate construction and land development loans with maturities beyond one year totaled $1.21 billion and were comprised of 73% of fixed interest rate loans.

 

TABLE 4. COMPARISON OF LOAN MATURITIES AND INTEREST SENSITIVITY (Dollars in thousands)

 

 

 

Total loans were $3.68 billion at December 31, 2010, an increase of $689 million, or 23%, from total loans of $2.99 billion at December 31, 2009. Total loans increased $11.5 million, or 0.4%, during 2009, from total loans of $2.98 billion at December 31, 2008. The increase in total loans during 2010 was due primarily to the loans acquired in the acquisition of OAK. In addition, during 2010, the Corporation originated $71 million of fifteen-year fixed-rate residential mortgage loans that it held in its portfolio, as opposed to selling them in the secondary market as has been its general practice. At April 30, 2010, OAK’s loan portfolio was recorded by the Corporation at its fair value of $627 million and was comprised of commercial loans totaling $191 million, real estate commercial loans totaling $294 million, real estate construction and land development loans totaling $39 million, real estate residential loans totaling $34 million and consumer installment and home equity loans totaling $69 million. A summary of the Corporation’s loan portfolio by category follows.

 

Commercial loans consist of loans to varying types of businesses, including municipalities, school districts and nonprofit organizations, for the purpose of supporting working capital and operational needs and term financing of equipment. Repayment of such loans is generally provided through operating cash flows of the customer. Commercial loans are generally secured with inventory, accounts receivable, equipment, personal guarantees of the owner or other sources of repayment, although the Corporation may also obtain real estate as collateral.

 

Commercial loans were $819.0 million at December 31, 2010, an increase of $234.7 million, or 40.2%, from commercial loans at December 31, 2009 of $584.3 million, with the increase due primarily to the acquisition of OAK. Commercial loans decreased $3.2 million, or 0.6%, during 2009 from commercial loans at December 31, 2008 of $587.5 million. Commercial loans represented 22.2% of the Corporation’s loan portfolio at December 31, 2010, compared to 19.5% and 19.7% at December 31, 2009 and 2008, respectively.

 

Real estate commercial loans include loans that are secured by real estate occupied by the borrower for ongoing operations, non-owner occupied real estate leased to one or more tenants and vacant land that has been acquired for investment or future land development. Real estate commercial loans were $1.08 billion at December 31, 2010, an increase of $291.3 million, or 37.1%, from real estate commercial loans at December 31, 2009 of $785.7 million, with the increase due primarily to the acquisition of OAK. Loans secured by owner occupied properties, non-owner occupied properties and vacant land comprised 63%, 34% and 3%, respectively, of the Corporation’s real estate commercial loans outstanding at December 31, 2010. Real estate commercial loans decreased $0.7 million, or 0.1%, during 2009 from real estate commercial loans at December 31, 2008 of $786.4 million. Real estate commercial loans represented 29.3% of the Corporation’s loan portfolio at December 31, 2010, compared to 26.2% and 26.4% at December 31, 2009 and 2008, respectively.

 

Real estate commercial lending is generally considered to involve a higher degree of risk than real estate residential lending and typically involves larger loan balances concentrated in a single borrower. In addition, the payment experience on loans secured by income-producing properties and vacant land 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 and real estate 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. The weakened economy in Michigan has resulted in higher loan delinquencies, customer bankruptcies and real estate foreclosures. Based on current economic conditions in Michigan, management expects real estate foreclosures to remain higher than historical averages. It is also management’s belief that the loan portfolio is generally well-secured, despite declining market values for all types of real estate in the State of Michigan and nationwide.

