UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-K

 

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2009

OR

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _______ to ________

 

Commission file number 000-22461

 

O.A.K. FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

          MICHIGAN                                                                                                                     38-2817345     

(State of other jurisdiction of incorporation or organization)                                               (I.R.S. Employer Identification No.)

 

2445 84th Street, S.W., Byron Center, Michigan 49315

(Address of principal executive offices) (Zip Code)

 

Registrant's telephone number, including area code: (616) 878-1591

 

Securities registered pursuant to Section 12(b) of the Act:  None

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $1.00 par value

(Title of Class)

___________

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes       No _X_.

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 of Section 15(d) of the Exchange Act.  Yes        No   X  .

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ____ No ____

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K.          .

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definitions of “large accelerated filer", “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer____       Accelerated Filer               Non-Accelerated Filer____     Smaller Reporting Company_ X__

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes         No   X  .   

 

State the aggregate market value of the voting and nonvoting common equity held by non-affiliates of the registrant computed by reference to the price at which the common equity was sold, or the average bid and asked prices of such common equity, as of the last business day of the registrant's most recently completed second quarter.

 

Aggregate Market Value of Common Stock Held by Non-Affiliates as of June 30, 2009:  $41,618,100

As of February 1, 2010, there were outstanding 2,703,009 shares of the Company's Common Stock ($1.00 par value).

 

Documents Incorporated by Reference:  Portions of the Company's Proxy Statement for the Annual Meeting of Shareholders to be held in 2010 are incorporated by reference into Part III of this report, or alternatively, will be filed as an amendment to this Annual Report on Form 10-K..

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PART I

 

Item 1.   Business.

 

The Company

 

OAK Financial Corporation (the "Company") was incorporated under the laws of the State of Michigan on October 13, 1988, for the purpose of becoming a bank holding company.  The Company is registered under the Bank Holding Company Act of 1956, as amended, and owns the outstanding stock of Byron Bank (the “Bank”), which is organized under the laws of the State of Michigan.  Aside from the Bank, the Company has no other substantial assets.  The Company conducts no business except for the provision of certain management and operational services to the Bank, the collection of dividends from the Bank and the payment of dividends to the Company's stockholders.  The executive office of the Company is located at 2445 84th Street, S.W., Byron Center, Michigan 49315.  While the Company's chief decision makers monitor the revenue streams of various products and services, operations are managed and financial performance is evaluated on a company wide basis.  Accordingly, all of the Company's operations are considered by Management to be aggregated in one reportable operating segment.

 

The Company and all its subsidiaries are provided staff resources through OAK ELC, an affiliated employee leasing company.  OAK ELC provides staffing solely to the Company and its subsidiaries.

 

Recent Development – Proposed Merger with Chemical Financial Corporation

 

On January 7, 2010, Chemical Financial Corporation ("Chemical") and the Company entered into a definitive Agreement and Plan of Merger (the "Merger Agreement") pursuant to which the Company will merge with and into Chemical (the "Merger").  Following the Merger, Byron Bank, the wholly owned subsidiary of the Company, will be consolidated with and into Chemical Bank, a wholly owned subsidiary of Chemical.  Under the terms of the Merger Agreement, included as Exhibit 2.1 to this Annual Report on Form 10-K, as of the effective time of the Merger shareholders of the Company will receive 1.306 shares of Chemical stock for each share of common stock they own, subject to adjustments under certain specified situations (the "Merger Consideration"). 

 

                The Merger Agreement contains customary representations, warranties and covenants of the Company and Chemical, including, among others, the Company's covenant to conduct its business in the ordinary course during the interim period between the execution of the Merger Agreement and the completion of the Merger and not to engage in certain transactions during such period without the consent of Chemical in writing. 

 

                Consummation of the Merger is subject to approval by the Company's shareholders, receipt of appropriate regulatory approvals, and certain other closing conditions.  Subject to the terms and conditions of the Merger Agreement, the transaction is expected to be completed in the second quarter of 2010.

 

Chemical will file a registration statement with the SEC to register the securities that the Company's shareholders will receive if the Merger is consummated. The registration statement will contain a prospectus and proxy statement and other relevant documents concerning the Merger. Shareholders are urged to read the registration statement, the prospectus and proxy statement, and any other relevant documents when they become available because they will contain important information about Chemical, the Company, and the Merger. Shareholders will be able to obtain the documents free of charge at the SEC's website, www.sec.gov.

 

In addition, in connection with the proposed transaction, the Company will be filing a proxy statement and other relevant documents to be distributed to the shareholders of the Company. Shareholders are urged to read the proxy statement regarding the Merger when it becomes available and any other relevant documents filed with the SEC, as well as any amendments or supplements to those documents, because they will contain important information.  Shareholders will be able to obtain a free copy of the proxy statement, as well as other filings containing information about Chemical and the Company, free of charge from the SEC's website (www.sec.gov), by contacting Chemical Financial Corporation, 333 East Main Street, P.O. Box 569, Midland, MI 48640-0569, Attention: Ms. Lori A. Gwizdala, Investor Relations, telephone 800-867-9757, or by contacting O.A.K. Financial Corporation, 2445 84th Street, SW, Byron Center, MI 49315, Attention: Mr. James A. Luyk, Investor Relations, telephone 616-588-7419.  SHAREHOLDERS SHOULD READ THE PROXY STATEMENT AND OTHER DOCUMENTS TO BE FILED WITH THE SEC CAREFULLY BEFORE MAKING A DECISION CONCERNING THE MERGER.

 

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The Company and its directors, executive officers, and certain other members of management and employees may be soliciting proxies from the Company's shareholders in favor of the Merger.  Information regarding the persons who may, under the rules of the SEC, be considered participants in the solicitation of the Company's shareholders in connection with the Merger will be set forth in the proxy statement when it is filed with the SEC.  Shareholders can find information about the Company's executive officers and directors in its most recent proxy statement filed with the SEC, which is available at the SEC’s website (www.sec.gov).  You can also obtain free copies of these documents from Chemical or the Company, as appropriate, using the contact information above.

 

The Bank

 

The Bank was organized in 1921 as a Michigan banking corporation.  The executive office of the Bank is located at 2445 84th Street, S.W., Byron Center, Michigan 49315.  The Bank's main office is located in Byron Center and it serves other communities with a total of 14 offices.  The Bank's offices are located in Kent County, Ottawa County and the northern portion of Allegan County.  The area in which the Bank's offices are located, which is primarily south and west of the city of Grand Rapids, has historically been rural in character but now has a growing suburban population as the Grand Rapids Metropolitan Area expands.

 

The Bank provides a broad range of financial products and services through its branch network in West Michigan.  A typical branch includes a full service lobby, most with drive-thru service and automatic teller machines.  The Bank provides a wide range of commercial and personal banking services, including but not limited to:  real estate, consumer and commercial loans, checking accounts, savings accounts, certificates of deposit, safe deposit boxes, internet banking, electronic ATM banking, telephone banking and other electronic banking services.  Currently, the Bank does not offer trust services.

 

The Bank owns a subsidiary, Byron Investment Services, Inc., which offers mutual fund products, securities brokerage services, retirement planning services, investment management and advisory services.  Byron Investment Services owns Byron Insurance Agency, Inc., which offers property and casualty, life, disability and long-term care insurance.  OAK Title Insurance Agency, Inc., a wholly owned subsidiary of Byron Investments Services, Inc., offers title insurance, through a joint venture with a regional title agency.

 

Effect of Government Monetary Policies

 

Earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States Government, its agencies, and the Federal Reserve Board. The Federal Reserve Board's monetary policies have had, and will likely continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order to, among other things, curb inflation or avoid a recession. The policies of the Federal Reserve Board have a major effect upon the levels of bank loans, investments and deposits through its open market operations in United States government securities, and through its regulation of, among other things, the discount rate on borrowings of member banks and the reserve requirements against member bank deposits.  It is not possible to predict the nature and impact of future changes in monetary and fiscal policies.

 

Bank Competition

 

The Bank has 14 offices, one within each of the communities it serves.  Within these communities, its principal competitors are Comerica Bank, JP Morgan Chase, Fifth-Third Bank, Flagstar Bank, PNC Bank, Huntington National Bank, Macatawa Bank, Mercantile Bank of Michigan, United Bank of Michigan, and various credit unions.  Additional competition comes from internet based financial services companies and other national banks offering web based services.  The Bank’s products, services, and pricing are competitive within the markets served.

 

The financial services industry is very competitive.  Principal methods of competition include loan and deposit pricing and the quality of services provided. The deregulation of the financial service industry has led to increased competition among banks and other financial institutions for funds, which traditionally have been deposited with commercial banks.  The enactment of the Gramm-Leach-Bliley Act of 1999, which permits the combination of banks, insurance companies, and securities firms, has also increased competition in the financial services industry. 

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Source of Revenue

 

The Bank's principal sources of revenue include net interest income and non-interest income.  The net interest revenue is the difference between the interest the Bank earns on loans and investments and the interest the Bank pays on deposits and other interest bearing borrowed funds.  Non-interest revenue includes deposit service charges, insurance premium income, brokerage fees, mortgage banking revenue, and other fees collected for services provided.  Mortgage banking revenue includes the gains resulting from the origination and sale of mortgage loans and fees received for servicing mortgage loans for others.  The sources of income for the three most recent years are as follows:

 

* 2008 revenue totals exclude the impairment charge on investment securities.

 

Employees

 

As of December 31, 2009, the Company and its subsidiaries employed 157 full-time and 95 part-time persons.  Management believes that relations with employees are good.

 

 

SUPERVISION AND REGULATION

 

The following is a summary of certain statutes and regulations affecting the Company and the Bank.  This summary is qualified in its entirety by such statutes and regulations.  A change in applicable laws or regulations may have a material effect on the Company, the Bank and the business of the Company and the Bank.

 

General

 

Financial institutions and their holding companies are extensively regulated under federal and state law. Consequently, the growth and earnings performance of the Company and the Bank can be affected not only by management decisions and general economic conditions, but also by the statutes administered by, and the regulations and policies of, various governmental regulatory authorities.  Those authorities include, but are not limited to, the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), the FDIC, the Michigan Office of Financial and Insurance Regulation ("OFIR"), the Internal Revenue Service, and state taxing authorities. The effect of such statutes, regulations and policies can be significant, and cannot be predicted with a high degree of certainty.

 

Federal and state laws and regulations generally applicable to financial institutions and their holding companies regulate, among other things, the scope of business, investments, reserves against deposits, capital levels relative to operations, lending activities and practices, the nature and amount of collateral for loans, the establishment of branches, mergers, consolidations and dividends.  The system of supervision and regulation applicable to the Company and the Bank establishes a comprehensive framework for their respective operations and is intended primarily for the protection of the FDIC's deposit insurance fund, the depositors of the Bank, and the public, rather than stockholders of the Bank or the Company.  Federal law and regulations establish supervisory standards applicable to the lending activities of the Bank, including internal controls, credit underwriting, loan documentation and loan-to-value ratios for loans secured by real property.

 

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Recent Regulatory Developments

 

Emergency Economic Stabilization Act of 2008.  On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was enacted. EESA enables the federal government, under terms and conditions to be developed by the Secretary of the Treasury, to insure troubled assets, including mortgage-backed securities, and collect premiums from participating financial institutions. EESA includes, among other provisions: (a) the $700 billion Troubled Assets Relief Program (TARP), under which the Secretary of the Treasury is authorized to purchase, insure, hold, and sell a wide variety of financial instruments, and (b) an increase in the amount of deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC). Under the TARP program, the Department of Treasury authorized a voluntary capital purchase program (CPP) to purchase senior preferred shares of qualifying financial institutions that elected to participate by November 14, 2008.    Our application to participate in the TARP program was approved, however after careful consideration we decided not to participate in the program. 

 

Federal Deposit Insurance Corporation (FDIC).  EESA temporarily raised the limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor and on May 20, 2009, this temporary increase in the insurance limit was extended until December 31, 2013. Separate from EESA, in October 2008, the FDIC also announced the Temporary Liquidity Guarantee Program. Under one component of this program, the FDIC temporarily provides unlimited coverage for noninterest bearing transaction deposit accounts through June 30, 2010.

 

Financial Stability Plan.  On February 10, 2009, the Financial Stability Plan (FSP) was announced by the U.S. Treasury Department. The FSP is a comprehensive set of measures intended to shore up the financial system. The core elements of the plan include making bank capital injections, creating a public-private investment fund to buy troubled assets, establishing guidelines for loan modification programs and expanding the Federal Reserve lending program. The U.S. Treasury Department has indicated more details regarding the FSP are to be announced at a future date.

 

American Recovery and Reinvestment Act of 2009.  On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (ARRA) was enacted. ARRA is intended to provide a stimulus to the U.S. economy in light of the significant economic downturn.  ARRA includes federal tax cuts, expansion of unemployment benefits and other social welfare provisions, and domestic spending in education, healthcare, and infrastructure, including the energy structure. ARRA also includes numerous non-economic recovery related items, including a limitation on executive compensation in federally aided financial institutions.  Under ARRA, an institution will be subject to a number of restrictions and standards through-out the period in which any obligation arising from financial assistance provided under TARP remains outstanding. 

 

Homeowner Affordability and Stability Plan.  On February 18, 2009, the Homeowner Affordability and Stability Plan (HASP) was announced by the President of the United States. HASP is intended to support a recovery in the housing market and ensure that workers can continue to pay off their mortgages through the following elements:

 

In addition, the U.S. Government, the Federal Reserve, the Treasury, the FDIC and other governmental and regulatory bodies have taken, or may be considering taking, other actions to address the financial crisis.  There can be no assurance, however, as to the actual impact of these actions on the financial markets and their potential impact on our business.

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The Company

 

General.  The Company is a bank holding company and, as such, is registered with, and subject to regulation by, the Federal Reserve Board under the Bank Holding Company Act, as amended (the "BHCA").  Under the BHCA, the Company is subject to periodic examination by the Federal Reserve Board, and is required to file with the Federal Reserve Board periodic reports of its operations and such additional information as the Federal Reserve Board may require.

 

In accordance with Federal Reserve Board policy, the Company is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances where the Company might not do so absent such policy.  In addition, if OFIR deems the Bank's capital to be impaired, OFIR may require the Bank to restore its capital by a special assessment upon the Company as the Bank's sole shareholder.  If the Company were to fail to pay any such assessment, the directors of the Bank would be required, under Michigan law, to sell the shares of the Bank's stock owned by the Company to the highest bidder at either a public or private auction and use the proceeds of the sale to restore the Bank's capital.

 

Investments and Activities.  In general, any direct or indirect acquisition by the Company of any voting shares of any bank which would result in the Company's direct or indirect ownership or control of more than 5 percent of any class of voting shares of such bank, and any merger or consolidation of the Company with another bank company, will require the prior written approval of the Federal Reserve Board under the BHCA.

 

The merger or consolidation of an existing bank subsidiary of the Company with another bank, or the acquisition by such a subsidiary of assets of another bank, or the assumption of liability by such a subsidiary to pay any deposits in another bank, will require the prior written approval of the responsible Federal depository institution regulatory agency under the Bank Merger Act.  In addition, in certain such cases an application to, and the prior approval of, the Federal Reserve Board under the BHCA and/or the OFIR under the Michigan Banking Code, may be required.

