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EX-21 - CHEMICAL FINANCIAL EXHIBIT 21 TO FORM 10-K - TCF FINANCIAL CORPchemex21_022510.htm
EX-32 - CHEMICAL FINANCIAL EXHIBIT 32 TO FORM 10-K - TCF FINANCIAL CORPchemex32_022510.htm
EX-24 - CHEMICAL FINANCIAL EXHIBIT 24 TO FORM 10-K - TCF FINANCIAL CORPchemex24_022510.htm
EX-31.1 - CHEMICAL FINANCIAL EXHIBIT 31.1 TO FORM 10-K - TCF FINANCIAL CORPchemex311_022510.htm
EX-23.2 - CHEMICAL FINANCIAL EXHIBIT 23.2 TO FORM 10-K - TCF FINANCIAL CORPchemex232_022510.htm
EX-99.1 - CHEMICAL FINANCIAL EXHIBIT 99.1 TO FORM 10-K - TCF FINANCIAL CORPchemex991_022510.htm
EX-31.2 - CHEMICAL FINANCIAL EXHIBIT 31.2 TO FORM 10-K - TCF FINANCIAL CORPchemex312_022510.htm
EX-99.2 - CHEMICAL FINANCIAL EXHIBIT 99.2 TO FORM 10-K - TCF FINANCIAL CORPchemex992_022510.htm
EX-23.1 - CHEMICAL FINANCIAL EXHIBIT 23.1 TO FORM 10-K - TCF FINANCIAL CORPchemex231_022510.htm
Table of Contents

CHEMICAL
FINANCIAL CORPORATIONSM
 
2009
Annual Report
to Shareholders

 
(LOGO)      


 

CHEMICAL FINANCIAL CORPORATION
 
 
2009 ANNUAL REPORT TO SHAREHOLDERS
 
         
Table of Contents   Page
 
 
       
    3  
       
    4  
       
    39  
       
    40  
       
    42  
       
Notes to Consolidated Financial Statements
    46  
       
    80  
       
    81  
       
    83  


Table of Contents

 
FORWARD-LOOKING STATEMENTS
 
This report contains forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy and Chemical Financial Corporation (Chemical) itself. Words such as “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “judgment,” “plans,” “predicts,” “projects,” “should,” “will,” variations of such words and similar expressions are intended to identify such forward-looking statements. Management’s determination of the provision and allowance for loan losses, the carrying value of goodwill and mortgage servicing rights and the fair value of investment securities (including whether any impairment on any investment security is temporary or other-than-temporary) and management’s assumptions concerning pension and other post retirement benefit plans involve judgments that are inherently forward-looking. All of the information concerning interest rate sensitivity is forward-looking. The future effect of changes in the financial and credit markets and the national and regional economy on the banking industry, generally, and on Chemical, specifically, are also inherently uncertain. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“risk factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. Chemical undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise.
 
Risk factors include, but are not limited to, the risk factors described in Item 1A in Chemical Financial Corporation’s Annual Report on Form 10-K for the year ended December 31, 2009; the risk factors described in Item 1A in O.A.K. Financial Corporation’s (OAK’s) Annual Report on Form 10-K for the year ended December 31, 2009; the timing and level of asset growth; changes in market interest rates; changes in banking laws and regulations; changes in tax laws; changes in prices, levies and assessments; the impact of technological advances and issues; governmental and regulatory policy changes; opportunities for acquisitions and the effective completion of acquisitions and integration of acquired entities; the possibility that anticipated cost savings and revenue enhancements from acquisitions, restructurings, reorganizations and bank consolidations may not be realized fully or at all or within expected time frames; the local and global effects of current and future military actions, and current uncertainties and fluctuations in the financial markets and stocks of financial services providers due to concerns about credit availability and concerns about the Michigan economy in particular. These and other factors are representative of the risk factors that may emerge and could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.
 
This report also contains forward-looking statements regarding Chemical’s outlook or expectations with respect to the planned acquisition of OAK, the expected costs to be incurred in connection with the acquisition, OAK’s future performance and consequences of its integration into Chemical and the impact of the transaction on Chemical’s future performance.
 