 

Real estate construction and land development loans are primarily originated for land development and construction of commercial properties. Land development loans include loans made to developers for the purpose of infrastructure improvements to vacant land to create finished marketable residential and commercial lots/land. Real estate construction loans often convert to a real estate commercial loan at the completion of the construction period; however, most land development loans are originated with the intention that the loans will be re-paid through the sale of finished properties by the developers within twelve months of the completion date. Real estate construction and land development loans were $142.6 million at December 31, 2010, an increase of

$21.3 million, or 17.6%, from real estate construction and land development loans at December 31, 2009 of $121.3 million, with the increase primarily due to the acquisition of OAK. Real estate construction and land development loans increased $2.3 million, or 1.9%, during 2009 from real estate construction and land development loans of $119.0 million at December 31, 2008. The Corporation’s land development loans totaled $53.4 million and $46.6 million at December 31, 2010 and 2009, respectively, and consisted primarily of loans to develop residential real estate. Real estate construction and land development loans represented 3.9% of the Corporation’s loan portfolio at December 31, 2010, compared to 4.1% and 4.0% at December 31, 2009 and 2008, respectively.

 

Real estate construction lending involves a higher degree of risk than real estate commercial lending and real estate residential lending because of the uncertainties of construction, including the possibility of costs exceeding the initial estimates, the need to obtain a tenant or purchaser of the property if it will not be owner-occupied or the need to sell developed properties. 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 has increased since early 2008 due to the recessionary economic environment within the State of Michigan. The sale of lots and units in both residential and commercial development projects remains weak, as customer demand also remains low, resulting in the inventory of unsold lots and housing units remaining high across the State of Michigan. The unfavorable economic environment in Michigan has resulted in the inability of most developers to sell their finished developed lots and units within their original expected time frames. Accordingly, few of the Corporation’s land development borrowers have sold developed lots or units since early 2008 due to the unfavorable economic environment.

 

The Corporation’s commercial loan portfolio, comprised of commercial, real estate commercial and real estate construction and land development loans, is well diversified across business lines and has no concentration in any one industry. The commercial loan portfolio totaling $2.04 billion at December 31, 2010 included 142 loan relationships of $2.5 million or greater. These 142 borrowing relationships totaled $747 million and represented 37% of the commercial loan portfolio at December 31, 2010. At December 31, 2010, 12 of these borrowing relationships had outstanding balances of $10 million or higher, totaling $166 million, or 8%, of the commercial loan portfolio at that date. Further, the Corporation had four loan relationships at December 31, 2010 with loan balances greater than $2.5 million and less than $10 million, totaling $32.2 million, that had unfunded credit amounts that, if advanced, could result in a loan relationship of $10 million or more.

 

Real estate residential loans consist primarily of one- to four-family residential loans with fixed interest rates of fifteen years or less. The Corporation generally sells fixed interest rate real estate residential loans originated with maturities of over fifteen years in the secondary market. 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. Real estate residential loans were $798.0 million at December 31, 2010, an increase of $58.7 million, or 7.9%, from real estate residential loans at December 31, 2009 of $739.4 million. The increase in real estate residential loans in 2010 was partially due to the acquisition of OAK and partially due to the Corporation electing to hold in its portfolio $71 million of fifteen-year term fixed interest rate real estate residential loans during 2010 that historically have been sold in the secondary market. Real estate residential loans decreased $100.2 million, or 11.9%, during 2009 from real estate residential loans of $839.6 million at December 31, 2008. The decrease in real estate residential loans in 2009 was attributable to both a significant decline in Michigan’s housing market due to the overall economic environment and customers refinancing adjustable rate and balloon mortgages to long-term fixed interest rate loans that the Corporation sold in the secondary market. While real estate residential loans have historically involved the least amount of credit risk in the Corporation’s loan portfolio, the risk on these loans has increased as the unemployment rate has increased and real estate property values have decreased in the State of Michigan. Real estate residential loans also include loans to consumers for the construction of single family residences that are secured by these properties. Real estate residential construction loans to consumers were $15.3 million at December 31, 2010, compared to $22.9 million at December 31, 2009 and $29.2 million at December 31, 2008. Real estate residential loans represented 21.7% of the Corporation’s loan portfolio at December 31, 2010, compared to 24.7% and 28.1% at December 31, 2009 and 2008, respectively.

 

The Corporation’s consumer loans consist of relatively small loan amounts to consumers to finance personal items; primarily automobiles, recreational vehicles and boats. These loans 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, the physical condition of the collateral 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.