 

With certain limited exceptions, the BHCA prohibits any bank holding company from engaging, either directly or indirectly through a subsidiary, in any activity other than managing or controlling banks unless the proposed non-banking activity is one that the Federal Reserve Board has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.  Under current Federal Reserve Board regulations, such permissible non-banking activities include such things as mortgage banking, equipment leasing, securities brokerage, and consumer and commercial finance company operations.  Well-capitalized and well-managed bank holding companies may engage de novo in certain types of non-banking activities without prior notice to, or approval of, the Federal Reserve Board, provided that written notice of the new activity is given to the Federal Reserve Board within 10 business days after the activity is commenced.  If a bank holding company wishes to engage in a non-banking activity by acquiring a going concern, prior notice and/or prior approval will be required, depending upon the activities in which the company to be acquired is engaged, the size of the company to be acquired and the financial and managerial condition of the acquiring bank holding company.

 

Eligible bank holding companies that elect to operate as financial holding companies may engage in, or own shares in companies engaged in, a wider range of non-banking activities, including securities and insurance activities and any other activity that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines by regulation or order is financial in nature, incidental to any such financial activity or complementary to any such financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally.  The Bank Holding Company Act generally does not place territorial restrictions on the domestic activities of non-bank subsidiaries of bank or financial holding companies. 

 

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Securities Regulation.  The Company's common stock is registered under the Securities Exchange Act of 1934, as amended (the "Exchange Act").  It is therefore subject to the information, proxy solicitation, insider trading and other restrictions and requirements of the SEC under the Exchange Act.  On July 30, 2002, the Sarbanes-Oxley Act of 2002 was signed into law.  The Sarbanes-Oxley Act provides for numerous changes to the reporting, accounting, corporate governance and business practices of companies as well as financial and other professionals who have involvement with the U.S. public markets.  The Company is generally subject to these requirements as well as SEC rules and regulation that implement the provisions of the Act.  At June 30, 2009, the Company’s aggregate market value dropped below $50 million and as a result the Company is now a “smaller reporting company” under SEC rules and is subject to the disclosure requirements and filing deadlines for smaller reporting companies.

 

Capital Requirements.  The Federal Reserve Board uses capital adequacy guidelines in its examination and regulation of bank holding companies.  If capital falls below minimum guidelines, a bank holding company may, among other things, be denied approval to acquire or establish additional banks or non-bank businesses.  The Federal Reserve Board's capital guidelines for bank holding companies are essentially the same as those described below for the Bank.

 

Dividends.  The Company is a corporation separate and distinct from the Bank.  Most of the Company's revenues are received by it in the form of dividends paid by the Bank.  Thus, the Company's ability to pay dividends to its stockholders is indirectly limited by statutory restrictions on the Bank's ability to pay dividends described below.  Further, in a policy statement, the Federal Reserve Board expressed its view that a bank holding company experiencing earnings weaknesses should not pay cash dividends exceeding its net income or which can only be funded in ways that weaken the bank holding company's financial health, such as by borrowing.  Additionally, the Federal Reserve Board possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations.  Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.  The "prompt corrective action" provisions of federal law and regulation authorizes the Federal Reserve Board to restrict the payment of dividends by the Company for an insured bank which fails to meet specified capital levels.

 

In addition to the restrictions on dividends imposed by the Federal Reserve Board, the Michigan Business Corporation Act provides that dividends may be legally declared or paid only if, after the distribution, a corporation, such as the Company, can pay its debts as they come due in the usual course of business and its total assets equal or exceed the sum of its liabilities plus the amount that would be needed to satisfy the preferential rights upon dissolution of any holders of preferred stock whose preferential rights are superior to those receiving the distribution. 

 

Our merger agreement with Chemical Financial Corporation limits our quarterly dividend to a maximum of $0.22 per share.

 

The Bank

 

General.  The Bank is a Michigan banking corporation, is a member of the Federal Reserve System and its deposit accounts are insured by the Deposit Insurance Fund (the "DIF") of the FDIC.  As a Federal Reserve System member and a Michigan chartered bank, the Bank is subject to the examination, supervision, reporting and enforcement requirements of the Federal Reserve Board as its primary federal regulator and OFIR, as the chartering authority for Michigan banks.  These agencies and the federal and state laws applicable to the Bank and its operations, extensively regulate various aspects of the banking business including, among other things, permissible types and amounts of loans, investments and other activities, capital adequacy, branching, interest rates on loans and deposits, the maintenance of non-interest bearing reserves on deposit accounts, and the safety and soundness of banking practices.

 

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Deposit Insurance.  As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC.  The FDIC has adopted a risk-based assessment system under which all insured depository institutions are placed into one of four categories and assessed insurance premiums, based upon their respective levels of capital and results of supervisory evaluation.  Institutions classified as well-capitalized (as defined by the FDIC) and considered healthy pay the lowest premium while institutions that are less than adequately capitalized (as defined by the FDIC) and considered of substantial supervisory concern pay the highest premium. 

 

In early 2006, Congress passed the Federal Deposit Insurance Reform Act of 2005, which made certain changes to the Federal deposit insurance program. These changes included merging the Bank Insurance Fund and the Savings Association Insurance Fund (the "SAIF"), increasing retirement account coverage to $250,000 and providing for inflationary adjustments to general coverage beginning in 2010, providing the FDIC with authority to set the fund's reserve ratio within a specified range, and requiring dividends to banks if the reserve ratio exceeds certain levels.  On September 9, 2009, the FDIC approved a rule to finalize the deposit insurance coverage regulations to reflect an extension of the temporary increase in standard maximum deposit insurance amount to $250,000 through December 31, 2013.

 

On October 14, 2008 the FDIC announced the Temporary Liquidity Guarantee Program (TLGP).  The program (1) guarantees newly issued senior unsecured debt of eligible institutions, including FDIC-insured banks and thrifts, as well as certain holding companies (the Debt Guarantee Program), and (2) provides full deposit insurance coverage for non-interest bearing deposit transaction accounts in FDIC insured institutions, regardless of the dollar amount (the Transaction Account Guarantee Program).  The insurance on senior unsecured debt, under the Transaction Account Guarantee Program, would be assessed an annualized fee based upon the maturity of the debt.  The fee will be lower for shorter-term debt and higher for longer-term debt.  The insurance on non-interest bearing transaction deposit accounts, under the Transaction Account Guarantee Program, would be assessed a fee equal to 10 basis points on deposits not otherwise covered by the existing deposit insurance limit of $250,000.  On August 29, 2009, the FDIC announced that the deposit insurance coverage under the Transaction Account Guarantee Program, which was scheduled to expire December 31, 2009, has been extended through June 30, 2010.  The fee will be equal to 15 basis points, 20 basis points, or 25 basis points, depending on the Risk Category assigned to the institution under the FDIC’s risk-based premium system.  Debt, under the Debt Guarantee Program, must have been issued by October 31, 2009 and is guaranteed until its maturity date or June 30, 2012, whichever comes first.  Participation in both the Transaction Account Guarantee and Debt Guarantee Program were optional.  The Bank elected to participate in both the Debt Guarantee Program and Transaction Account Guarantee Program.  The Bank did not issue any debt under the Debt Guarantee Program.

 

On November 12, 2009, the FDIC adopted a final rule on assessment regulations to require depository institutions to prepay their quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, on December 30, 2009.  The projected assessment base for each quarter represents the September 31, 2009, assessment base increased quarterly by a 5 percent annual growth rate.  This rule resulted in a prepaid assessment totaling $4.3 million for the Bank. 

 

FICO Assessments.  The Bank, as a member of the DIF, is subject to assessments to cover the payments on outstanding obligations of the Financing Corporation ("FICO"). FICO was created to finance the recapitalization of the Federal Savings and Loan Insurance Corporation, the predecessor to the SAIF, which insures the deposits of thrift institutions.  From now until the maturity of the outstanding FICO obligations in 2019, DIF members will share the cost of the interest on the FICO bonds on a pro rata basis.  It is estimated that FICO assessments during this period will be less than 0.030 percent of deposits.

 

OFIR Assessments.  Michigan banks are required to pay supervisory fees to OFIR to fund the operations of OFIS.  The amount of supervisory fees paid by a bank is based upon the bank's total assets, as reported to OFIR.

 

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Capital Requirements.  The Federal Reserve has established the following minimum capital standards for state-chartered, member banks, such as the Bank:  a leverage requirement consisting of a minimum ratio of Tier 1 capital to total average assets of 3 percent for the most highly-rated banks with minimum requirements of 4 percent to 5 percent for all others, and a risk-based capital requirement consisting of a minimum ratio of total capital to total risk-weighted assets of 8 percent, at least one-half of which must be Tier 1 capital.  Tier 1 capital consists principally of stockholders' equity.  These capital requirements are minimum requirements.  Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual institutions.

 

Federal law provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions.  The extent of the regulators' powers depends on whether the institution in question is "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," or "critically undercapitalized."  Federal regulations define these capital categories as follows:

 

 

As of December 31, 2009 the Bank's ratios exceeded minimum requirements for the well capitalized category. (See "Liquidity and Capital Resources.")

 

Depending upon the capital category to which an institution is assigned, the regulators' corrective powers include:  requiring the submission of a capital restoration plan; placing limits on asset growth and restrictions on activities; requiring the institution to issue additional capital stock (including additional voting stock) or to be acquired; restricting transactions with affiliates; restricting the interest rate the institution may pay on deposits; ordering a new election of directors of the institution; requiring that senior executive officers or directors be dismissed; prohibiting the institution from accepting deposits from correspondent banks; requiring the institution to divest certain subsidiaries; prohibiting the payment of principal or interest on subordinated debt; and ultimately, appointing a receiver for the institution.

 

In general, a depository institution may be reclassified to a lower category than is indicated by its capital levels if the appropriate federal depository institution regulatory agency determines the institution to be otherwise in an unsafe or unsound condition or to be engaged in an unsafe or unsound practice.  This could include a failure by the institution, following receipt of a less-than-satisfactory rating on its most recent examination report, to correct the deficiency.

 

Dividends.  Under Michigan law, the Bank is restricted as to the maximum amount of dividends it may pay on its common stock.  The Bank may not pay dividends except out of net income after deducting its losses and bad debts. A Michigan state bank may not declare or pay a dividend unless the bank will have surplus amounting to at least 20 percent of its capital after the payment of the dividend.

 

As a member of the Federal Reserve System, the Bank is required by federal law to obtain the prior approval of the Federal Reserve Board for the declaration or payment of a dividend, if the total of all dividends declared by the Bank's Board of Directors in any year will exceed the total of (i) the Bank's retained net income (as defined and interpreted by regulation) for that year plus (ii) the retained net income for the preceding two years, less any required transfers to surplus.  Federal law generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized.  Further, federal regulatory agencies can prohibit a banking institution or bank holding company from engaging in unsafe and unsound business practices and could prohibit payment of dividends if such payment could be deemed an unsafe and unsound business practice.

 

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Insider Transactions.  The Bank is subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the Company or its subsidiaries, on investments in the stock or other securities of the Company or its subsidiaries and the acceptance of the stock or other securities of the Company or its subsidiaries as collateral for loans.  Certain limitations and reporting requirements are also placed on extensions of credit by the Bank to its directors and officers, to directors and officers of the Company and its subsidiaries, to principal stockholders of the Company, and to "related interests" of such directors, officers and principal stockholders.  In addition, federal law and regulations may affect the terms upon which any person becoming a director or officer of the Company or one of its subsidiaries or a principal shareholder of the Company may obtain credit from banks with which the Bank maintains a correspondent relationship.

 

Safety and Soundness Standards.  Pursuant to FDICIA, the FDIC adopted guidelines to establish operational and managerial standards to promote the safety and soundness of federally insured depository institutions.  The guidelines establish standards for internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.

 

Investments and Other Activities.  Under federal law and regulations, Federal Reserve System member banks and FDIC-insured state banks are prohibited, subject to certain exceptions, from making or retaining equity investments of a type, or in an amount, that are not permissible for a national bank.  Federal law, as implemented by regulations, also prohibits state banks and their subsidiaries, subject to certain exceptions, from engaging as principal in any activity that is not permitted for a national bank or its subsidiary, respectively, unless the bank meets, and continues to meet, its minimum regulatory capital requirements and the bank's primary federal regulator determines the activity would not pose a significant risk to the deposit insurance fund of which the bank is a member.  Impermissible investments and activities must be divested or discontinued within certain time frames set by the bank's primary federal regulator in accordance with federal law.  These restrictions are not currently expected to have a material impact on the operations of the Bank.

 

Consumer Protection Laws.  The Bank's business includes making a variety of types of loans to individuals. In making these loans, the Bank is subject to State usury and regulatory laws and to various federal statutes, including the privacy of consumer financial information provisions of the Gramm-Leach-Bliley Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Fair and Accurate Credit Transactions Act, the Truth in Lending Act, the Real Estate Settlement Procedures Act, the Home Mortgage Disclosure Act, and regulations issued under each of those statutes.  These laws generally prohibit discrimination, specify disclosures to be made to borrowers regarding credit and settlement costs, and regulate the mortgage loan servicing activities of the Bank, including the maintenance and operation of escrow accounts and the transfer of mortgage loan servicing.  In receiving deposits, the Bank is subject to extensive regulation under State and federal law and regulations, including the Truth in Savings Act, the Expedited Funds Availability Act, the Bank Secrecy Act, the Electronic Funds Transfer Act, and the Federal Deposit Insurance Act.  Violation of these laws could result in the imposition of significant damages and fines upon the Bank and its directors and officers.

 

The USA Patriot Act.  The Patriot Act contains sweeping anti-money laundering and financial transparency laws.  Under the Act and implementing regulations, among other requirements financial institutions must establish anti-money laundering programs that include (i) internal policies, procedures, and controls, (ii) specific designation of an anti-money laundering compliance officer, (iii) ongoing employee training programs, and (iv) an independent audit function to test the anti-money laundering program.  Financial institutions must also implement a risk-based customer identification program in connection with opening new accounts.  The program must contain requirements for identity verification, record-keeping, comparison of information to government-maintained lists, and notice to customers.  Bank regulators are directed to consider a holding company's effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications.

 

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Branching Authority.  Michigan banks, such as the Bank, have the authority under Michigan law to establish branches anywhere in the State of Michigan, subject to receipt of all required regulatory approvals.

 

Banks may establish interstate branch networks through acquisitions of other banks.  The establishment of de novo interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is allowed only if specifically authorized by state law.

 

Michigan permits both U.S. and non-U.S. banks to establish branch offices in Michigan.  The Michigan Banking Code permits, in appropriate circumstances and with the approval of OFIR, (1) acquisition of Michigan banks by FDIC-insured banks, savings banks or savings and loan associations located in other states, (2) sale by a Michigan bank of branches to an FDIC-insured bank, savings bank or savings and loan association located in a state in which a Michigan bank could purchase branches of the purchasing entity, (3) consolidation of Michigan banks and FDIC-insured banks, savings banks or savings and loan associations located in other states having laws permitting such consolidation, (4) establishment of branches in Michigan by FDIC-insured banks located in other states, the District of Columbia or U.S. territories or protectorates having laws permitting a Michigan bank to establish a branch in such jurisdiction, and (5) establishment by foreign banks of branches located in Michigan.

 

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge through the investor relations link on our website, at www.BankAtByron.com.  The reports are also available through the SEC website.

 

Item 1A.  Risk Factors.

 

You should carefully consider the following risk factors, together with the other information provided in this Annual Report on Form 10-K.

 

Risks Relating to Our Proposed Merger with Chemical Financial Corporation

 

Our proposed merger with Chemical Financial Corporation ("Chemical") may be delayed or may not occur at all for a variety of reasons.

 

The merger agreement with Chemical may be terminated at any time before the completion of the merger, by either us or Chemical, under certain circumstances described in the merger agreement, including, but not limit to, if:

 

In addition, the merger agreement may be terminated by Chemical at any time before the completion of the merger if, among other things:

 

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Even if our proposed merger with Chemical is completed, our stockholders may receive less consideration than 1.306 shares of Chemical common stock for each share of our common stock, depending on certain adjustment provisions in the Merger Agreement.