Risk factors also include, but are not limited to, risks and uncertainties related both to the proposed acquisition of OAK and to the integration of the acquired business into Chemical after closing, including:
 
Completion of the transaction is dependent on, among other things, receipt of regulatory and OAK shareholder approvals, the timing of which cannot be predicted with precision at this point and which may not be received at all. The impact of the completion of the transaction on Chemical’s financial statements will be affected by the timing of the transaction, including in particular the ability to complete the acquisition in the second quarter of 2010.
 
The transaction may be more expensive to complete and the anticipated benefits, including anticipated cost savings and strategic gains, may be significantly harder or take longer to achieve than expected or may not be achieved in their entirety as a result of unexpected factors or events.
 
Chemical’s ability to achieve anticipated results from the transaction is dependent on the state of the economic and financial markets going forward, which have been under significant stress recently. Specifically, Chemical may incur more credit losses from OAK’s loan portfolio than expected and deposit attrition may be greater than expected.
 
The integration of OAK’s business and operations into Chemical, which will include conversion of OAK’s operating systems and procedures, may take longer than anticipated or be more costly than anticipated or have unanticipated adverse results relating to OAK’s or Chemical’s existing businesses.
 
Additional Information About the Chemical/OAK Transaction
 
Chemical has filed a registration statement with the Securities and Exchange Commission (SEC) to register the securities that the OAK shareholders will receive if the merger is consummated. The registration statement contains a prospectus and proxy statement and other relevant documents concerning the merger. Investors are urged to read the registration statement, the prospectus and proxy statement, and any other relevant documents because they contain important information about Chemical, OAK, and the merger. Investors may obtain the documents free of charge at the SEC’s website, www.sec.gov.


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The proposed transaction will be submitted to the shareholders of OAK for their consideration and approval. In connection with the proposed transaction, OAK has filed a proxy statement and other relevant documents to be distributed to the shareholders of OAK. Investors are urged to read the proxy statement regarding the proposed transaction and any other relevant documents filed with the SEC, as well as any amendments or supplements to those documents, because they contain important information. Investors may obtain a free copy of the proxy statement, as well as other filings containing information about Chemical and OAK, 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. INVESTORS SHOULD READ THE PROXY STATEMENT AND OTHER DOCUMENTS FILED WITH THE SEC CAREFULLY BEFORE MAKING A DECISION CONCERNING THE TRANSACTION.
 
OAK and its directors, executive officers, and certain other members of management and employees may be soliciting proxies from OAK shareholders in favor of the transaction. Information regarding the persons who may, under the rules of the SEC, be considered participants in the solicitation of OAK shareholders in connection with the proposed transaction is set forth in the proxy statement filed with the SEC. You can find information about OAK’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 OAK, as appropriate, using the contact information above.


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SELECTED FINANCIAL DATA
 
 
                                             
    Years Ended December 31,      
    2009     2008     2007     2006     2005      
 
    (Dollar amounts in thousands, except per share data)      
Earnings Summary
                                           
Net interest income
  $ 147,444     $ 145,253     $ 130,089     $ 132,236     $ 141,851      
Provision for loan losses
    59,000       49,200       11,500       5,200       4,285      
Noninterest income
    41,119       41,197       43,288       40,147       39,220      
Operating expenses
    117,610       109,108       104,671       97,874       98,463      
Net income
    10,003       19,842       39,009       46,844       52,878      
 
 
Per Common Share Data
                                           
Net income:
                                           
Basic
  $ 0.42     $ 0.83     $ 1.60     $ 1.88     $ 2.10      
Diluted
    0.42       0.83       1.60       1.88       2.10      
Cash dividends paid
    1.18       1.18       1.14       1.10       1.06      
Book value at end of period
    19.85       20.58       21.35       20.46       19.98      
Market value at end of period
    23.58       27.88       23.79       33.30       31.76      
 
 
Common shares outstanding at end of period
(In thousands)
    23,891       23,881       23,815       24,828       25,079      
 
 
Year End Balances
                                           
Total assets
  $ 4,250,712     $ 3,874,313     $ 3,754,313     $ 3,789,247     $ 3,749,316      
Total loans
    2,993,160       2,981,677       2,799,434       2,807,660       2,706,695      
Total deposits
    3,418,125       2,978,792       2,875,589       2,898,085       2,819,880      
Federal Home Loan Bank advances/other borrowings
    330,568       368,763       347,412       354,041       400,363      
Total shareholders’ equity
    474,311       491,544       508,464       507,886       501,065      
 