 

Consumer installment and home equity loans (consumer loans) were $845.0 million at December 31, 2010, an increase of $82.5 million, or 10.8%, from consumer loans at December 31, 2009 of $762.5 million, with the increase due primarily to the acquisition of OAK. Consumer loans increased $113.4 million, or 17.5%, during 2009 from consumer loans of $649.2 million at December 31, 2008. The increase in consumer loans during 2009 was primarily attributable to an increase in indirect consumer loans, due to a combination of an increased sales effort, new technology to support indirect loan application processing and a

reduction in the number of competing lenders. Indirect consumer loans include automobile, recreational vehicle and boat financing purchased from dealerships. At December 31, 2010, approximately 45% of consumer loans were secured by the borrowers’ personal residences (primarily second mortgages), 25% by automobiles, 19% by recreational vehicles, 8% by marine vehicles and the remaining 3% was mostly unsecured. Consumer loans represented 22.9% of the Corporation’s loan portfolio at December 31, 2010, compared to 25.5% and 21.8% at December 31, 2009 and 2008, respectively.

 

Consumer loans generally have shorter terms than residential mortgage loans, but generally involve more credit risk than real estate 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 lending collections are dependent on the borrowers’ continuing financial stability and are more likely to be affected by adverse personal situations. Overall, credit risk on these loans has increased as the unemployment rate has increased. The unemployment rate in the State of Michigan was 11.7% at December 31, 2010, down from 14.6% at December 31, 2009, although higher than 10.2% at December 31, 2008 and the national average of 9.4% at December 31, 2010. The Corporation has experienced significant increases in losses on consumer loans, with net loan losses totaling 116 basis points of average consumer loans during 2010, compared to 77 basis points of average consumer loans in 2009 and 71 basis points of average consumer loans in 2008. The credit risk on home equity loans has historically been low as property values of residential real estate have historically increased year over year. However, credit risk has increased since the beginning of 2008 as property values have declined throughout the State of Michigan, thus increasing the risk of insufficient collateral, and in many instances no collateral, as the majority of these loans are secured by a second mortgage on the borrowers’ residences.

 

ASSET QUALITY

 

Nonperforming Assets

 

Nonperforming assets consist of originated loans for which the accrual of interest has been discontinued, originated loans that are past due as to principal or interest by 90 days or more and are still accruing interest, originated loans which have been modified due to a decline in the credit quality of the borrower (collectively referred to as nonperforming loans or nonperforming loans of the originated portfolio) and assets obtained through foreclosures and repossessions, including foreclosed and repossessed assets acquired as a result of the OAK transaction. The Corporation transfers an originated loan that is 90 days or more past due to nonaccrual status (except for real estate residential loans that are transferred at 120 days past due), 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 originated loan that is 90 days or more past due (120 days or more past due on real estate residential loans) and still accruing interest is probable.

 

Nonperforming assets do not include acquired loans that were not performing in accordance with the loans’ contractual terms. These loans were recorded at their estimated fair value, which included estimated credit losses, at the acquisition date and are considered performing due to the application of ASC 310-30 as discussed in Note 1 to the consolidated financial statements under the subheading, Loans Acquired in a Business Combination. Accordingly, these acquired loans have been excluded from Table 5 — Nonperforming Assets.

 

Nonperforming assets were $175.2 million at December 31, 2010, compared to $153.3 million at December 31, 2009 and $113.3 million at December 31, 2008, and represented 3.3%, 3.6% and 2.9%, respectively, of total assets. The decrease in this ratio at December 31, 2010 compared to December 31, 2009 was attributable to the acquisition of OAK, which increased total assets $820 million at the acquisition date, with no increase in nonperforming loans, as the acquired loans were recorded at their fair value, which included a discount attributable, in part, to credit quality. It is management’s belief that the elevated levels of nonperforming assets are primarily attributable to the unfavorable economic climate within the State of Michigan, which has resulted in cash flow difficulties being encountered by many business and consumer loan customers. The unemployment rate in Michigan was 11.7% at December 31, 2010, compared to 9.4% nationwide. The Corporation’s nonperforming assets are not concentrated in any one industry or any one geographical area within Michigan, other than $10.2 million in nonperforming land development loans. At December 31, 2010, there were seven commercial loan relationships exceeding $2.5 million, totaling $24.3 million, that were in nonperforming status. Based on declines in both residential and commercial real estate appraised values due to the weakness in the Michigan economy over the past several years, management continues to evaluate and, when appropriate, discount appraised values and obtain new appraisals to compute estimated fair market values of impaired real estate secured loans and other real estate properties. Due to the economic climate within Michigan, it is management’s belief that nonperforming assets will remain at elevated levels throughout 2011.