 

The terms of our merger agreement with Chemical provide that the amount of the merger consideration that our stockholders will be entitled to receive for each share of our common stock upon completion of the merger is 1.306 shares of Chemical common stock, subject to certain adjustments.   

 

If our shareholders' equity falls below a certain level and/or we experience loan losses, impairments and charge-offs beyond certain specified levels, the number of Chemical shares we receive will be reduced as provided in the merger agreement.  Beyond certain levels, Chemical has the right to terminate the merger agreement.

 

Accordingly, our shareholders may receive an amount of merger consideration that is less than 1.306 shares of Chemical common stock for each share of our common stock upon completion of the merger.  The dollar value of the Chemical common stock to be received by our shareholders upon consummation of the merger will vary depending on the market price of Chemical common stock upon completion of the merger.

 

During the pendency of the merger with Chemical, we may not be able to enter into a business combination with another party because of restrictions in the merger agreement.

 

Covenants in the merger agreement limit our ability to make acquisitions or complete other transactions that are not in the ordinary course of business pending completion of the merger with Chemical. While the merger agreement is in effect, and subject to limited exceptions, we are prohibited from soliciting, initiating or encouraging alternative transactions with a third party.

 

Risks Relating to Our Business

 

The Company has credit risk inherent in its asset portfolio, and its allowance for loan losses may not be sufficient to cover actual loan losses.

 

The Bank's loan customers may not repay their loans according to their respective terms, and any collateral securing the payment of these loans may be insufficient to assure repayment. As a result, the Bank may experience significant credit losses, which could have a material adverse effect on the Company.

 

To offset this risk, the Company makes various assumptions and judgments about the collectibility of the Bank's loan portfolio, including the creditworthiness of borrowers and the value of the real estate and other assets that may serve as collateral for the repayment of loans.  In determining the size of the allowance for loan losses, the Company relies on its experience and its evaluation of current economic conditions.  However, if its assumptions prove to be incorrect, the allowance for loan losses may not be sufficient to cover actual loan losses inherent in the Bank's loan portfolio, and adjustments may be necessary to account for changing economic conditions or adverse developments in the loan portfolio. Material additions to the allowance would materially decrease net income.

 

The allowance for loan losses is based upon ranges of estimates and is not intended to imply either limitations on the usage of the allowance or precision of the specific amounts.  The Company does not view the allowance for loan losses as being divisible among the various categories of loans.  The entire allowance is available to absorb any future losses without regard to the category or categories in which the charged-off loans are classified.  In addition, federal and state regulators periodically review the Company's allowance for loan losses and may require the Company to increase the provision for loan losses or recognize additional loan charge-offs. Any increase in the allowance for loan losses or loan charge-offs required by these regulatory agencies could have a material adverse effect on the results of operations and financial condition of the Company.

 

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Fluctuations in interest rates and economic conditions could reduce the Company's profitability and negatively affect its capital and liquidity.

 

The Company realizes income primarily from the difference between interest earned on loans and investments and the interest paid on deposits and borrowings.  The Company's interest income and interest expense are affected by general economic conditions and by the policies of regulatory authorities.  While the Company has taken measures intended to manage the risks of operating in a changing interest rate environment, there can be no assurance that these measures will be effective in avoiding undue interest rate risk.  The Company expects that it will periodically experience "gaps" in the interest rate sensitivities of its assets and liabilities, meaning that either its interest-bearing liabilities will be more sensitive to changes in market interest rates than its interest-earning assets, or vice versa.  In either event, if market interest rates should move contrary to its position, this "gap" will work against it, and its earnings may be negatively affected.

 

The Company is unable to predict fluctuations of market interest rates, which are affected by, among other factors, changes in the following:

 

In addition, substantially all of the Bank's loans are to businesses and individuals in West Michigan, and any decline in the economy of West Michigan could adversely affect the Bank.

 

The Company relies heavily on its management team.  The loss of key managers may adversely affect its operations.

 

The success of the Company depends in large part on its ability to attract and to retain senior management experienced in banking and financial services.  The unexpected loss of services of any key management personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse effect on the Company's business and financial results.

 

Competition with other financial institutions could adversely affect the Company's profitability.

 

The Company faces vigorous competition from banks and other financial institutions, including savings and loan associations, savings banks, finance companies, mortgage banking companies, credit unions, and other financial organizations.  A number of these banks and other financial institutions have substantially greater resources and lending limits, larger branch systems, and a wider array of banking services.  To a limited extent, the Company also competes with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, and insurance companies, which are not subject to the same degree of regulation as that imposed on the Bank.  As a result, these non-bank competitors may have an advantage over the Company in providing certain services, and this competition may reduce or limit the Company's margins on banking services, reduce its market share, and adversely affect its results of operations and financial condition.

 

The Company's operations may be affected by its ability to adapt to and take advantage of technological changes.

 

The banking industry continues to experience rapid technological changes with frequent introductions of new technology-driven products and services.  The success of the Company will depend in part on its ability to invest in technology resources and/or negotiate favorable contracts with third-party service providers to provide certain back office functions that benefit from technologically advanced resources.  Many of the Company's competitors have substantially greater resources to invest in technological improvements or to do so at a lower cost than is available to the Company.  In addition, improvements in the ability to deliver financial products and services over the internet may continue to expand the Bank's field of competition to institutions located outside of the Bank's geographic market.  There can be no assurance that the Company will be able to effectively implement new technology-driven products and services or be successful in marketing such products and services to its customers.

 

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Changes in economic conditions could adversely affect the Company's loan portfolio.

 

The Company's success depends to a great extent upon general economic conditions.  The economy in the State of Michigan has generally been slow within the past five years or more.  While general economic conditions appear to have stabilized in recent months, the unemployment rate in Michigan remains to be the highest in the nation and continues to contribute to the decline in the real estate market. 

 

The Company provides banking services to customers primarily in West Michigan.  The Company's loan portfolio, the ability of the borrowers to repay these loans, and the value of the collateral securing these loans is therefore impacted by local economic conditions.

 

A continued deterioration in economic conditions could have many adverse consequences, including the following:

 

 

The Company operates in a highly regulated environment and may be adversely affected by changes in federal and local laws and regulations.

 

The Company is subject to extensive regulation, supervision, and examination by federal and state banking authorities.  Any change in applicable regulations or federal or state legislation could have a substantial impact on it and the Bank and its operations.  Additional legislation and regulations may be enacted or adopted in the future that could significantly affect its powers, authority, and operations, which could increase its costs of doing business and, as a result, give an advantage to its competitors who may not be subject to similar legislative and regulatory requirements.  Further, regulators have significant discretion and power to prevent or remedy unsafe or unsound practices or violations of laws by banks and bank holding companies in the performance of their supervisory and enforcement duties.  The exercise of regulatory power may have a negative impact on the Company's results of operations and financial condition.  The effect of this regulation can be significant and cannot be predicted with a high degree of certainty.

 

The Company's ability to pay dividends on its common stock is limited not only by its profitability, but also by bank regulation and by contract.

 

Most of the Company's revenues are received in the form of dividends paid to it by its subsidiary Bank.  Thus, its ability to pay dividends to the holders of its common stock is indirectly limited by statutory restrictions on the ability of its subsidiary Bank to pay dividends to it.  Further, in a policy statement, the Federal Reserve Board has expressed its view that a bank holding company experiencing earnings weaknesses should not pay cash dividends exceeding its net income or that can only be funded in ways that weaken the bank holding company's financial health, such as by borrowing.  In addition, the Federal Reserve Board possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations.  Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies.  The FDIC has similar enforcement powers over the Bank.  Federal law has "prompt corrective action" provisions that authorize the Federal Reserve Board to restrict its payment of dividends for an insured bank that fails to meet specified capital levels.

 

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In addition to the restrictions on dividends imposed by federal banking regulation, the Michigan Business Corporation Act provides that dividends may be legally declared or paid only if, after the distribution, the Company is able to pay its debts as they become due in the usual course of business and its total assets equal or exceed the sum of its total liabilities plus the amount that would be needed to satisfy the preferential rights upon dissolution of any holders of preferred stock whose preferential rights are superior to those receiving the dividend.

 

In addition, under Michigan banking laws, the Bank may not pay dividends except out of net income after deducting its losses and bad debts.  The Bank may not declare or pay a dividend unless it will have surplus amounting to at least 20% of its capital after the payment of the dividend.

 

Our merger agreement with Chemical Financial Corporation limits our quarterly dividend to a maximum of $0.22 per share.

 

There is a limited trading market for the Company's common stock.

 

The Company's common stock is reported on the OTC Bulletin Board under the symbol "OKFC."  The development and maintenance of an active trading market depends, however, upon the existence of willing buyers and sellers, the presence of which is beyond the Company's control or the control of any market maker.  Although the Company is publicly traded and files reports with the SEC, the volume of trading activity in its stock is relatively limited.  Even if a more active market develops, there can be no assurance that such a market will continue.

 

The value of certain securities in our investment portfolio may be negatively affected by disruptions in the market for those securities and future declines or other-than-temporary impairments could materially adversely affect our future earnings and regulatory capital.

 

Continued volatility in the market value for certain of our investment securities, whether caused by changes in market perceptions of credit risk, as reflected in the expected market yield of the security, or actual defaults in the portfolio could result in significant fluctuations in the value of the securities.  During the fourth quarter of 2008, the Corporation recorded an impairment charge on certain money market preferred and preferred stock securities in our portfolio.  In addition, changes in accounting resulting from changes in and interpretations of applicable accounting standards may affect how we account for certain investment securities in our portfolio.  The valuation and accounting for our investment securities could have a material adverse impact on our net income and shareholders’ equity depending on the direction of the fluctuations. Furthermore, future downgrades or defaults could result in future classifications as other than temporarily impaired. This could have a material impact on our future earnings and financial condition.  

 

The state of financial markets and the economy may adversely affect our sources of liquidity and capital.

 

There has been significant turmoil and volatility in worldwide financial markets over the past couple of years. These conditions resulted in a disruption in the liquidity of financial markets.  If similar situations were to occur in the future it could directly impact us to the extent we need to access capital markets to raise funds to support our business and overall liquidity position. This situation could affect the cost of such funds or our ability to raise such funds. If we were unable to access any of these funding sources when needed, it could adversely impact our financial condition, results of operations, cash flows, and level of regulatory-qualifying capital.

 

 

Item 1B.  Unresolved Staff Comments.

 

There are no unresolved SEC comments with respect to reports filed by the Company under the Securities Exchange Act of 1934.

 

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Item 2.   Properties.

 

The Company and the Bank own a total of 13 facilities and lease 1 facility in West Michigan.  The facilities are located in Kent, Ottawa, and Allegan Counties.  The individual properties are not material to the Company's or the Bank's business or to the consolidated financials. 

 

With the exception of the potential remodeling of certain facilities to provide for the efficient use of work space or to maintain an appropriate appearance, each property is considered adequate for current and anticipated needs.

 

In addition to the facilities described above, at December 31, 2008, the Bank owned another facility, which was previously occupied by the Bank’s mortgage lending operations, which were consolidated into the main office in Byron Center.  This property was sold in the first quarter of 2009. 

 

Item 3.   Legal Proceedings.

 

From time to time, we may be involved in various legal proceedings that are incidental to our business. In the opinion of management, we are not a party to any current legal proceedings that are material to our financial condition, either individually or in the aggregate. 

 

Item 4.   Submission of Matters to Vote of Security Holders.

 

No matters were submitted to a vote of security holders during the fourth quarter of 2009.

 

Executive Officers of the Company

 

The Board of Directors appoints the executive officers of the Bank.  There are no family relationships among the officers and/or the directors of the Company, or any arrangement or understanding between any officer and any other person pursuant to which the officer was elected.  The following table sets forth certain information with respect to the Company's executive officers (included for information purposes only) as of December 31, 2009:

 

 

Prior to being named President and Chief Executive Officer in 2002, Mr. Gill served as President and Chief Executive Officer of Pavilion Bancorp, Inc. for more than five (5) years.

 

Prior to being named Executive Vice President and Chief Financial Officer in 2000, Mr. Luyk served as regional controller for Huntington National Bank.

 

Prior to being named Executive Vice President and Chief Lending Officer in 2006, Mr. Rahn served as Vice President, in charge of commercial lending, at the Bank for more than three years.  Prior to joining the Bank Mr. Rahn served as Senior Vice President in charge of the Traverse City, Michigan region, at Irwin Union Bank, which is now First Financial Bank.

 

 

 

 

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PART II

 

Item 5.   Market Price and Dividends for Registrant's Common Equity and Related Stockholder Matters.

 

The following table sets forth the range of high and low sales prices of the Company's common stock during 2009 and 2008, based on information available to the Company, as well as per share cash dividends declared during those periods. 

 

 

At February 1, 2010, the Company has 731 record holders of our common stock.  In addition to these record holders, we estimate that there were approximately 450 beneficial owners of our common stock who own their shares through brokers or banks.  The common stock is traded and quoted on the Over-the-Counter Bulletin Board under the symbol "OKFC".

 

The Company is a holding company and substantially all of its assets are held by its subsidiaries. The Company’s ability to pay dividends to its shareholders depends primarily on the Bank's ability to pay dividends to the Company.  Dividend payments and extensions of credit to the Company from the Bank are subject to legal and regulatory limitations, generally based on capital levels and current and retained earnings imposed by law and regulatory agencies with authority over the Bank. The ability of the Bank to pay dividends is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements.

 

The Company’s merger agreement with Chemical Financial Corporation limits the Company’s quarterly dividend to a maximum of $0.22 per share.

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SHAREHOLDER RETURN PERFORMANCE GRAPH

 

Set forth below is a line graph comparing the yearly percentage change in the cumulative total shareholder return on the Corporation's common stock with that of the cumulative total return on the Hemscott Group Index and the NASDAQ Market Index for the five-year period ended December 31, 2009.  The Hemscott Group Index is an index composed of over 100 banks and bank holding companies located in the Midwest.  The following information is based on an investment of $100, on December 31, 2004, in the Company’s common stock, the Hemscott Group Index, and the NASDAQ Stock Market Index, with dividends reinvested.  The Company's Common Stock is thinly traded on the OTC Bulletin Board.  Accordingly, the returns reflected in the following graph and table is based on sale prices of the Company's stock of which management is aware.  There may have been sales at higher or lower prices, of which management is not aware.

 

COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURN

AMONG O.A.K. FINANCIAL CORP., NASDAQ MARKET INDEX

AND HEMSCOTT GROUP INDEX

ASSUMES $100 INVESTED ON JANUARY 1, 2005

ASSUMES DIVIDEND REINVESTED

FISCAL YEAR ENDING DECEMBER 31, 2009

 

             Source: HEMSCOTT, Inc., Richmond, Virginia

 

Unregistered Sales of Common Stock

 

The Company did not sell any shares of its common stock during 2009 that were not registered under the Securities Act of 1933, as amended, except as may have been previously reported by the Company in a Quarterly Report on Form 10-Q or a Current Report on Form 8-K.

 

Repurchases of Common Stock

 

The Company did not repurchase any shares of its common stock during the fourth quarter of 2009.

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Item 6.   Selected Financial Data (dollars in thousands, except per share data).