 
Average Balances
                                           
Total assets
  $ 4,066,229     $ 3,784,617     $ 3,785,034     $ 3,763,067     $ 3,788,469      
Total earning assets
    3,847,006       3,550,611       3,551,867       3,521,489       3,550,695      
Total loans
    2,980,126       2,873,151       2,805,880       2,767,114       2,641,465      
Total interest-bearing liabilities
    3,002,050       2,711,413       2,718,814       2,692,410       2,718,267      
Total deposits
    3,195,411       2,924,361       2,923,004       2,861,916       2,886,209      
Federal Home Loan Bank advances/other borrowings
    348,235       325,177       327,831       362,990       377,499      
Total shareholders’ equity
    483,034       509,100       505,915       510,255       493,419      
 
 
Financial Ratios
                                           
Net interest margin
    3.91 %     4.16 %     3.73 %     3.82 %     4.04 %    
Return on average assets
    0.25       0.52       1.03       1.24       1.40      
Return on average shareholders’ equity
    2.1       3.9       7.7       9.2       10.7      
Efficiency ratio
    61.4       57.8       59.6       56.1       54.2      
Average shareholders’ equity as a percentage of average assets
    11.9       13.5       13.4       13.6       13.0      
Tangible shareholders’ equity as a percentage of total assets
    9.6       11.0       11.7       11.6       11.7      
Dividend payout ratio
    281.0       142.2       71.2       58.5       50.5      
Tier 1 risk-based capital ratio
    14.2       15.1       16.1       16.2       16.5      
Total risk-based capital ratio
    15.5       16.4       17.3       17.5       17.8      
 
 
Credit Quality
                                           
Allowance for loan losses
  $ 80,841     $ 57,056     $ 39,422     $ 34,098     $ 34,148      
Total nonperforming loans
    135,755       93,328       63,360       26,910       19,697      
Total nonperforming assets
    153,295       113,251       74,492       35,762       26,498      
Net loan charge-offs
    35,215       31,566       6,176       5,650       4,303      
Allowance for loan losses as a percentage of total period-end loans
    2.70 %     1.91 %     1.41 %     1.21 %     1.26 %    
Allowance for loan losses as a percentage of nonperforming loans
    60       61       62       127       173      
Nonperforming loans as a percentage of total loans
    4.54       3.13       2.26       0.96       0.73      
Nonperforming assets as a percentage of total assets
    3.61       2.92       1.98       0.94       0.71      
Net loan charge-offs as a percentage of average total loans
    1.18       1.10       0.22       0.20       0.16      


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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
BUSINESS OF THE CORPORATION
 
Chemical Financial Corporation (Corporation) is a financial holding company with its business concentrated in a single industry segment — commercial banking. The Corporation, through its subsidiary bank, offers a full range of commercial banking services. These banking services include business and personal checking accounts, savings and individual retirement accounts, time deposit instruments, electronically accessed banking products, residential and commercial real estate financing, commercial lending, consumer financing, debit cards, safe deposit box services, money transfer services, automated teller machines, access to insurance products and corporate and personal trust and investment management services.
 
The principal markets for the Corporation’s commercial banking services are communities within Michigan in which the branches of the Corporation’s subsidiary bank are located and the areas immediately surrounding those communities. As of December 31, 2009, the Corporation operated through one subsidiary bank, Chemical Bank, headquartered in Midland, Michigan, serving 90 communities through 129 banking offices located in 31 counties across Michigan’s lower peninsula. In addition to its banking offices, the Corporation operated three loan production offices and 140 automated teller machines, both on- and off-bank premises. Chemical Bank operates through an internal organizational structure of four regional banking units. Chemical Bank’s regional banking units are collections of branch banking offices organized by geographical regions within the State of Michigan.
 
The principal source of revenue for the Corporation is interest and fees on loans, which accounted for 74% of total revenue in 2009, 72% of total revenue in 2008 and 71% of total revenue in 2007. Interest on investment securities is also a significant source of revenue, accounting for 8% of total revenue in 2009 and 10% of total revenue in both 2008 and 2007. Business volumes are influenced by overall economic factors including market interest rates, business and consumer spending, consumer confidence and competitive conditions in the marketplace.
 