Table 5 provides a five-year history of nonperforming assets, including the composition of nonperforming loans of the originated portfolio, by major loan category.

 

TABLE 5. NONPERFORMING ASSETS

 

 

 

The following schedule provides the composition of nonperforming loans of the originated portfolio, by major loan category, as of December 31, 2010 and 2009.

 

 

Total nonperforming loans of the originated portfolio at December 31, 2010 were $147.7 million, an increase of $11.9 million, or 8.8%, compared to $135.8 million at December 31, 2009. The Corporation’s nonperforming loans to commercial borrowers (commercial, real estate commercial and real estate construction and land development) of the originated portfolio, including loans modified under troubled debt restructurings, were $104.4 million at December 31, 2010, an increase of $13.2 million, or 14%, from $91.2 million at December 31, 2009. The net increase in nonperforming loans to commercial borrowers of the originated portfolio during 2010 was largely due to an increase in loans modified under troubled debt restructurings. Nonperforming loans to commercial borrowers comprised 71% of total nonperforming loans at December 31, 2010, compared to 67% at December 31, 2009. Likewise, as disclosed in Table 6, the majority of the Corporation’s net loan charge-offs during 2010 occurred within these three commercial loan categories, with 55% of net loan charge-offs during 2010 attributable to commercial borrowers, although down from 75% in 2009. Nonperforming real estate residential loans of the originated portfolio, including loans modified under troubled debt restructurings, were $37.6 million at December 31, 2010, an increase of $1.0 million, or 3.0%, from $36.6 million at December 31, 2009. Nonperforming consumer loans of the originated portfolio were $5.7 million at December 31, 2010, a decrease of $2.3 million, or 28%, from $8.0 million at December 31, 2009.

 

The following schedule summarizes changes in nonaccrual loans of the originated portfolio during 2010 and 2009:

 

The following schedule presents data related to nonperforming commercial, real estate commercial and real estate construction and land development loans of the originated portfolio by dollar amount as of December 31, 2010 and 2009.

 

 

Nonperforming commercial loans of the originated portfolio were $22.5 million at December 31, 2010, an increase of $1.8 million, or 8.9%, from $20.7 million at December 31, 2009. The nonperforming commercial loans of the originated portfolio at December 31, 2010 were not concentrated in any single industry and it is management’s belief that the increase from December 31, 2009 was primarily reflective of the unfavorable economic conditions in Michigan.

 

Nonperforming real estate commercial loans of the originated portfolio were $71.7 million at December 31, 2010, an increase of $18.3 million, or 34%, from $53.4 million at December 31, 2009. At December 31, 2010, the Corporation’s nonperforming real estate commercial loans of the originated portfolio were comprised of $34.6 million of loans secured by owner occupied real estate, $29.4 million of loans secured by non-owner occupied real estate and $7.7 million of loans secured by vacant land, resulting in approximately 6% of owner occupied real estate commercial loans of the originated portfolio, 12% of non-owner occupied real estate commercial loans of the originated portfolio and 29% of vacant land loans of the originated portfolio in a nonperforming status at December 31, 2010. At December 31, 2010, the Corporation’s nonperforming real estate commercial loans of the originated portfolio were comprised of a diverse mix of commercial lines of business and were also geographically disbursed throughout the Corporation’s market areas. The largest concentration of the $71.7 million in nonperforming real estate commercial loans of the

originated portfolio at December 31, 2010 was one customer relationship totaling $6.8 million that was secured by a combination of vacant land and non-owner occupied commercial real estate. This same customer relationship had another $0.4 million included in nonperforming real estate construction and land development loans of the originated portfolio. At December 31, 2010, $11.4 million of the nonperforming real estate commercial loans of the originated portfolio were in various stages of foreclosure with 38 borrowers. Challenges remain in the Michigan economy, thus creating a difficult business environment for many lines of business across the state.