 

                                            SUMMARY OF SELECTED CONSOLIDATED FINANCIAL DATA

 

 

 

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FORWARD LOOKING STATEMENTS

 

This report includes "forward‑looking statements" as that term is used in the securities laws. All statements regarding our expected financial position, business and strategies are forward‑looking statements. In addition, the words "anticipates," "believes," "estimates," "seeks," "expects," "plans," "intends," and similar expressions, as they relate to us or our management, are intended to identify forward‑looking statements. The presentation and discussion of the provision and allowance for loan losses and statements concerning future profitability or future growth or increases, are examples of inherently forward looking statements in that they involve judgments and statements of belief as to the outcome of future events. The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on its operations and its future prospects include, but are not limited to, changes in: interest rates, general economic conditions, legislative/regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality or composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in our market area and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward‑looking statements and undue reliance should not be placed on such statements. Further information concerning the Company, including additional factors that could materially affect financial results, is included in the Company’s other filings with the Securities and Exchange Commission.

 

 

Item 7.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

FOR THE YEARS ENDED DECEMBER 31, 2009, 2008 AND 2007

 

The following financial review presents management's discussion and analysis of consolidated financial condition and results of operations during the period of 2007 through 2009.  The discussion should be read in conjunction with the Company's consolidated financial statements and accompanying notes.

 

Critical Accounting Policies

 

As described under “Supervision and Regulation”, the financial services industry is highly regulated. Furthermore, the nature of the financial services industry is such that, other than described below, the use of estimates and management judgment are not likely to present a material risk to the financial statements.  In cases where estimates or management judgment are required, internal controls and processes are established to provide assurance that such estimates and management judgments are materially correct to the best of management’s knowledge.

 

Allowance for loan losses - Accounting for loan classifications, accrual status, and determination of the allowance for loan losses is based on regulatory guidance.  This guidance includes, but is not limited to, generally accepted accounting principles, the uniform retail credit classification and account management policy issued by the Federal Financial Institutions Examination Council and the joint policy statement on the allowance for loan losses methodologies issued by the Federal Financial Institutions Examination Council, Federal Deposit Insurance Corporation, and various other regulatory agencies.  Accordingly, the allowance for loan losses includes a reserve calculation based on an evaluation of loans determined to be impaired, risk ratings, historical losses, loans past due, general and local economic conditions, trends, portfolio concentrations, collateral values and other subjective factors.

 

Commercial loan rating system and identification of impaired loans – The Company has a defined risk rating system that is designed to assess the risk of individual loans and overall risk of the commercial loan portfolio.  The system assigns a risk weighting to factors such as cash flow, collateral, financial condition, operating performance, repayment history, management, and strength of the industry.  An assessment of risk is performed as a part of the loan approval process as well as periodic updates based on the circumstances of the individual loan.  Also, in addition to routine examinations by bank regulators, the Company employs external loan review services to assess the accuracy of risk ratings. 

 

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Fair value of securities available-for-sale - Securities available-for-sale represent those securities not classified as trading or held to maturity and are reported at fair value with unrealized gains and losses, net of applicable income taxes reported in comprehensive income. The Company determines whether a decline in fair value below the amortized cost basis is other than temporary. If the decline in value is judged to be other than temporary, the cost basis of the security is written down to fair value as a new cost basis and the amount of the write-down is recognized as a charge to non-interest income.  In determining fair value for financial assets the use of assumptions about future cash flows and appropriately risk-adjusted discount rates are acceptable when relevant observable inputs are not available.  In some cases an entity may determine that observable inputs require significant adjustment based on unobservable data.  More information on the specific methods used to determine fair values of the Company’s securities available-for-sale at December 31, 2009 can be found under “Fair Values of Financial Instruments” in the accompanying notes to the consolidated financial statements.

 

Gains and losses realized on the sale of securities available for sale are determined using the specific identification method and are recognized on a trade-date basis. Premiums and discounts are recognized in interest income computed on the level-yield method.

 

 

FINANCIAL CONDITION

 

Summary

 

Total assets declined $19 million, or 2 percent during 2009 to $822 million.  For the year, available for sale securities declined $27 million, or 25 percent, total loans outstanding increased $6 million, or 1 percent and total deposits increased $13 million, or 2 percent.  The decline in available for sale securities was the result of the sale of investment securities, primarily for asset and liability management purposes.  The increase in total loans was due to an increase in commercial loans, which increased $4 million, or 1 percent, in 2009 and commercial real estate, which increased $2 million, or 1 percent, in 2009.  The increase in total deposits was due to increases in checking and savings accounts of $42 million, or 13 percent, which were partially offset by declines in time deposits of $29 million, or 8 percent.  A discussion of changes in balance sheet amounts by major categories follows.

 

Securities (in thousands)

 

We maintain a diversified securities portfolio, which includes obligations of government sponsored agencies, securities issued by states and political subdivisions, corporate securities, mortgage-backed securities, money market preferred stocks, and preferred stocks.  The primary objective of our investing activities is to provide a source of liquidity, provide for safety of the principal invested and manage our exposure to changes in interest rates. 

 

 

 

We pledge some of our securities to secure Federal Home Loan Bank borrowings, to secure repurchase agreements and for other purposes as required or permitted by law.  During 2009 we reduced the amount of pledged securities as part of our overall liquidity and asset and liability management activities.  We also have securities pledged at the Federal Reserve Bank Discount Window as part of our liquidity contingency plan.

 

All of our securities are classified as available-for-sale.  As a result, changes in market value are recognized as adjustments to the carrying amount on the balance sheet and gains or losses are reported, net of tax, as an adjustment to the Bank’s stockholders’ equity.  Our total holdings declined approximately $27 million from December 31, 2008 to December 31, 2009.  The decrease is largely the result of the asset liability management of the Bank in relation to the loan and deposit growth experienced in 2009.  The tax equivalent yield on our investment portfolio was 5.10 percent for 2009, compared to 5.29 percent for 2008.

 

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We owned four money market preferred “MMP” securities, which we had purchased in 2007 with an original par value totaling $7.5 million.  These securities were marketed and sold as liquid, short-term investments in highly rated corporations.  The market for MMP securities, a type of auction-rate-securities, (“ARS”), froze in February 2008 when all the ARS market-maker, (broker-dealer) firms ceased making a market.  Most of the broker-dealers have reached settlement agreements with the State Attorney Generals and / or the Securities and Exchange Commission. 

 

Due to the high level of uncertainty surrounding the ARS, management applied a conservative approach to account for these securities.  An unrealized loss of $3.2 million was recorded in 2008 as an other-than-temporary impairment, using the illiquid market price of the underlying collateral at December 31, 2008 to determine the “fair-market” value.

 

At December 31, 2009, three of the four auction rate securities had converted to their underlying collateral of preferred stock and the four securities had a combined unrealized gain of $1.9 million.  All four issuers of these securities continue to be highly rated by Standard & Poor’s Corporation.  Additionally, all four securities are current on all interest and dividend payments.  After the impairment charge, the tax-equivalent book yield on these securities is approximately 10.3 percent.   

 

No assurance can be provided regarding the future performance of these securities.  It is possible that further market deterioration would require additional impairment charges.  Conversely, it is possible that one or all of these securities would be repurchased at amounts that would allow the reversal of the recorded impairment charges.

 

We also own capital stock in the Federal Reserve Bank System (“FRB”) and the Federal Home Loan Bank of Indianapolis (“FHLBI”), which are classified as restricted investments. 

 

Schedule of Maturities of Investment Securities and Weighted Average Yields

 

The following is a schedule of contractual maturities and their weighted average yield of each category of investment securities at December 31, 2009.  The weighted average interest rates have been computed on a fully taxable equivalent basis, using a 34 percent tax rate, based on amortized cost. 

 

 

 

 

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The Loan Portfolio

 

Our lending policy is intended to reduce credit risk, enhance earnings and guide the lending officers in making credit decisions.  The Board of Directors of the Bank approves the loan authority for each lender and has appointed a Chief Lending Officer who is responsible for the supervision of the lending activities of the Bank.  We use the services of an independent third party, to periodically review the credit quality of the loan portfolio, separate from the loan approval process.  These reviews are submitted to the Risk Management Officer and to the Audit Committee. 

 

Requests for credit are considered on the basis of the creditworthiness of each applicant, without consideration of race, color, religion, national origin, sex, marital status, physical handicap, age, or the receipt of income from public assistance programs.  Consideration is given to the applicant's capacity for repayment based on cash flow, collateral, capital and alternative sources of repayment.  Loan applications are accepted at all of our offices and are approved within the limits of each lending officer's authority.  Loan requests in excess of specific lending officers’ authority, are required to be presented to the Commercial Loan Committee, the Director’s Loan Committee or the Board of Directors for review and approval.

 

We do not have any foreign loans and there were no large concentrations of loans that are not disclosed as a separate category.  Our largest concentration of loans is to businesses in the form of commercial loans and real estate mortgages.   Management reviews the concentration, and changes in concentrations of loans, using the method of coding the commercial loan portfolio by North American Industry Classification System (NAICS) code.

 

During 2009 our commercial real estate and commercial loan portfolios increased $4 million and $2 million, respectively.  The commercial and commercial real-estate loan portfolios are the primary source of growth for the Bank’s total loan portfolios and are expected to continue to be in the future.  Loans for construction and land development increased $5 million in 2009, due largely to advances on existing lines of credit.  Loans secured by residential real estate declined $5 million, from December 31, 2008 to December 31, 2009.  The decline was primarily from the significant refinancing activity of residential mortgages that occurred in 2009.  Consumer loans declined less than $1 million from December 31, 2008 to December 31, 2009.  The slight decline in total consumer loans is the result of declines in both our direct and indirect consumer lending business. 

 

It is our general practice to sell all conforming residential real estate loans.  During 2009, the we sold loans totaling about $2 million with the servicing rights retained and $160 million with the servicing rights released.  As a result of fewer loans being sold with servicing rights retained, our servicing portfolio continues to decline.  At December 31, 2009 and 2008, we were servicing loans for others totaling approximately $102 million and $136 million, respectively. 

 

In addition to the communities served by our branches, principal lending markets include nearby communities and metropolitan areas.  We have been able to expand our services to the broader market through our Mobile Banking service.  Subject to established underwriting criteria, we will occasionally participate with other financial institutions to reduce our exposure to risk on certain large commercial loans or to fund loans, which would otherwise exceed the Bank's legal lending limit if made solely by the Bank.

 

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Loan Portfolio Composition (in thousands)

 

 

Commercial, Construction & Land Development and Commercial Real-Estate Loans:  Business loans are originated for a variety of purposes, including working capital financing, machinery and equipment acquisition and the financing of commercial real-estate.  The loans are generally secured by all assets of the borrower and are underwritten based on an assessment of the industry in which the borrower operates, management, economic conditions, cash flow, owners equity and collateral.  Commercial real-estate loans are secured by properties located in the Bank’s primary market area.

 

Residential Real-Estate Loans:  Residential real-estate loans are originated in our primary market area.  Generally, we sell all salable loans in the secondary market.  Loans are underwritten to the Secondary Market Investors Guidelines using the automated underwriting system designed by the investor that will be purchasing a particular loan.  On occasion, residential real-estate loans will be retained in the Bank’s portfolio.  Personal loans secured by the equity in the borrower’s residence are also granted for a variety of needs. 

 

Consumer Loans:  Consumer loans are originated for a variety of purposes including the acquisition of new and used automobiles, boats and recreational vehicles.  Consumer loans are underwritten based on the borrowers’ credit history, monthly income, stability of employment, the amount of the down payment and the type of collateral.

 

Management takes steps in the loan administration area to ensure that our underwriting standards are adequate.  However, asset quality is also dependent upon general and local economic conditions and other factors outside of our control.

 

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Non-performing Assets (in thousands)

 

Non-performing assets are comprised of loans for which the accrual of interest has been discontinued, accruing loans 90 days or more past due and other real estate, which has been acquired primarily through foreclosure and is awaiting disposition.  Loans, including loans considered impaired under SFAS No. 118 and SFAS No. 114, are generally placed on a non-accrual basis when principal or interest is past due 90 days or more or when, in the opinion of management, full collection of principal and interest is unlikely.

 

 

Total non-performing assets finished the year at $13.8 million, up $8.5 million from December 31, 2008.  Total non-performing assets represent 1.68 percent of total assets, at December 31, 2009, compared to .63 percent at December 31, 2008.  Non-accrual loans increased $6.5 million from December 31, 2008 to December 31, 2009.  A large percentage of the balance at December 31, 2009 consists of credits related to construction and real-estate development.  Loans that were 90 days or more past due and still accruing interest increased less than $1 million from December 31, 2008 to December 31, 2009.  Other real estate increased $1.7 million from December 31, 2008 to December 31, 2009. 

 

There continues to be significant economic weakness and credit quality continues to be under pressure due to the decline in real estate values and the weakening economy.  As a result, the allowance for loan losses as a percentage of portfolio loans increased from 1.33 percent at December 31, 2008 to 1.87 percent at December 31, 2009.  As of December 31, 2009 there were no other interest bearing assets, which required classification.

 

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Foregone Interest on Non-Performing Loans (in thousands)

 

The table below presents the interest income that would have been earned on non-performing loans outstanding for the years presented had those loans been accruing interest in accordance with the original terms of the loan agreements (pro forma interest) and the amount of interest income actually included in net interest income for those years.

 

 

Allowance for Loan Losses (dollars in thousands)

 

 

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During 2009, we recorded approximately $6.2 million in net loans charged off, or .89 percent of average loans outstanding.  That compares to $2.8 million in net loans charged off, or .45 percent of average loans outstanding in 2008.  The increase is across broad categories of loans, resulting from the current economic environment and its affect on borrowers, combined with the declines in real estate values. 

 

Allocation of the Allowance for Loan Losses (dollars in thousands)

 

The allowance for loan losses is analyzed quarterly by management.  In so doing, management assigns a portion of the allowance to specific credits that have been identified as problem loans, reviews past loss experience, the local economy and a number of other factors.  Management believes that the allowance for loan losses is adequate. 

 

 

In determining the adequacy of the allowance for loan losses, management determines (i) a specific allocation for loans when a loss is probable, (ii) an allocation based on credit risk rating for other adversely rated loans, (iii) an allocation based on historical losses for various categories of loans, and (iv) subjective factors including local and general economic factors and trends.  The allowance for loan losses as a percent of total loans reflects management's assessment of the credit quality of the Bank’s loan portfolio. 

 

The first element reflects our estimate of probable losses based upon our systematic review of specific loans. These estimates are based upon a number of objective factors, such as payment history, financial condition of the borrower, and discounted collateral exposure.

 

The second element reflects the application of our loan rating system. This rating system is similar to those employed by state and federal banking regulators. Loans that are rated below a certain predetermined classification are assigned a loss allocation factor.

 

The third element is determined by assigning allocations based principally upon the five-year average of loss experience for each type of loan.  Additionally, an allocation is provided based on the current delinquency rate for some loan categories.  Loss analyses are conducted at least annually.

 

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

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imprecision necessarily inherent in the estimates of expected credit losses. We also consider a number of subjective factors when determining the allowance for loan losses, including local and general economic business factors and trends, portfolio concentrations and changes in the size, mix and general terms of the loan portfolios.

 

Considerable attention has been devoted to the national housing market and the national economy.  The Michigan economy continues to struggle due to the current housing slump, the struggling auto industry and high unemployment rates.  The economy in West Michigan, while slightly stronger than the state as a whole, is still significantly influenced by the conditions of the economy across the state and throughout the nation.  Although highly subjective, the economic conditions in Michigan are reflected in the amount reserved in the allowance for possible loan losses.

 

Actual losses experienced in the future could vary from the estimated allocation of the loan loss reserve.  Changes in local and national economic factors could affect the adequacy of the allowance for loan losses. 

 

Sources of Funds

 

The primary sources of funding for the Bank are deposits (including brokered deposits), Federal Home Loan Bank advances, federal funds purchased and other borrowed funds.  An increase in the consumers’ savings rate contributed to a $13 million, or 2 percent, increase in deposits from December 31, 2008 to December 31, 2009.  Checking accounts increased $13 million and money market and savings accounts increased $29 million in 2009.  These increases were partially offset by a $29 million decline in time deposits. The decline in time deposits includes a $13 million decline in brokered time deposits. 