RECENT MARKET DEVELOPMENTS
 
At December 31, 2009, the Corporation held $16.2 million of Federal Home Loan Bank of Indianapolis (FHLB) stock. The Corporation carries FHLB stock at cost, or par value, and evaluates FHLB stock for impairment based on the ultimate recoverability of par value rather than by recognizing temporary declines in value. As part of the impairment assessment of FHLB stock, management considers, among other things, (i) the significance and length of time of any declines in net assets of the FHLB compared to its capital stock, (ii) commitments by the FHLB to make payments required by law or regulations and the level of such payments in relation to its operating performance, (iii) the impact of legislative and regulatory changes on financial institutions and, accordingly, the customer base of the FHLB and (iv) the liquidity position of the FHLB. The Corporation received $0.5 million of cash dividend payments on its FHLB stock during 2009, down from $0.8 million received during 2008. The FHLB has historically paid a quarterly dividend in the month following the end of a quarter. During 2009, the Corporation received four quarterly dividend payments, three of which were delayed by one month compared to when such payments had been historically made. The FHLB was profitable through the first three quarters of 2009, with net income of $96.4 million, despite recognizing $44.9 million of other-than-temporary impairment losses on the credit-loss portion of its private-label mortgage-backed securities portfolio. At September 30, 2009, the FHLB was considered well-capitalized in accordance with regulatory requirements and its capital was 4.1% of total assets, compared to 3.7% at December 31, 2008. Standard & Poor’s gave the FHLB a rating of AAA on December 9, 2009. Given all of the factors available, it was the Corporation’s assessment that the overall financial condition of the FHLB did not indicate an impairment of its FHLB stock at December 31, 2009.
 
In December 2008, the Federal Deposit Insurance Corporation (FDIC) finalized a rule that raised the then current deposit assessment rates uniformly by 7 basis points for the first quarter of 2009 assessment. The new rule resulted in annualized assessment rates for Risk Category 1 institutions ranging from 12 to 14 basis points. Chemical Bank was by definition a Risk Category 1 institution during all of 2009. In February 2009, the FDIC issued final rules to amend the Deposit Insurance Fund (DIF) restoration plan, change the risk-based assessment system and set increased assessment rates for Risk Category 1 institutions beginning in the second quarter of 2009. Effective April 1, 2009, for Risk Category 1 institutions, the methodology for establishing assessment rates for large institutions, such as Chemical Bank, was established to determine the initial base assessment rate by using a weighted combination of weighted-average regulatory examination component ratings, long-term debt issuer ratings (converted to numbers and averaged) and certain financial ratios. The new initial base assessment rates for Risk Category 1 institutions range from 12 to 16 basis points, on an annualized basis, and from 7 to 24 basis points after the effect of potential base-rate adjustments. Chemical Bank’s quarterly FDIC assessments in 2009 totaled $5.2 million, compared to $0.9 million in 2008.
 
In May 2009, the FDIC issued a final rule which levied a special assessment applicable to all FDIC insured depository institutions totaling 5 basis points of each institution’s total assets less Tier 1 capital as of June 30, 2009, not to exceed 10 basis points of domestic


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deposits. The special assessment was part of the FDIC’s efforts to restore the DIF reserves. The Corporation recognized $1.8 million of additional deposit insurance expense in the second quarter of 2009 related to the special assessment. In November 2009, the FDIC issued a final rule that required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. In conjunction with the adoption of the prepaid assessment, the FDIC also adopted a uniform 3 basis point increase in assessment rates effective on January 1, 2011. The prepayment calculation is based on an institution’s assessment rate in effect on September 30, 2009 and assumes a 5% annual growth rate in the assessment base. On December 30, 2009, the Corporation prepaid $19.7 million in risk-based assessments.
 
In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was signed into law. The EESA created the Troubled Asset Relief Program (TARP), under which the United States Department of the Treasury (Treasury) was given the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. EESA also temporarily increased the amount of deposit insurance coverage available on customer deposit accounts from $100,000 per depositor to $250,000 per depositor until December 31, 2009. In May 2009, the Helping Families Save Their Homes Act was signed into law, which extended the temporary deposit insurance increase of $250,000 per depositor through December 31, 2013.
 