 

Nonperforming real estate construction and land development loans of the originated portfolio were $10.2 million at December 31, 2010, a decrease of $7.0 million, or 41%, from $17.2 million at December 31, 2009. At December 31, 2010, all of the nonperforming real estate construction and land development loans were land development loans secured primarily by residential real estate improved lots and housing units. The $10.2 million of nonperforming loans secured by land development projects represented 29% of total land development loans of the originated portfolio outstanding of $34.7 million at December 31, 2010. The economy in Michigan has adversely impacted housing demand throughout the state and, accordingly, a significant percentage of the Corporation’s residential real estate development borrowers have experienced cash flow difficulties associated with a significant decline in sales of both lots and residential real estate.

 

Nonperforming real estate residential loans of the originated portfolio, including loans modified under troubled debt restructurings, were $37.6 million at December 31, 2010, an increase of $1.0 million, or 3.0%, from $36.6 million at December 31, 2009. At December 31, 2010, a total of $9.7 million of nonperforming real estate residential loans of the originated portfolio were in various stages of foreclosure.

 

Nonperforming consumer loans of the originated portfolio were $5.7 million at December 31, 2010, a decrease of $2.3 million, or 28%, from $8.0 million at December 31, 2009. The decrease in nonperforming consumer loans during 2010 was primarily attributable to elevated levels of net loan charge-offs of consumer loans of the originated portfolio, which were $9.0 million during 2010, compared to $5.6 million during 2009.

 

The unfavorable economic climate in Michigan has resulted in an increasing number of both business and consumer customers with cash flow difficulties and thus the inability to maintain their loan balances in a performing status. The Corporation determined that it was probable that certain customers who were past due on their loans, if provided a reduction in their monthly payment for a limited time period, would be able to bring their loan relationship to a performing status and was believed by the Corporation to potentially result in a lower level of loan losses and loan collection costs than if the Corporation currently proceeded through the foreclosure process with these borrowers.

 

The Corporation’s loans modified under troubled debt restructurings-commercial and real estate commercial generally consist of allowing borrowers to defer scheduled principal payments and make interest only payments for a short period of time at the stated interest rate of the original loan agreement or lower payments due to a modification of the loan’s contractual terms. The outstanding balance of these loans was $15.1 million at December 31, 2010. The Corporation does not expect to incur a loss on these loans based on its assessment of the borrowers’ expected cash flows, and accordingly, no additional provision for loan losses has been recognized related to these loans. Additionally, these loans are individually evaluated for impairment and transferred to nonaccrual status when it is probable that any remaining principal and interest payments due on the loan will not be collected in accordance with the contractual terms of the loan.

 

The Corporation’s loans modified under troubled debt restructurings-real estate residential generally consist of reducing a borrower’s monthly payments by decreasing the interest rate charged on the loan to 3% for a specified period of time (generally 24 months). The outstanding loan balance of these loans was $22.3 million at December 31, 2010, compared to $17.4 million at December 31, 2009. All loans reported as loans modified under troubled debt restructurings-real estate residential will remain in nonperforming status until a sustained payment history has been observed. The Corporation recognized $0.6 million and $0.8 million of additional provision for loan losses during 2010 and 2009, respectively, related to impairment on these loans based on the present value of expected future cash flows discounted at the loan’s original effective interest rate. These loans are moved to nonaccrual status when the loan becomes ninety days past due as to principal or interest and sooner if conditions warrant.