 

We were also able to reduce our use of non-deposit funding sources such as Fed funds purchased, repurchase agreements and Federal Home Loan Bank advances, during 2009.  Total other borrowings declined $30 million from December 31, 2008 to December 31, 2009.  Federal funds purchased declined $1 million, repurchase agreements declined $15 million, and FHLB advances declined $14 million.

 

Deposits are gathered from the communities the Bank serves. Increasing core deposits is a key element of our strategic plan.  In addition to the traditional bank offices, we provide a wide array of alternative electronic methods to serve customers.  Use of the Bank’s cash management products as well as business sweep products has continued to increase during the past year.  We expect these products to continue to be excellent tools in marketing to potential business customers.  Mobile Banking, a business banking courier service in West Michigan that provides convenient, safe, and reliable pick-up and delivery for a variety of items including cash, checks and important Bank documents, has also been beneficial in increasing our customer base.  This service continues to be a key factor in attracting new business customers to the Bank.

 

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Average Deposit Balances (dollars in thousands)

 

The following table lists the total average deposit balances during 2009 and 2008 and the weighted average rates paid on the funds provided:

 

 

We continue to operate in a very competitive environment.  Management monitors interest rates at other financial institutions in the area to insure that its rates are competitive with the market.  We also offer a wide variety of products to meet the various needs of our customers.  We offer business and consumer checking accounts, regular and money market savings accounts, and certificates of deposit with many term options.  The decline in short-term market interest rates, that occurred at the end of 2008, contributed to a significant decrease in the average rates paid on deposits.

 

Repurchase Agreements, Federal Funds Purchased and Borrowed Funds (dollars in thousands)

 

 

The repurchase agreements are fixed rate borrowings arrangements that are secured by U.S. federal agency securities.  These securities are being held by the counterparty to the repurchase agreement.  The maximum amounts outstanding at any month end during both 2008 and 2009 were $20 million.  The yield on the repurchase agreements was 4.83 percent at December 31, 2008 and 4.78 percent at December 31, 2009. 

 

The majority of the Bank’s FHLB borrowings have a fixed term and fixed interest rate, some of which can be called by the issuer after a lockout period.  At December 31, 2008 we also had a variable rate FHLB advance, which could be pre-paid at any time and was paid-off during 2009.

 

 

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RESULTS OF OPERATIONS

 

Summary

 

Net income was $540,000 in 2009, down 65 percent from the $1,536,000 reported for 2008.  Basic and diluted earnings per share for the full year amounted to $0.20 in 2009, compared to the $0.57 reported in 2008.  The results for 2009 were significantly influenced by a $5,095,000 increase in the provision for loan losses, a $366,000 increase in loan and collection expenses, a $676,000 increase in losses on ORE properties and a $1,101,000 increase in FDIC insurance premiums.  

 

Net income declined 77 percent from 2007 to 2008.  Increases in net interest income, service charges on deposit accounts and mortgage banking revenue, were offset by a higher provision for loan losses, an impairment charge on investment securities, losses on other real estate and higher loan and collection expenses.  This resulted in a decline in earnings per share from $2.49 in 2007 to $0.57 in 2008. 

 

Earnings Performance (in thousands, except per share data)

 

 

Net interest income increased $1,135,000, or 5 percent in 2009, compared to 2008.  This was primarily due to the 6 percent increase in average earning assets for the year, compared to 2008, and was partially offset by a slight decline in the net interest margin, from 3.40 percent in 2008 to 3.34 percent in 2009.  Non-interest income increased $5,490,000, or 103 percent from 2008 to 2009, which was the result of a $2,029,000 increase in mortgage banking revenue in 2009 and the $3,231,000 impairment charge auction rate securities that was taken in 2008.  Excluding the impairment charge on investments, non-interest income increased 26 percent in 2009, compared to 2008.  Service charges on deposits declined 5 percent and insurance premiums and brokerage fees declined 7 percent in 2009, compared to 2008.  Total non-interest expenses increased $3,003,000, or 13 percent from 2008 to 2009.  This was the result of a 6 percent increase in salaries and benefits expenses, a 114 percent increase in losses on other real estate, and a 248 percent increase in FDIC fees. 

 

Net interest income increased $865,000, or 4 percent in 2008, compared to 2007.  This was due to the increase in average earning assets that occurred during the year, which was partially offset by a decline in the net interest margin from 2007 to 2008.   Average earning assets increased $76 million from 2007 to 2008.  The net interest margin was 3.40 percent in 2008 compared to 3.63 percent in 2007.  Non-interest income declined $2,935,000, or 36 percent from 2007 to 2008.  The decline can be attributed to a $3,231,000 impairment charge on the Bank’s money-market preferred (MMP) auction rate securities.  The impairment charge represented approximately 43% of the $7.5 million par value of these securities.  While it is normal for security values to rise and fall, it was determined that the decline in market value of the MMP’s was determined to be other-than-temporary.  Deposit service charges increased 4 percent and mortgage banking fees increased 19 percent in 2008, compared to 2007.  Total non-interest expenses increased $2,070,000 million, or 10 percent from 2007 to 2008.  This was largely due to increases in occupancy expenses related to our new East Paris branch and the renovation of a couple of older branches, increases in FDIC fees, losses on other real estate and loan collection costs.

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Net Interest Income (in thousands)

 

The following schedule presents the average daily balances, interest income (on a fully taxable-equivalent basis) and interest expense and average rates earned and paid for the Company's major categories of assets, liabilities, and stockholders' equity for the periods indicated:

 

 

 

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Net interest income is our principal source of income.  In the current year, tax equivalent net interest income increased $1,159,000 to $26,536,000 million in 2009, a 5 percent increase from 2008.  This resulted in a net interest margin, as a percentage of average earning assets, on a fully taxable equivalent basis, of 3.34 percent.

 

In 2009, the yield on total earning assets declined 79 basis points, compared to a 88 basis point decline in the total interest-bearing liabilities cost of funds.  The decline in the interest yield was primarily the result of a decline in the yield that was earned on variable rate loans, due to lower interest rates.  The decline in the cost of funds was a result of declines in the interest rates paid on deposits and a decline in the cost of purchased funding.  The decline in the cost of purchased funding was primarily due to a liquidity premium that was placed on purchased funding in 2008 because of the financial crisis and global liquidity crisis.  The liquidity premium has eased in response to the government sponsored actions to increase liquidity in the financial system.  The net result was a 6 basis point decline in the net interest margin, from 3.40 percent in 2008 to 3.34 percent in 2009.

 

In 2008, the yield on total earning assets declined 106 basis points, compared to a 105 basis point decline in the total interest-bearing liabilities cost of funds.  The decline in the interest yield was also the result of a decline in the yield that was earned on variable rate loans, due to the decline in short term interest rates.  The decline in the cost of funds was a result of decline in the interest rates paid on deposits and a shift of funds to lower cost alternative sources of funds.  This resulted in the Company’s net interest margin declining 23 basis points, from 3.63 percent in 2007 to 3.40 percent in 2008.

 

The decline in short-term interest rates that occurred in late 2008 put pressure on the net interest margin in the early part of 2009.  The net interest margin improved steadily throughout 2009 as higher cost fixed rate funding sources repriced at lower interest rates.  The net interest margin is also considerably affected by the monetary policies of the U.S. government, local competition and level of economic activity.  There is no assurance regarding rates and the Bank's net interest margin.

 

Change in Tax Equivalent Net Interest Income (in thousands)

 

 

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Interest from loans is the primary source of interest income for the Bank.  Net interest income is significantly influenced by results of the Bank's lending activities.  Fully tax equivalent interest income decreased $3,479,000 from 2008 to 2009, compared to a $4,630,000 decrease in interest expense for the same period, resulting in a $1,151,000 million increase in fully tax equivalent net interest income.  The increase in net interest income that was the result of the growth in earning assets was partially offset by the decline in the net interest margin. 

 

Fully tax equivalent interest income decreased $2,610,000 from 2007 to 2008, compared to a $3,644,000 decrease in interest expense for the same period, resulting in a $1,034,000 increase in fully tax equivalent net interest income.  The increase in net interest income that was the result of the growth in earning assets was largely offset by the decline in net interest income that was the result of the decline in interest rates. 

 

The Bank's asset/liability committee seeks to manage sources and uses of funds and to monitor the gap in maturities of these funds to maintain a steady net interest margin in varying market conditions.

 

Composition of Average Earning Assets and Interest Paying Liabilities

 

 

The Bank’s earning asset ratio has remained at 95 percent for 2009, 2008 and 2007. 

 

The free funds ratio, funds on which the Bank does not pay interest, was 14 percent in 2009, compared to 15 percent in 2007 and 17 percent in 2006.  The decline is mainly the result of the increase in interest bearing deposits.

 

Provision and Allowance for Loan Loss

 

The provision for loan losses charged to earnings was $10,050,000 in 2009.  This compares to a charge of $4,955,000 in 2008 and $1,221,000 in 2007. The significant increases in the provision that was charged to earnings in both 2008 and 2009 reflects continued credit deterioration in the weakened economy as well as significant declines in collateral values.  Due to the current state of the economy, both in Michigan and nationally, we are projecting that the provision for loan losses charged to income in 2010 will remain at an elevated level.  The actual provision charged to income may vary from the projected amount based on changes in these factors. 

 

Management monitors the underwriting standards and loan administration of the Bank, to ensure that they are appropriate.  Future changes in asset quality will be subject to continued adherence to established policies and the general economic conditions of the markets in which the Bank operates.

 

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Non-interest Income (in thousands)

 

 

Non-interest income increased $5,490,000, or 103 percent in 2009, compared to 2008.  The increase was primarily the result of a $1,941,000 increase in gains from the sale of mortgage loans, a $592,000 increase in net gains from the sale of investment securities and the $3,231,000 impairment charge on the on auction rate securities, which occurred in 2008.  The increase in gains on the sale of loans was due to the considerable increase in mortgage refinance activity that occurred in 2009.  The higher net gains from the sale of securities was the result of the sale of securities for asset liability management purposes.  Service charges on deposit accounts declined $251,000, or 5 percent in 2009, compared to 2008.  The decline was due to lower NSF fees resulting from the increase in the consumer savings rate.  Brokerage revenue declined $73,000 in 2009, compared to 2008, due to lower investment activity in response to the market uncertainly.   

 

Non-interest income declined $2,935,000, or 36 percent in 2008, compared to 2007.  The decline was the result of the $3,231,000 impairment charge on the Bank’s money-market preferred securities, due to deterioration in the market value of these securities.  Excluding this charge, non-interest income increased $296,000, or 4 percent, in 2008, compared to 2007.  Service charges on deposit accounts increased $192,000, or 4 percent in 2008, compared to 2007.  The increase was due to increases in ATM fee income, resulting from the placement of several new offsite ATM’s during 2008.  Net gains on the sale of loans increased $274,000, or 26 percent in 2008, compared to 2007.  The increase was due to increased mortgage activity as well as income derived from the sale of the guaranteed portion of some SBA loans.  Insurance premium revenue declined $112,000, or 12 percent from 2007 to 2008.  This was due to a decline in annual profit-sharing income received from the insurance underwriters, which is based on the production of the insurance agency and the loss rate of the policyholders. 

 

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Net Gains on the Sale of Real Estate Mortgage Loans (in thousands)

 

 

The gain on the sale of real estate loans increased 165 percent from 2008 to 2009.  Mortgage refinancing activity was high for the first three quarters of 2009, declining slightly during the fourth quarter.  Total real estate mortgages originated totaled $173 million in 2009, compared to $83 million, in 2008.  We sell the majority of the loans that we originate with servicing rights released.  Selling loans with servicing rights released reduces the Bank’s exposure to changes in the value of the servicing rights, due to changes in interest rates.  Net gains as a percentage of real estate mortgage loan sales for 2009 was 2.02 percent, compared to 1.77 percent in 2008.

 

The gain on the sale of real estate loans increased 23 percent from 2007 to 2008.  We experienced high volume of mortgage refinancing activity both early in 2008 and late in 2008 as interest rates on mortgages dropped for periods of time.  Total real estate mortgages originated totaled $83 million in 2008, compared to $73 million in originations in 2007.  Net gains as a percentage of real estate mortgage loan sales for 2008 was 1.77, compared to 1.64 percent in 2007. 

 

Net gains on the sale of loans are generally a function of the volume of loans sold.  The volume of loans sold is dependent upon our ability to originate loans, which is particularly sensitive to the absolute level of interest rates.  Net gains on the sale of real estate mortgage loans are also dependent upon economic and competitive factors as well as management's ability to effectively manage our exposure to changes in interest rates. The Bank aggressively markets its real estate services. 

 

Realized Gains and Losses on the Sale of Securities (in thousands)

 

 

The Company recognized a net gain of $649,000 on the sale of securities in 2009, compared to a net gain of $57,000 in 2008 and a net gain of $12,000 in 2007.   In addition to providing interest income and secondary liquidity, our securities portfolio is an important part of our asset and liability management plan.  Generally, the majority of the securities in the investment portfolio are classified as available for sale to provide flexibility in managing our liquidity and interest rate risk. 

 

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Non-interest Expense (in thousands)

 

 

Non-interest expense increased $3,003,000, or 13 percent in 2009, compared to 2008.  Salaries and employee benefits expenses increased $710,000 or 6 percent from 2008 to 2009.  The increase is primarily from higher incentive compensation related to the increased mortgage production that occurred in 2009, as well as an increase in employee medical insurance costs.  Occupancy and equipment costs increased $21,000, or less than 1 percent in 2009, compared to 2008.  Capital expenditures were reduced in 2009, keeping depreciation expenses relatively flat for the year.  Professional and legal fees, losses on other real estate and loan and collection cost combined for an increase of $1,437,000, or 73 percent in 2009, compared to 2008.  The increases in all three expense categories are primarily related to the collection, maintenance and disposition of non-performing assets.  Also included in professional and legal fees is approximately $200,000 in expenses related to the merger.  FDIC insurance fees increased $1,101,000, or 248 percent in 2009, compared to 2008.  The increase in FDIC insurance fees reflects higher FDIC insurance premiums, addition premiums related to the FDIC’s Temporary Liquidity Guarantee Program (TLGP) and a special assessment of $385,000 that occurred in the second quarter of 2009.  Telephone expense increased $234,000, or 72 percent in 2009, compared to 2008.  The increase was primarily related to line upgrades, which occurred in the fourth quarter of 2008, to improve data processing efficiencies.

 

Non-interest expense increased $2,070,000, or 10 percent in 2008, compared to 2007.  Salaries and employee benefits expenses increased $114,000 or less than 1 percent from 2007 to 2008.  Increases from normal annual salary adjustments and increases in employee medical insurance costs were largely offset by the reversal of annual incentive accruals in the fourth quarter of 2008.  Occupancy and equipment costs increased $437,000, or 16 percent in 2008, compared to 2007.  The increase is the result of the addition of our new East Paris branch as well as the renovation of a couple of older branches.  Data processing and software expenses increased $233,000, or 12 percent in 2008, compared to 2007, as we continue to invest in technology and software upgrades.  FDIC insurance fees increased $271,000, or 157 percent in 2008, compared to 2007.  The increase in FDIC insurance fees reflects the full utilization of the Bank’s FDIC credits during 2007.  The loss on other real estate and loan and collection costs increased $925,000, or 497 percent, from 2007 to 2008.  The increase is a result of a decline in credit quality and the significant decline in real estate values.   