In October 2008, the Treasury announced that it would purchase equity stakes in a wide variety of banks and thrifts. Under the program, known as the Capital Purchase Program (CPP), the Treasury made $250 billion of the $700 billion authorized under TARP available to U.S. financial institutions through the purchase of preferred stock. In conjunction with the purchase of preferred stock, the Treasury received, from participating financial institutions, warrants to purchase common stock with an aggregate market price equal to 15% of the preferred stock investment. Participating financial institutions were required to agree to restrictions on future dividends and share repurchases during the period in which the preferred stock remained outstanding. On December 18, 2008, the Corporation announced that it had elected not to accept the $84 million capital investment approved by the Treasury as part of the CPP. The board of directors and management of the Corporation determined that the potential dilution to the Corporation’s shareholders and various restrictions outweighed any potential benefits from the Corporation’s participation in the CPP.
 
In November 2008, the FDIC adopted a final rule relating to the Temporary Liquidity Guarantee Program (TLGP). The TLGP, an initiative to counter the system-wide crisis in the nation’s financial sector, was amended by the FDIC in August 2009 to extend maturity dates originally adopted under the November 2008 final rule. Under the TLGP, the FDIC will (i) guarantee, through the earlier of maturity or December 31, 2012, certain newly-issued senior unsecured debt issued by participating institutions on or after October 14, 2008 and through October 31, 2009 and (ii) provide full FDIC deposit insurance coverage for covered accounts, which are defined as noninterest-bearing transaction deposit accounts, Negotiable Order of Withdrawal (NOW) accounts paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts (IOLTA) held at participating FDIC-insured institutions through June 30, 2010. The fee assessment for coverage of senior unsecured debt ranges from 50 basis points to 100 basis points per annum, depending on the initial maturity of the debt. The fee assessment for deposit insurance coverage is an annualized 10 basis points assessed quarterly on amounts in covered accounts exceeding $250,000. The Corporation has elected to participate in both guarantee programs. In October 2009, the FDIC also established a limited, six-month emergency guarantee facility upon expiration of the debt guarantee program, under which certain eligible participating entities can issue FDIC-guaranteed debt starting October 31, 2009 through April 30, 2010. The fee for issuing debt under the emergency facility will be at least 300 basis points per annum. At December 31, 2009, the Corporation had not issued and does not expect to issue any FDIC-guaranteed debt under the TLGP. The Corporation’s additional FDIC fee assessment in 2009 related to the full deposit coverage for NOW accounts paying less than 0.5% interest per annum and IOLTA was $0.1 million.
 
CRITICAL ACCOUNTING POLICIES
 
The Corporation’s consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (GAAP) and follow general practices within the industry in which the Corporation operates. Application of these principles requires management to make estimates, assumptions and complex judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the consolidated financial statements could reflect different estimates, assumptions and judgments. Actual results could differ significantly from those estimates. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value or when a decline in the value of an asset not carried at fair value on the financial statements warrants an impairment write-down or a valuation reserve to be established. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third-party sources, when


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available. When third-party information is not available, valuation adjustments are estimated by management primarily through the use of internal discounted cash flow analysis.
 
The most significant accounting policies followed by the Corporation are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the other notes to the consolidated financial statements and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, estimates and assumptions underlying those amounts, management has identified the determination of the allowance for loan losses, pension plan accounting, income and other taxes, the evaluation of goodwill impairment and fair value measurements to be the accounting areas that require the most subjective or complex judgments, and as such, could be most subject to revision as new or additional information becomes available or circumstances change, including overall changes in the economic climate and/or market interest rates. Management reviews its critical accounting policies with the Audit Committee of the board of directors at least annually.
 