 

Other real estate and repossessed assets is a component of nonperforming assets that includes residential and commercial real estate and development properties acquired through foreclosure or by acceptance of a deed in lieu of foreclosure, and also other personal and commercial assets. Other real estate and repossessed assets were $27.5 million at December 31, 2010, an increase of $10.0 million, or 57%, from $17.5 million at December 31, 2009. The increase from December 31, 2009 was partially attributable to $2.7 million of other real estate and $0.2 million of repossessed assets acquired in the OAK acquisition at the acquisition date. The increase was also attributable to the foreclosure and transfer into other real estate of one real estate commercial loan acquired in the OAK acquisition with a carrying value of $4.3 million.

The following schedule provides the composition of other real estate and repossessed assets at December 31, 2010 and 2009:

 

 

The following schedule summarizes other real estate and repossessed asset activity during 2010 and 2009:

 

The historically large inventory of real estate properties for sale across the State of Michigan has resulted in an increase in the Corporation’s carrying time and cost of holding other real estate. Consequently, the Corporation had $8.9 million in real estate properties at December 31, 2010 that had been held in excess of one year as of that date, of which $2.9 million was vacant land, $2.1 million were commercial properties, $2.6 million were residential real estate properties and $1.3 million were residential development properties. Due to the redemption period on foreclosures being relatively long in Michigan (six months to one year) and the Corporation having a significant number of nonperforming loans that were in the process of foreclosure at December 31, 2010, it is anticipated that the level of other real estate will remain at elevated levels throughout 2011. Other real estate properties are carried at the lower of cost or fair value less estimated cost to sell.

 

At December 31, 2010, all of the other real estate properties had been written down to fair value through a charge-off at the transfer of the loan to other real estate, a write-down recorded as an operating expense to recognize a further market value decline of the property after the initial transfer date or a recording at fair value in conjunction with the OAK acquisition. Accordingly, at December 31, 2010, the carrying value of other real estate of $27.0 million, was reflective of $35.7 million in charge-offs, write-downs or fair value adjustments, and represented 43% of the contractual loan balance remaining at the time the property was transferred to other real estate.

 

During 2010, the Corporation sold 185 pieces of other real estate properties for net proceeds of $14.5 million. On an average basis, the net proceeds from these sales represented 110% of the carrying value of the property at the time of sale, although the net proceeds represented 56% of the remaining loan balance at the time the Corporation received title to the properties.

 

As previously discussed, due to the application of ASC 310-30, nonperforming assets at December 31, 2010 did not include acquired loans totaling $21.4 million that were not performing in accordance with the loan’s original contractual terms due to a market interest yield recognized on these loans in interest income during 2010. Additionally, the risk of credit loss at the acquisition date was recognized as part of the fair value adjustment. These loans are included in the Corporation’s impaired loan schedule in Note 4 to the consolidated financial statements.

Impaired Loans

 

A loan is considered impaired when management determines it is probable that all of the principal and interest due will not be collected according to the original contractual terms of the loan agreement. The Corporation has determined that all of its nonaccrual loans and loans modified under troubled debt restructurings meet the definition of an impaired loan. Acquired loans that meet the definition of an impaired loan are included even though the amortization of the accretable yield results in interest income recognition on these loans. In most instances, impairment is measured based on the fair market value of the underlying collateral. It is the Corporation’s general policy to, at least annually, obtain new appraisals on impaired commercial and real estate commercial loans that are secured by real estate. At December 31, 2010, the Corporation had a current appraisal on approximately 90% of impaired loans, with 50% of these appraisals being performed during the second half of 2010. Impairment may also be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate. A portion of the allowance for loan losses may be specifically allocated to impaired loans.