 

 

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Provision for Income Taxes

 

The provision for income taxes was a credit of $872,000 in 2009, compared with a credit of $395,000 in 2008 and an expense of $2,286,000 in 2007.  The resulting credits in both 2009 and 2008 are due to the percentage of income that is exempt from federal taxes in comparison to the Company’s overall income before taxes.

 

 

LIQUIDITY AND CAPITAL RESOURCES

 

Capital

 

Capital provides the foundation for future growth and expansion.  The major component of capital is stockholders' equity.  Stockholders' equity was $69.7 million at December 31, 2009, a decline of $0.7 million, or 1 percent from a year ago.  The decrease resulted from the dividends that were paid during 2009 being higher than the Company’s net income for the year.  This was partially offset by an increase in accumulated other comprehensive income.  The Company generally funds growth from existing capital and the retention of earnings.  We regularly review the capital level of the Bank and the Corporation. 

 

In 2009, the Company declared cash dividends totaling $2.4 million, approximately 440 percent of earnings.  In 2008, the Company declared cash dividends totaling $2.4 million, approximately 155 percent of earnings. 

 

On October 3, 2008, Congress passed the Emergency Economic Stabilization Act of 2008 (“EESA”), which provides the U.S. Secretary of Treasury with broad authority to implement certain actions to help restore stability and liquidity to U.S. markets.  On October 14, 2008 the U.S. Treasury Department announced the Treasury Capital Purchase Program (“CPP”), which provided direct equity investment of perpetual preferred stock by the Treasury in qualified financial institutions.  This was a voluntary capital purchase program to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the economy.  Participation in this program was not automatic and was subject to approval by the Treasury.

 

The Treasury Capital Purchase Program required that participating entities have preferred securities authorized for issuance.  On October 16, 2008 the Corporation’s Board of Directors adopted a resolution to amend our articles of incorporation to authorize the issuance of 500,000 shares of preferred stock.  The resolution was voted on and approved at a special meeting of the shareholders that was held on December 22, 2008, which was adjourned to January 9, 2009. 

 

The Company applied for $20 million in funds under the Capital Purchase Program and received approval of the application from the U.S. Treasury in January, 2009.  After careful consideration and evaluation, a decision was made to decline participation in the program.  We believed that our capital is adequate to support our business.   Furthermore, the constraints and uncertainty of participating in the CPP outweighed the expected benefits.

 

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Capital Resources (in thousands)

 

Under the regulatory "risk-based" capital guidelines in effect for both banks and bank holding companies, minimum capital levels are based upon perceived risk in the Company's various asset categories.  These guidelines assign risk weights to on-balance sheet and off-balance sheet categories in arriving at total risk-adjusted assets.  Regulatory capital is divided by the computed total of risk adjusted assets to arrive at the minimum levels prescribed by the Federal Reserve Board at December 31, 2009, as shown in the table below:

 

 

 

Interest Rate Risk

 

The primary components of the balance sheet are interest-earning assets, which are funded by interest-bearing liabilities.  The differences in cash flows of these rate sensitive assets and liabilities, combined with shifts, or changes in the overall market yield curve result in interest rate risk.  Interest rate risk is the change in net interest income due to interest rate changes.  Interest rate risk is inherent to banking and cannot be eliminated.

 

The Asset and Liability Management Committee (ALCO) is responsible for overseeing the financial management of net interest income, liquidity, investment activities, and other related activities.   In regard to interest rate risk, management has relied on re-pricing GAP analysis, which is a traditional method of assessing interest rate risk.  Recognizing that there is no single measure that absolutely measures current or future risk, management also relies on a simulation analysis to assess risk in dynamic interest rate environments.

 

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Maturities and Sensitivities of Loans to Changes in Interest Rates

 

The following table shows the amount of total loans outstanding as of December 31, 2009, which based on scheduled maturity dates, are due in the periods indicated:

 

 

 

Below is a schedule of the amounts maturing or re-pricing as of December 31, 2009, which are classified according to their sensitivity to changes in interest rates:

 

 

At December 31, 2009, the Bank had $289 million in variable rate loans that had reached their contractual floors and are therefore being reported as fixed rate loans in the table above.  The table below shows the number of basis points that interest rates would need to increase before these loans would begin to float with changes in interest rates.

 

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Asset/Liability Gap Position (in thousands)

 

 

The asset/liability gap reflects the projected repayment and maturities of the Bank's loans, investments, deposits and borrowings. Management has made a number of assumptions to improve the usefulness of the gap analysis and to manage interest rate risk. The assumptions include, but are not limited to, prepayments on loans, repayment speeds on certain investment securities, and the likelihood of certain call and put features on financial instruments being exercised. Management attempts to reflect the sensitivity of assets and liabilities; however, customer behavior in different rate and economic environments is not entirely predictable.  As such, interest rate risk cannot be eliminated.

 

At December 31, 2009 the cumulative one-year liability gap position was approximately 6 percent of earning assets. The previous table reflects that the Bank has an asset-repricing gap of approximately $101 million at 3 months and an asset-repricing gap of $30 million at one year.  Management recognizes that GAP analysis alone is not a reliable measure of interest rate risk.  Management is comfortable with the Bank's current GAP position and interest rate exposure and will continue to monitor the Bank’s sensitivity to changes in interest rates.  Management regularly reviews the asset liability gap position and other available information to manage the overall interest rate risk of the Bank.

 

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Market Risk

 

The Bank complements its stable core deposit base with alternate sources of funds, which include advances from the Federal Home Loan Bank, brokered certificates of deposit from outside its market area, federal funds purchased and repurchase agreements.  Management evaluates the funding needs and makes a decision, whether to fund internally or from alternate sources, based on current interest rates and terms.  To date, the Bank has not employed the use of derivative financial instruments in managing the risk of changes in interest rates.

 

Changes in Market Value of Portfolio Equity and Net Interest Income (dollars in thousands)

 

 

 

Simulation models are useful tools, but require numerous assumptions that have a significant impact on the measured interest rate risk. The use of simulation models requires numerous assumptions, which could impact the results.  Simulation models require the ability to accurately predict customer behavior to interest rate changes, changes in the competitive environment and other economic factors.

 

Liquidity

 

Liquidity is measured by our ability to raise funds through deposits, borrowed funds, capital or cash flow from the repayment of loans and investment securities. These funds are used to meet deposit withdrawals, maintain reserve requirements, fund loans and operate our Company.  Liquidity is primarily achieved through the growth of deposits and liquid assets such as securities available for sale, matured securities, and federal funds sold. Asset and liability management is the process of managing the balance sheet to achieve a mix of earning assets and liabilities that maximizes profitability, while providing adequate liquidity.

 

Our liquidity strategy is to fund loan growth with deposits and other borrowed funds and to maintain an adequate level of short-term and medium-term investments to meet typical daily loan and deposit activity.  The growth of the Bank’s loan portfolio during 2009 was primarily funded through the growth of checking and savings accounts.  Checking and savings deposits increased by $42 million from December 31, 2008 to December 31, 2009.

 

The Bank has the ability to borrow money on a daily basis through one of its correspondent banks using an established federal funds purchased line of credit. The Bank has established an unsecured federal funds purchased borrowing limit totaling $25 million. At December 31, 2009, the Bank had less than $1 million in federal funds purchased.  During 2009, the Bank’s federal funds purchased position averaged $1.7 million.  In addition, as a member of the Federal Home Loan Bank of Indianapolis ("FHLBI"), the Bank has access to FHLBI's borrowing programs. At December 31, 2009, FHLB advances totaled $49.4 million and the Bank could borrow an additional $31.6 million without pledging any additional collateral.

 

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In 2008, we expanded our liquidity contingency plan by pledging collateral at the Federal Reserve Discount Window.  At December 31, 2009 we had approximately $7.6 million of municipal securities, which were unable to be pledged towards other borrowings, pledge at the Federal Reserve Discount Window.

 

Net cash flows from operating activities can fluctuate from year to year based on the amount of the Company’s earnings for the year, the provision for loan losses recorded during the year, the dollar amount of mortgage loans originated compared to the amount of mortgage loans sold, and the gain generated from the sale of those loans.  The changes from 2008 to 2009 are largely due to lower net income, a higher provision for loan losses, higher gains from the sale of loans and investment securities and the impairment charge on investment securities taken in 2008.  The changes from 2007 to 2008 are primarily due to lower net income, a higher provision for loan losses and the impairment charge on investment securities taken in 2008. 

 

Cash flows from investment activities reflect cash used to fund the increase in total loans, cash received from the maturity and sale of available for sale securities and the reinvestment of that cash through the purchase of new securities.  The changes in cash flows from investment activities are mainly the result of the growth of the Bank’s loan portfolio and net proceeds from the maturities, sales and purchases of available for sale securities.  Total loans increased by $12 million from 2008 to 2009 compared to an increase of $107 million from 2007 to 2008.  Net proceeded from the maturities, sales and purchases of investment securities were $29 million in 2009 compared to $8 million in 2008 and a net use of funds of less than $1 million in 2007.

 

Net cash flows from financing activities reflect the increases or decreases in the products used to fund the loan growth of the Bank.  The cash flows from financing activities of the Bank’s was a use of funds of $20 million in 2009, and funds provided of $95 million and $67 million in 2008 and 2007, respectively. 

 

The Company’s cash and cash equivalents declined $1 million, to $14 million at December 31, 2009.  Overall liquidity is primarily determined by deposit and loan growth in addition to borrowing and security investment activity.

 

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Contractual Obligations (dollars in thousands)

 

 

 

Other Commercial Commitments

 

All of the commercial commitments are underwritten using the commercial loan underwriting guidelines.  The amount of unfunded commitments declined 15% from 2008 to 2009. 

 

 

 

Impact of Inflation

 

The majority of assets and liabilities of financial institutions are monetary in nature.  Generally, changes in interest rates have a more significant impact than inflation on the earnings of the Bank.  Although influenced by inflation, changes in rates do not necessarily move in either the same magnitude or direction as changes in the price of goods and services.  Inflation does impact the growth of total assets, creating a need to increase equity capital at a higher rate to maintain an adequate equity-to-assets ratio, which in turn reduces the amount of earnings available for cash dividends.

 

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Selected Quarterly Financial Data (Unaudited):

   (in thousands, except per share data)

 

Item 7A:  Quantitative and Qualitative Disclosures About Market Risk

 

A derivative financial instrument includes futures, forwards, interest rate swaps, option contracts, and other financial instruments with similar characteristics.  The Company currently does not enter into futures, forwards, swaps, or options.  However, the Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit and standby letters of credit.  These instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.  Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower if deemed necessary by the Company.  Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions.  Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Company until the instrument is exercised.

 

The Company's exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee (See "Market Risk" from Item 7).  Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to manage the inherent risk while at the same time maximizing income.  Management realizes certain risks are inherent and that the goal is to identify and minimize these risks.  Tools used by management include the standard GAP report and a simulation model.  The Company has no market risk sensitive instruments held for trading purposes.

 

Item 8.  Financial Statements and Supplementary Data

 

 

The Consolidated Financial Statements, Notes to Consolidated Financial Statements and the Report of the Independent Public Accountants are included in the following pages.

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OAK Financial Corporation

Management’s Report on Internal Control Over Financial Reporting

 

The management of OAK Financial Corporation is responsible for establishing and maintaining adequate internal control over financial reporting.  OAK Financial Corporation’s internal control system was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of its financial statements.

 

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective, provide only reasonable assurance with respect to financial statement preparation and presentation.

 

Management of OAK Financial Corporation assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework. Based on our assessment we believe that, as of December 31, 2009, the Company’s internal control over financial reporting is effective based on those criteria.

 

Plante & Moran, PLLC, an independent registered public accounting firm, has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting.

 

 

Dated:  February 8, 2010

 

 

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Report of Independent Registered Public Accounting Firm

 

To the Board of Directors and Stockholders

O.A.K. Financial Corporation and Subsidiaries

 

We have audited the accompanying balance sheets of O.A.K. Financial Corporation as of December 31, 2009 and 2008, and the related statements of income, stockholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2009. We also have audited the Company's internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying financial statements. Our responsibility is to express an opinion on these financial statements and an opinion on the company's internal control over financial reporting based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

 

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of O.A.K. Financial Corporation as of December 31, 2009 and 2008, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, O.A.K. Financial Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

As discussed in Note 20, the Company entered into a definitive agreement and plan of merger on January 7, 2010 with Chemical Financial Corporation.

 

/s/ Plante & Moran, PLLC

 

Auburn Hill, Michigan

February 8, 2010

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The accompanying notes are an integral part of these consolidated financial statements.

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The accompanying notes are an integral part of these consolidated financial statements

48

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The accompanying notes are an integral part of these consolidated financial statements.

49

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The accompanying notes are an integral part of these consolidated financial statements.

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NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

                OAK Financial Corporation (the “Corporation”) and its subsidiaries provide a variety of financial services typically provided in the commercial banking industry.  The Corporation is a Bank Holding Company and owns the stock of Byron Bank (the “Bank”).  The Bank’s commercial banking activities include checking and savings accounts, commercial lending, direct consumer financing, and mortgage lending.  The Bank also provides mutual fund products, securities brokerage services, retirement planning services, investment management and advisory services, as well as property and casualty, life, disability and long-term care insurance products through two subsidiary companies, Byron Investment Services and Byron Insurance Agency.  The principal markets are suburban communities south and west of Grand Rapids in Kent, Ottawa and Allegan counties.  The economies of these communities are relatively stable and reasonably diversified.  The bank’s primary competitors include both large and local financial institutions.  The Bank is State chartered and is a member of the Federal Reserve Bank ("FRB").  The Bank is subject to the regulations and supervision of the FDIC, the FRB and the Michigan Office of Financial and Insurance Regulation ("OFIR") and undergoes periodic examinations by these regulatory authorities.

 

                The accounting and reporting policies and practices of the Corporation conform with accounting principles generally accepted in the United States of America and prevailing practices within the banking industry. We have certain critical accounting policies, including accounting for the allowance for loan losses, the fair market value of investment securities and the valuation of deferred tax assets, that require us to make material estimates and assumptions that are particularly susceptible to changes in the near term as we prepare the consolidated financial statements and report amounts for each of these items. The fair value of financial instruments is particularly sensitive to estimates and assumption.  Actual results may vary from these estimates.

 

                Principles of Consolidation:  The consolidated financial statements include the accounts of OAK Financial Corporation and its subsidiaries.  The income, expense, assets and liabilities of the subsidiaries are included in the respective accounts of the consolidated financial statements, after elimination of all material intercompany transactions and accounts.

 

                Statement of Cash Flows:  For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from other financial institutions, and federal funds sold. We report net cash flows for customer loan and deposit transactions.

 

                Securities:  Securities can be classified as trading, held to maturity or available for sale. Trading securities are bought and held principally for the purpose of selling them in the near term and are reported at fair value with realized and unrealized gains and losses included in earnings. We do not have any trading securities. Securities held to maturity represent those securities for which we have the positive intent and ability to hold until maturity and are reported at cost, adjusted for amortization of premiums and accretion of discounts computed on the level-yield method. We did not have any securities held to maturity at December 31, 2009 and 2008. Securities available for sale represent those securities not classified as trading or held to maturity and are reported at fair value with unrealized gains and losses, net of applicable income taxes reported in comprehensive income. We determine whether a decline in fair value below the amortized cost basis is other than temporary. If the decline in value is judged to be other than temporary, the cost basis of the security is written down to fair value as a new cost basis and the amount of the write-down is recognized as a charge to non-interest income. Gains and losses realized on the sale of securities available for sale are determined using the specific identification method and are recognized on a trade-date basis. Premiums and discounts are recognized in interest income computed on the level-yield method.   

 

 

 

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NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Loans:  Loans are reported at their outstanding unpaid principal balances adjusted for any charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans.  Interest on loans is accrued over the term of the loan based on the principal amount outstanding.  The accrual of interest income is discontinued when a loan becomes 90 days past due and the borrower's capacity to repay the loan and collateral values appear insufficient. When the accrual of interest is discontinued, all uncollected accrued interest is reversed.  Payments received on loans that are on non-accrual are generally applied to the principal balance until the loan qualifies to be returned to accrual status.  A non-accrual loan may be restored to accrual status when interest and principal payments are current and the loan appears otherwise collectible.  Loan origination fees, net of certain direct loan origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

 

Allowance for Loan Losses:  Some loans will not be repaid in full.  Therefore, an allowance for loan losses is maintained at a level, which represents our best estimate of losses incurred. In determining the allowance and the related provision for loan losses, we consider four principal elements:  (i) specific allocations based upon probable losses identified during the review of the loan portfolio, (ii) allocations established for other adversely rated loans, (iii) allocations based on historical loan loss experience, and (iv) additional allowances based on subjective factors, including changes in lending policies and procedures, local and general economic business conditions and trends, portfolio concentrations, experience and depth of lending management, and external conditions that may effect the performance of the loan portfolios. Increases in the allowance are recorded by a provision for loan losses charged to expense.  Although we periodically allocate portions of the allowance to specific loans and loan portfolios, the entire allowance is available for any losses, which occur. Collection efforts continue and recoveries may occur after a loan is charged against the allowance.

 

A loan is considered impaired when full payment under the loan or lease terms is not expected.  Impairment is evaluated by assessing payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans are evaluated for impairment when payments are delayed, typically 90 days or more, or when the internal grading system indicates a doubtful classification.  Impairment of commercial and construction loans is measured on a loan by loan basis using the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent.  Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures.

 

                Loans Held for Sale:  Loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated fair value in the aggregate.  Net unrealized losses, if any, are recognized in a valuation allowance by charges to income.  

 

Other Real Estate Owned:  Other real estate owned includes any real estate, other than Bank premises, owned or controlled by the Company and its consolidated subsidiaries.  These consist primarily of assets for which the Company has received physical possession of the property through foreclosure proceedings.  These assets are reported at either the fair value of the asset, minus the estimated costs to sell the asset, or the cost of the asset.  If the fair value of the asset, minus the estimated costs to sell the asset, is less than the asset’s cost, the deficiency is recognized as a valuation allowance against the asset, which is created through a charge to expense.

 

                Premises and Equipment:  Land is carried at cost.  Premises and equipment are stated at cost less accumulated depreciation.  Depreciation is computed using both the straight-line and accelerated methods over the useful lives of the respective assets.  Maintenance, repairs and minor alterations are charged to current operations as expenditures occur and major improvements are capitalized. These assets are reviewed for impairment.

 

 

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NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Servicing:  Mortgage servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of financial assets.  Capitalized servicing rights are reported in other assets and are amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets.  Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost.  Impairment is determined by stratifying rights by predominant characteristics, such as interest rates and terms.  Fair value is determined using prices of similar assets with similar characteristics, when available, or based upon discounted cash flows using market-based assumptions. Impairment is recognized through a valuation allowance.

 

Income Taxes:  Income tax expense is the sum of the current year income tax due or refundable and the change in deferred tax assets and liabilities.  Deferred tax assets and liabilities are the expected future tax consequence of temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates.  A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.  The Corporation and its subsidiary file a consolidated federal income tax return on a calendar year basis.

 

Off Balance Sheet Instruments:  In the ordinary course of business, the Bank enters into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit, standby letters of credit, and forward contracts for the sale of mortgage loans held for sale.  Unless otherwise required, these financial instruments are recorded when they are funded.

 

Derivative Financial Instruments:   Derivatives are required to be recorded on the balance sheet as assets and liabilities measured at their fair value. The accounting for increases and decreases in the value of derivatives depends upon the use of derivatives and whether the derivatives qualify for hedge accounting.  The Bank does not currently designate the use of any derivatives as hedges.

 

   The fair-value of derivative financial instruments, not designated as hedges, are recorded on our balance sheet and are adjusted on an ongoing basis to reflect their then current fair value. The changes in the fair value of derivative financial instruments not designated as hedges are recognized currently in earnings.

 

Fair Values of Financial Instruments:  Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately.  Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items.  Changes in assumptions or in market conditions could significantly affect the estimates.  The fair value estimates of existing on – and off-balance sheet financial instruments do not include the value of anticipated future business or the values of assets and liabilities not considered financial instruments.

 

Earnings Per Share:  Basic earnings per share is net income divided by the weighted average number of common shares outstanding during the period.  Diluted earnings per common share includes the dilutive effect of additional potential common shares that could be issued under the stock option plan.

 

Comprehensive Income:  Comprehensive income consists of net income and other comprehensive income, which includes the unrealized gains and losses on available-for-sale securities.  The unrealized gains and losses on available-for-sale securities are reported as a separate component of the equity section of the balance sheet, net of tax.

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NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

 

Contingencies:  Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated.  Management does not believe there are any such matters that will have a material effect on the financial statements.

 

Stock Compensation Plans:  The Corporation accounts for stock option plans using the fair value method.  No compensation cost related to stock options was recognized during 2009, 2008 or 2007, as no options were granted in those years. 

 

Segment Reporting:  While management monitors the revenue streams of various products and services offered, operations are managed and financial performance is evaluated on a company wide basis.  Accordingly, all of the Corporation's operations are considered by management to be aggregated in one reportable operating segment.

 

Restricted Investments:  The Bank is a member of the Federal Home Loan Bank System and is required to invest in capital stock of the Federal Home Loan Bank of Indianapolis ("FHLB").  The amount of the required investment is determined and adjusted periodically by the FHLB. The investment is carried at cost plus the value assigned to stock dividends.

 

The Bank is also a member of the Federal Reserve Bank System.  The amount of the required investment is determined by the FRB at the time the Bank becomes a member.  The amount of the investment may be adjusted thereafter and is carried at cost.

 

Reclassifications:  Certain amounts in the 2008 and 2007 consolidated financial statements have been reclassified to conform with the 2009 presentation.

 

Subsequent Events:  The financial statements and related disclosures include evaluation of events up through and including February 8, 2010, which is the date the financial statements were available to be issued.

 

Recent Pronouncements:  The Financial Accounting Standards Board issued new guidance in 2009 on the accounting for transfers of financial assets.  The new guidance eliminates the concept of a qualifying special-purpose entity.  Other changes from current accounting standards include new de-recognition criteria for a transfer to be accounted for as a sale, and a changes to the amount of recognized gain/loss on transfers accounted for as a sale when beneficial interests are received by the transferor.  This new standard will be applied prospectively to new transfers of financial assets and will be effective for the first annual period beginning after November 15, 2009 and interim periods within that first annual period.  Early application is prohibited.  The Company is currently assessing the impact this new standard will have on its financial statements.

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NOTE 2.  COMPREHENSIVE INCOME (in thousands)

 

The components of comprehensive income and related tax effects for the year ended December 31, are as follows:

 

 

NOTE 3.  RESTRICTIONS ON CASH AND AMOUNTS DUE FROM BANKS

 

The Bank is required to deposit certain amounts with the Federal Reserve Bank.  These reserve balances vary depending upon the level of certain customer deposits in the Bank.  At December 31, 2009 and 2008, those required reserve balances were $1,238,000 and $1,105,000, respectively.

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NOTE 4.  AVAILABLE-FOR-SALE SECURITIES (in thousands)

 

The amortized cost, gross unrealized gains, gross unrealized losses and fair value of investment securities, all of which are classified as available-for-sale as of December 31, are as follows:

 

 

Investment securities with carrying values of approximately $28.2 million and $54.3 million at December 31, 2009 and 2008, respectively, were pledged to secure borrowing arrangements disclosed in notes 9 and 10 or for other purposes as required or permitted by law.

 

The amortized cost and fair value of available-for-sale securities by contractual maturity at December 31, 2009 is shown below.  Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

 

 

 

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NOTE 4.  AVAILABLE-FOR-SALE SECURITIES (Continued)

 

The gross gains and gross losses realized on sales for the years ended December 31 are as follows:

 

 

The unrealized losses shown in the following table resulted primarily from changes in market rates across the yield curve.  The issuers of the bonds are of high quality and the fair value is expected to recover as the bonds approach the maturity date.  The Bank has the intent and ability to hold the bonds for foreseeable future and therefore the unrealized losses on securities are considered temporary and have not been recognized into income.  At December 31, 2009, the Corporation had 32 securities that were in a loss position, compared to 55 securities that were in a loss position at December 31, 2008. 

 

 

 

 

 

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NOTE 5.  LOANS AND ALLOWANCE FOR LOAN LOSSES (in thousands)

 

Major loan classifications at December 31, are as follows:

 

The following is an analysis of changes in the allowance for loan losses for the years ended December 31:

 

The following is a summary of information pertaining to impaired loans as of December 31:

 

The following is a summary of information pertaining to impaired loans for the years ended December 31:

 

 

No additional funds are committed to be advanced in connection with impaired loans.

 

 

 

 

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NOTE 6.  PREMISES AND EQUIPMENT (in thousands)

 

A summary of premises and equipment at December 31 follows:

 

 

Depreciation expense for each of the years ending December 31, 2009, 2008 and 2007 was $1.4 million, $1.4 million and $1.2 million, respectively.

 

NOTE 7.  SERVICING (in thousands)

 

Mortgage servicing rights (“MSR”s) reflect the present value of the future income stream from mortgage servicing fees, ancillary income from processing mortgage related payments, delinquency effects and overnight income of processing (“float”).  The value is the sum of the present value of these future income streams, which is impacted by assumptions on prepayment or decay rates, mortgage classifications and the applied discount rate.

 

The process is to classify the serviced mortgages into groups based on maturity, payment terms, seasoning and interest rate.  The result is a series of mortgage pools with homogeneous characteristics, which are then subjected to appropriate prepayment speeds to derive a future stream of expected cash flows for each pool.  The current industry accepted rate is used to discount the future cash flows.  The sum of the present value of each pool is the mortgage servicing portion of the valuation.  The Bank employs an independent third party to determine the fair value of the mortgage servicing rights.

 

Loans serviced for others are not included on the accompanying consolidated balance sheets.  The unpaid principal balances of mortgage and other loans serviced for others were $102 million and $136 million at December 31, 2009 and 2008, respectively.

 

The balance of capitalized servicing rights, net of valuation allowance, included in other assets at December 31, 2009 and 2008, was $212,000 and $538,000 respectively.  The fair value of these rights was $800,000 and $1,400,000, at December 31, 2009 and 2008, respectively.  The fair value of servicing rights was determined using an average discount rate of 7.69 percent in 2009 and 7.94 percent in 2008, with prepayment speeds ranging from 0 percent to 30.6 percent in 2009 and from 0 percent to 19.3 percent in 2008.

 

The following table summarizes the mortgage servicing rights capitalized and amortized, along with the aggregate activity in related valuation allowances:

 

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NOTE 8.  DEPOSITS (dollars in thousands)

 

Deposits at year-end were as follows:

 

 

At December 31, 2009, scheduled maturities of certificates of deposit are as follows:

 

 

Brokered time deposits totaled approximately $189 million and $202 million at December 31, 2009 and 2008.

 

NOTE 9.  FEDERAL FUNDS PURCHASED & REPURCHASE AGREEMENTS (dollars in thousands)

 

The Bank has the ability to borrow money on a daily basis through one of its correspondent banks using an established federal funds purchased line of credit.  The Bank has established an unsecured federal funds purchased borrowing limit totaling $25 million at December 31, 2009.  At December 31, 2009 and 2008 the Bank had $0.9 million and $2.3 million outstanding, respectively.  During 2009, the Bank’s federal funds purchased position averaged $1.7 million, compared to an average federal funds purchased position of $17.9 million for 2008.  The average rate paid on federal funds purchased during 2009 and 2008 were 0.98% and 2.77%, respectively. 

 

Repurchase agreements are financing arrangements secured by U.S. federal agency securities.  At December 31, 2009, the Bank had one repurchase agreement totaling $5.6 million.  This borrowing was secured by securities that had a carrying amount of $7.1 million at December 31, 2009.  At maturity, the securities underlying the arrangements are returned to the Bank.

 

The repurchase agreement at December 31, 2009 and its contractual maturity is as follows:

 

 

 

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NOTE 10.  FHLB ADVANCES & OTHER BORROWED FUNDS (dollars in thousands)

 

Each Federal Home Loan Bank advance is payable at its maturity date, and may be subject to a prepayment fee if paid prior to the maturity date. Advances with put options held by the Federal Home Loan Bank amounted to $16.8 million at December 31, 2009 and 2008. At December 31, 2009 and 2008, the Federal Home Loan Bank borrowings were collateralized by a blanket lien on all qualified 1 to 4 family residential mortgage loans, consumer home equity loans, and specifically identified commercial real estate and U.S. government agency securities.  U.S. government agency securities pledged to FHLB borrowings had carrying values of approximately $11.9 and $14.5 million, at December 31, 2009 and 2008, respectively.  The total available credit for FHLB borrowings at December 31, 2009 and December 31, 2008, was $81.0 million and $80.5 million, respectively.  At December 31, 2009, the Bank had no variable rate FHLB advances and fixed rate FHLB advances totaled $49.4 million.  The average interest rate on the FHLB borrowings was 4.43 percent and 4.74 percent, for 2009 and 2008, respectively.

 

The Federal Home Loan Bank advances at December 31, 2009 and their contractual maturities are as follows:

 

 

 

Other borrowed funds as of December 31, 2009 and December 31, 2008, were comprised entirely of TT&L notes, with balances of $1,033,000 and $1,030,000, respectively.

 

NOTE 11.  FEDERAL INCOME TAXES  (in thousands)

 

The provision for federal income taxes for the years ended December 31 consists of:

 

A reconciliation between federal income tax expense and the amount computed by applying the statutory federal income tax rate of 34 percent to income before taxes for the years ended December 31, is as follows:

 

 

	2009		2008		2007
Statutory rate applied to income    before income taxes	($113)		$1,544		$2,267
Deferred expense (benefit)	(1,494)		(1,939)		19
Federal income tax expense	($872)		($395)		$2,286

 

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NOTE 11.  FEDERAL INCOME TAXES  (Continued)

 

The net deferred income tax asset recorded includes the following amounts of deferred tax assets and liabilities:

 

An impairment charge recorded on the Company’s auction rate securities, in the fourth quarter of 2008, resulted in a deferred tax asset of $1.1 million.  If the Company were to sell these securities, the associated loss would be considered a capital loss, which can only be recovered through offsetting capital gains.  The Company’s management has identified strategies that could be used to generate capital gains to offset the capital loss, if the value of these securities does not recover.  The fair value of these securities at December 31, 2009, was significantly higher than the book value of the securities after the impairment charge was taken.  The result of this would be a reduced capital loss if the securities were sold.  Management has not determined if, or when, it would implement these strategies. 

 

 

NOTE 12.  RELATED PARTY TRANSACTIONS

 

Certain directors, executive officers and their related interests were loan customers of the Bank. All such loans were made on substantially the same terms, including interest rates and collateral, as those prevailing at the same time for comparable transactions and do not represent more than a normal risk of collectibility or present other unfavorable features.  The total loans outstanding to these customers aggregated approximately $64,000 and $83,000 at December 31, 2009 and 2008, respectively.  During 2009, there were no new loans and repayments were approximately $19,000.

 

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NOTE 13.  OFF-BALANCE SHEET ACTIVITIES (in thousands)

 

The Bank is a party to credit related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments include commitments to extend credit, standby letters of credit and commercial letters of credit.  Such commitments involve to varying degrees elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.  The Bank follows the same credit policy to make such commitments, including collateral as is followed for those loans recorded in the consolidated financial statements; no significant losses are anticipated as a result of these commitments.