 

Impaired loans totaled $161.7 million at December 31, 2010, an increase of $37.7 million, or 30%, compared to $124.0 million at December 31, 2009. Impaired loans increased $47.5 million, or 62%, during 2009 from $76.5 million at December 31, 2008. The increase in impaired loans during 2010 was due to increases in the amount of loans modified under troubled debt restructurings and loans acquired in the acquisition of OAK that were not performing in accordance with the loans’ contractual terms. Impaired loans at December 31, 2010 included $21.4 million of loans acquired in the OAK acquisition that were recorded at fair value at the acquisition date. After analyzing the various components of the customer relationships and evaluating the underlying collateral of impaired loans, it was determined that impaired commercial, real estate commercial and real estate construction and land development loans totaling $44.9 million at December 31, 2010 required a specific allocation of the allowance for loan losses (valuation allowance), compared to $38.2 million of impaired loans at December 31, 2009 and $30.3 million of impaired loans at December 31, 2008. The valuation allowance on these impaired loans was $15.0 million at December 31, 2010, compared to $10.5 million at December 31, 2009 and $9.2 million at December 31, 2008. At December 31, 2010 and 2009, loans modified under troubled debt restructurings-real estate residential of $22.3 million and $17.4 million, respectively, also required a valuation allowance of $0.8 million and $0.7 million, respectively. Loans modified under troubled debt restructurings-commercial and real estate commercial of $15.1 million at December 31, 2010 did not require a valuation allowance as the Corporation expects to collect the full principal and interest owed on each loan. At December 31, 2010, there was no valuation allowance required on impaired loans acquired in the OAK acquisition. The process of measuring impaired loans and the allocation of the allowance for loan losses requires judgment and estimation. The eventual outcome may differ from the estimates used on these loans. A discussion of the allowance for loan losses is included under the subheading, “Allowance for Loan Losses,” below.

ALLOWANCE FOR LOAN LOSSES

 

The allowance for loan losses (allowance) provides for probable losses in the originated loan portfolio that have been identified with specific customer relationships and for probable losses believed to be inherent in the remainder of the originated loan portfolio but that have not been specifically identified. The allowance is comprised of specific allowances (assessed for originated loans that have known credit weaknesses), pooled allowances based on assigned risk ratings and historical loan loss experience for each loan type, and an unallocated allowance for imprecision in the subjective nature of the specific and pooled allowance methodology. Management evaluates the allowance on a quarterly basis in an effort to ensure the level is adequate to absorb probable losses inherent in the loan portfolio. This evaluation process is inherently subjective as it requires estimates that may be susceptible to significant change and has the potential to affect net income materially. The Corporation’s methodology for measuring the adequacy of the allowance includes several key elements, which includes a 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, review of collateral values, 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 other factors affecting business sectors. Management believes that the allowance is currently maintained at an appropriate level, considering the inherent risk in the loan portfolio. Future significant adjustments to the allowance may be necessary due to changes in economic conditions, delinquencies or the level of loan losses incurred. Further discussion of the Corporation’s methodology used to determine the allowance is included in Notes 1 and 4 to the consolidated financial statements.

 

The Corporation’s allowance at December 31, 2010 did not include losses inherent in the acquired loan portfolio, as an allowance was not carried over on the date of acquisition. The acquired loans were recorded at their estimated fair value at the date of acquisition, with the estimated fair value including a component for expected credit losses. A portion of the allowance, however, may be set aside in the future, related to the acquired loans, if an acquired loan pool experiences a decrease in expected cash flows as compared to those expected at the acquisition date. An allowance for loan losses related to acquired loans was not required at December 31, 2010 due to no material changes in expected cash flows since the date of acquisition.

 

A summary of the activity in the allowance for loan losses for the last five years is included in Table 6.

 

TABLE 6. ANALYSIS OF ALLOWANCE FOR LOAN LOSSES

 

 

The Corporation’s allowance was $89.5 million at December 31, 2010, compared to $80.8 million at December 31, 2009 and $57.1 million at December 31, 2008. The allowance as a percentage of originated loans was 2.86% at December 31, 2010, compared to 2.70% at December 31, 2009 and 1.91% at December 31, 2008. The allowance as a percentage of nonperforming originated loans was 61% at December 31, 2010, compared to 60% at December 31, 2009 and 61% at December 31, 2008.

 

The allocation of the allowance in Table 7 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.

 

TABLE 7. ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

 

 

The following schedule summarizes impaired loans to commercial borrowers and the related valuation allowance at December 31, 2010 and 2009 and partial loan charge-offs taken on these impaired loans (confirmed losses):