 

At December 31, 2009 and 2008, the following financial instruments were outstanding whose contract amounts represent credit risk:

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  The commitments for equity lines of credit may expire without being drawn upon.  Therefore, the total commitment amounts do not necessarily represent future cash requirements.  The amount of collateral obtained, if it is deemed necessary by the Bank, is based on management's credit evaluation of the customer.

 

Unfunded commitments under commercial lines‑of-credit, revolving credit lines and overdraft protection agreements are commitments for possible future extensions of credit to existing customers. These lines-of-credit usually do not contain a specified maturity date and may not be drawn upon to the total extent to which the Bank is committed.  A portion of these commitments are unsecured.

 

Commercial and standby letters-of-credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party.  Those letters-of-credit are primarily issued to support public and private borrowing arrangements.  Essentially all letters of credit issued have expiration dates within one year. The credit risk involved in issuing letters-of-credit is essentially the same as that involved in extending loan facilities to customers.  The Bank generally holds collateral supporting those commitments if deemed necessary.

 

Mandatory forward sales commitments:  The Bank will occasionally enter into commitments to sell loans (service released) with investors, whereby the agreed upon price for the loan or group of loans is determined prior to the sale of the loans.  These commitments have expiration dates ranging from 45 to 75 days, and contain late fee provisions and pair-off fee provisions if the loans are not delivered timely.  The bank does not designate these derivatives as hedging instruments and does not recognize the change in their fair value in earnings.  The fair value for mandatory forward sales commitments is based on current market prices versus the committed prices.  At December 31, 2009 the Bank had one mandatory forward sales commitment totaling $80,000.

 

Rate lock commitments with customers:  The Bank enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding (rate lock commitments).  Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives.  We do not designate these derivatives as hedging instruments.  At December 31, 2009 we had $10.7 million in rate lock commitments with customers, which were placed with our investors on “Best Efforts” contracts.

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NOTE 14.  REGULATORY MATTERS (dollars in thousands)

 

The Corporation (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by its primary regulator, the FRB. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by the FRB that, if undertaken, could have a direct material effect on the Corporation's and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and the Bank must meet specific capital guidelines that involve quantitative measures of the their assets, liabilities, capital and certain off-balance-sheet items as defined in the regulations and calculated under regulatory accounting practices.  The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

 

Quantitative measurements established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total capital and Tier 1 capital to risk weighted assets and Tier 1 capital to average assets.  Management believes that, at December 31, 2009, the Corporation and the Bank meet all capital adequacy requirements to which they are subject. As of December 31, 2009 the most recent notification from the FRB categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the following table.  There are no conditions or events since the most recent notification that management believes has changed the Bank's category.

 

The Corporation's and the Bank's actual capital amounts and ratios at December 31, 2009 and 2008 are also presented in the table below:

 

 

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NOTE 14.  REGULATORY MATTERS (Continued)

 

The Bank is also subject to limitations under the Federal Reserve Act on the amount of loans or advances that can be extended to the Corporation and dividends that can be paid to the Corporation.  Loans or advances are limited to 10 percent of the Bank's capital stock and surplus on a secured basis. Generally, approval is needed if total dividends declared in any calendar year exceed the retained "net profit" (as defined in the Federal Reserve Act) of that year plus the retained "net profit" of the preceding two years.  In addition, dividends paid by the Bank to the Corporation would be prohibited if the effect thereof would cause the Bank's capital to be reduced below applicable minimum capital requirements.  At January 1, 2010, the Corporation’s subsidiary bank, without obtaining prior governmental approvals, could declare aggregate dividends equal to the net profits (as measured under current regulations), if any, earned for the period from January 1, 2010 through the date of declaration less approximately $0.5 million from retained net profits of the proceeding two years.  During 2009, the Corporation’s subsidiary bank did not pay any dividend to the Corporation.  Dividends paid by the Corporation during 2009 were paid through the Corporation’s cash on hand and the sale of available for sale securities. 

 

On October 16, 2008 the Corporation’s Board of Directors adopted a resolution to amend the articles of incorporation to authorize the issuance of 500,000 share of preferred stock.  The resolution was voted on and approved at a special meeting of the shareholders that was held on December 22, 2008 and adjourned to January 9, 2009.

 

 

NOTE 15.  EMPLOYEE BENEFIT PLANS AND POST RETIREMENT BENEFITS

 

The Corporation maintains a 401(k) covering substantially all employees. The Corporation matches employee contributions to the 401(k) up to a maximum of 4.5 percent of employees' eligible wages.  The total Corporation contributions to the 401(k) match were $395,000, $353,000, and $334,000 for 2009, 2008 and 2007 respectively.  The Corporation does not offer any other pension or retirement plans.

 

The Bank offers a deferred compensation plan for all directors who elect to participate.  The cost of the plan was $135,000, $89,000 and $120,000 in 2009, 2008, and 2007, respectively.  The accrued benefit obligation for this plan was $1,197,000 and $1,161,000 as of December 31, 2009 and 2008, respectively, and is included in other liabilities.  The Bank has purchased life insurance policies on the participating directors to fund the deferred compensation.  The cash surrender value of the policies was $2,475,000 and $2,508,000 at December 31, 2009 and 2008, respectively, and is included in other assets. 

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NOTE 16.  STOCK OPTIONS

 

The Corporation maintains stock option plans for non-employee directors (the Director's Plan) and employees and officers of the Corporation and its subsidiary (the Employees' Plan).  The stock compensation plans were established in 1999, and authorize the issue of up to 219,615 options under the Employees’ Plan and up to 46,585 options under the Directors’ Plan.  Both the Employees’ Plan and the Directors’ Plan expired on January 28, 2009.  Stock options granted prior to the expiration of the plan can be exercised for a period of 10 years from the date granted.

 

Generally options under both plans become exercisable after the first anniversary of the award date.  The option exercise price is at least 100 percent of the market value of the common stock at the grant date.  No options have been granted during the periods presented below.         

 

The following tables summarize information about stock option transactions:

 

 

 

 

All options expire 10 years after the date of the grant.    

 

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NOTE 17.  EARNINGS PER SHARE (in thousands, except earnings per share)

 

A reconciliation of basic and diluted earnings per share for the years ended December 31, follows:

 

 

 

 

NOTE 18.  FAIR VALUE

The following table presents information about the Company’s assets and liabilities measured at fair value on a recurring basis at December 31, 2009, and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value.

In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access.

Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability.

In instances in which the inputs used to measure fair value may fall into different levels of the fair value hierarchy, the level in the fair value hierarchy within which the fair value measurement in its entirety has been determined is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

The company had no investment securities available for sale at December 31, 2009 or December 31, 2008, for which it utilized significant Level 3 inputs to determine fair value. 

 

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NOTE 18.  FAIR VALUE (continued)

Disclosures concerning assets and liabilities measured at fair value are as follows:

 

 

The Company also has certain assets that are measured at fair value on a nonrecurring basis.  These assets are not measured at fair value on an ongoing basis, but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment).   The following table presents the Company’s assets carried at fair value on a nonrecurring basis as of December 31, 2009.

 

 

The fair value of impaired loans accounted for under accounting standards related to loan impairment, is estimated using either discounted cash flows or collateral value.  Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.  At December 31, 2009, substantially all of the total impaired loans were evaluated based on the fair value of the collateral.  In accordance with accounting standard related to fair value measurements and disclosures, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy.  Impaired loans are categorized as Level 3 assets because the values are based on available collateral (typically based on outside appraisals) and customized discounting criteria, if deemed necessary.  The change in fair value of impaired loans is accounted for in the allowance for loan losses (see Note 5).

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NOTE 18.  FAIR VALUE (continued)

 

Other real estate is reported at either the fair value of the real estate, minus the estimated costs to sell the asset, or the cost of the asset.  The determination of the fair value of the real estate relies primarily on appraisals from third parties.  If the fair value of the real estate, minus the estimated costs to sell the asset, is less than the asset’s cost, the deficiency is recognized as a valuation allowance against the asset through a charge to expense.  The valuation allowance is therefore increased or decreased, through charges or credits to expense, for changes in the asset’s fair value or estimated selling costs.

The Company also has other assets, which under certain conditions, are subject to measurement at fair value.  These assets include mortgage servicing rights and loans held for sale.  The Company estimated the fair values of these assets utilizing Level 3 inputs, including, the discounted present value of expected future cash flows.  At December 31, 2009, we estimate that there is no impairment of these assets and therefore, no impairment charge to other expense was required to adjust these assets to their estimated fair values.

 

The carrying amount and estimated fair values of financial instruments at December 31, are as follows:

 

Carrying amount is the estimated fair value of cash and cash equivalents, accrued interest receivable and payable, restricted investments, demand deposits, short-term borrowings, and variable rate loans or deposits that reprice frequently and fully.  Security fair values are based on market prices or dealer quotes, and if no such information is available, on the rate and term of security and information about the issuer.  For fixed rate loans or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk.  Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values.  Fair value of loans held for sale is based on market quotes.  Fair value of debt is based on current rates for similar financing.

 

Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items.  Changes in assumptions or in market conditions could significantly affect the estimates. 

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NOTE 19.  OAK FINANCIAL CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL INFORMATION (in thousands)

 

The following summarizes parent company only condensed balance sheets as of December 31, 2009 and 2008 and the related condensed statements of income and cash flows for each of the three years in the period ended December 31, 2009, 2008 and 2007:

 

 

 

 

 

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NOTE 19.  OAK FINANCIAL CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL INFORMATION (Continued)

 

 

 

NOTE 20.  SUBSEQUENT EVENT – PROPOSED MERGER WITH CHEMICAL FINANCIAL CORPORATION

 

On January 7, 2010, Chemical Financial Corporation ("Chemical") and the Company entered into a definitive Agreement and Plan of Merger (the "Merger Agreement") pursuant to which the Company will merge with and into Chemical (the "Merger").  Following the Merger, Byron Bank, the wholly owned subsidiary of the Company, will be consolidated with and into Chemical Bank, a wholly owned subsidiary of Chemical.  Under the terms of the Merger Agreement, as of the effective time of the Merger shareholders of the Company will receive 1.306 shares of Chemical stock for each share of common stock they own, subject to adjustments under certain specified situations. 

 

Consummation of the Merger is subject to approval by the Company's shareholders, receipt of appropriate regulatory approvals, and certain other closing conditions.  Subject to the terms and conditions of the Merger Agreement, the transaction is expected to be completed in the second quarter of 2010.

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Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

 

None

 

Item 9A.  Controls and Procedures

 

(a)           Evaluation of Disclosure Controls and Procedures.

 

The Corporation’s Chief Executive Officer and the Chief Financial Officer, after evaluating the effectiveness of the Corporation’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15(d)-15(e)) as of the end of the period covered by this Form 10-K Annual Report have concluded that the Corporation’s disclosure controls and procedures were adequate and effective to ensure that material information relating to the Corporation would be made known to them by others within the Corporation, particularly during the period in which this Form 10‑K Annual Report was being prepared.

 

                (b)           Management's Report on Internal Control Over Financial Reporting.

 

The Corporation’s management report on internal control over financial reporting is included in Item 8 on page 44 of this Annual Report and is incorporated herein by reference.   The attestation report of Plante & Moran, PLLC, the Corporation's independent registered public accounting firm, on the effectiveness of the Corporation’s internal control over financial reporting is included in Item 8 on page 45 of this Annual Report and is incorporated herein by reference.

 

(c)           Changes in Internal Controls.

 

During the fourth quarter ended December 31, 2009, there have been no changes in the Corporation's internal control over financial reporting that have materially affected or are reasonably likely to materially affect the Corporation’s internal control over financial reporting.

 

Item 9B.  Other Information

 

                None.

 

PART III

 

The information required by Part III of Form 10-K is hereby incorporated by reference to our definitive proxy statement to be filed within 120 days of our December 31, 2009 year end or if not so filed within such 120-day period, will be filed as an amendment to this Annual Report on Form 10-K with such 120-day period.

 

Item 10.  Directors, Executive Officers, and Corporate Governance.

 

The information required by this Item is hereby incorporated by reference to our definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days of our December 31, 2009 fiscal year end, or, alternatively, by amendment to this Form 10-K, no later than the end of such 120 day period.

 

There have been no material changes to the procedures by which shareholders may recommend nominees to the Corporation’s Board of Directors.

 

 

 

Audit Committee Financial Expert

 

The Board of Directors of the Corporation has determined that Robert F. Dentzman, a director and member of the Audit Committee, qualifies as an "Audit Committee Financial Expert" as defined in rules adopted by the Securities and Exchange Committee pursuant to the Sarbanes-Oxley Act of 2002 and is "independent," as defined in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act of 1934.

 

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Executive Officers

                                                                                       

Reference is made to additional item under Part I of this report on Form 10-K.

 

Code of Ethics

 

The honesty, integrity and sound judgment of the chief executive officer and senior financial officers is fundamental to the reputation and success of OAK Financial Corporation.  While all employees, officers, and directors are required to adhere to the OAK Financial Corporation Code of Ethics, the professional and ethical conduct of the chief executive officer and senior financial officers is essential to the proper function and success of OAK Financial Corporation as a leading financial services provider.  Executives of OAK Financial Corporation subject to this Code include the Chief Executive Officer, the Chief Financial Officer, the Chief Accounting Officer, the Controller, and any other officer performing accounting, auditing, financial management or similar functions.  The Code of Ethics is incorporated by reference as an exhibit to this Report on Form 10-K.

 

Item 11.  Executive Compensation.

 

The information required by this Item is hereby incorporated by reference to our definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days of our December 31, 2009 fiscal year end, or, alternatively, by amendment to this Form 10-K, no later than the end of such 120 day period.

 

Item 12.  Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters.

 

The information required by this Item is hereby incorporated by reference to our definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days of our December 31, 2009 fiscal year end, or, alternatively, by amendment to this Form 10-K, no later than the end of such 120 day period.

 

Securities Authorized for Issuance Under Equity Compensation Plans.  The Company had the following equity compensation plans at December 31, 2009:

 

 

EQUITY COMPENSATION PLAN INFORMATION

 

 

                These equity compensation plans are more fully described in Note 16 to the Consolidated Financial Statements.

 

 

 

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Item 13.  Certain Relationships and Related Transactions and Director Independence.

 

The information required by this Item is hereby incorporated by reference to our definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days of our December 31, 2009 fiscal year end, or, alternatively, by amendment to this Form 10-K, no later than the end of such 120 day period.

 

Each of the Corporation’s directors, other than Patrick Gill, are independent under Nasdaq listing standards. 

 

 

Item 14. Principal Accountant Fees and Services.

 

The information required by this Item is hereby incorporated by reference to our definitive proxy statement to be filed with the Securities and Exchange Commission within 120 days of our December 31, 2009 fiscal year end, or, alternatively, by amendment to this Form 10-K, no later than the end of such 120 day period.

 

 

PART IV

 

Item15.  Exhibits and Financial Statement Schedules.

 

 

 

 

 

 

 

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SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, dated February 8, 2010.

 

 

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.  Each director of the Registrant, whose signature appears below, hereby appoints Patrick K. Gill and James A. Luyk, and each of them severally, as his or her attorney-in-fact, to sign in his or her name and on his or her behalf, as a director of the Registrant, and to file with the Commission any and all Amendments to this Report on Form 10-K.

 

 

 

 

 

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EXHIBIT INDEX

 

The following exhibits are filed herewith, indexed according to the applicable assigned number:

 

 

 

                The following exhibits, indexed according to the applicable assigned number, were previously filed by the Registrant and are incorporated by reference in this Form 10-K Annual Report.

 

 

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