Allowance for Loan Losses
 
The allowance for loan losses (allowance) is calculated with the objective of maintaining a reserve sufficient to absorb inherent loan losses in the loan portfolio. The loan portfolio represents the largest asset type on the consolidated statements of financial position. The determination of the amount of the allowance is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected cash flows on impaired loans, estimated losses on commercial, real estate commercial and real estate construction-commercial loans and on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The principal assumption used in deriving the allowance is the estimate of a loss percentage for each type of loan. In determining the allowance and the related provision for loan losses, the Corporation considers four principal elements: (i) specific impairment reserve allocations (valuation allowances) based upon probable losses identified during the review of impaired commercial, real estate commercial and real estate construction-commercial loan portfolios, (ii) allocations established for adversely-rated commercial, real estate commercial and real estate construction-commercial loans and nonaccrual real estate residential and nonaccrual consumer loans, (iii) allocations on all other loans based principally on the most recent three years of historical loan loss experience and loan loss trends, and (iv) an unallocated allowance based on the imprecision in the overall allowance methodology. It is extremely difficult to accurately measure the amount of losses that are inherent in the Corporation’s loan portfolio. The Corporation uses a defined methodology to quantify the necessary allowance and related provision for loan losses, but there can be no assurance that the methodology will successfully identify and estimate all of the losses that are inherent in the loan portfolio. As a result, the Corporation could record future provisions for loan losses that may be significantly different than the levels that have been recorded in the three-year period ended December 31, 2009. Note 1 to the consolidated financial statements further describes the methodology used to determine the allowance. In addition, a discussion of the factors driving changes in the amount of the allowance is included under the subheading “Provision and Allowance for Loan Losses” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
 
The Corporation has a loan review function, which is independent of the loan origination function, which reviews management’s evaluation of the allowance at least annually. The Corporation’s loan review function performs a detailed credit quality review at least annually on commercial, real estate commercial and real estate construction-commercial loans, particularly focusing on larger balance loans and loans that have deteriorated below certain levels of credit risk.
 
Pension Plan Accounting
 
The Corporation has a defined benefit pension plan for certain salaried employees. Effective June 30, 2006, benefits under the defined benefit pension plan were frozen for approximately two-thirds of the Corporation’s salaried employees as of that date. Pension benefits continued unchanged for the remaining salaried employees. The Corporation’s pension benefit obligations and related costs are calculated using actuarial concepts and measurements. Benefits under the plan are based on years of vested service, age and amount of compensation. Assumptions are made concerning future events that will determine the amount and timing of required benefit payments, funding requirements and pension expense.
 
The key actuarial assumptions used in the pension plan are the discount rate and long-term rate of return on plan assets. These assumptions have a significant effect on the amounts reported for net periodic pension expense, as well as the respective benefit obligation amounts. The Corporation evaluates these critical assumptions annually.
 
At December 31, 2009, 2008 and 2007, the Corporation calculated the discount rate for the pension plan using the results from a bond matching technique, which matched cash flows of the pension plan against both a bond portfolio derived from the Standard & Poor’s bond database of AA or better bonds and the Citigroup Pension Discount Curve, to determine the discount rate. As of


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December 31, 2009, 2008 and 2007, the discount rate was established at 6.15%, 6.50% and 6.50%, respectively, to reflect market interest rate conditions.
 
The assumed long-term rate of return on pension plan assets represents an estimate of long-term returns on an investment portfolio consisting primarily of equity and fixed income investments. When determining the expected long-term return on pension plan assets, the Corporation considers long-term rates of return on the asset classes in which the Corporation expects the pension funds to be invested. The expected long-term rate of return is based on both historical and forecasted returns of the overall stock and bond markets and the actual portfolio. The following rates of return by asset class were considered in setting the assumptions for long-term return on pension plan assets:
 
                         
    December 31, 2009     December 31, 2008     December 31, 2007  
   
 
Equity securities
    7% – 9%       7% – 8%       8% – 9%  
Debt securities
    4% – 6%       4% – 6%       4% – 6%  
Other
    2% – 5%       2% – 5%       3% – 5%  
 
The assumed long-term return on pension plan assets is developed through an analysis of forecasted rates of return by asset class and forecasted asset allocations. It is used to compute the subsequent year’s expected return on assets, using the “market-related value” of pension plan assets. The difference between the expected return and the actual return on pension plan assets during the year is either an asset gain or loss, which is deferred and amortized over future periods when determining net periodic pension expense. The Corporation’s projection of the long-term return on pension plan assets was 7% in 2009, 2008 and 2007.
 
Other assumptions made in the pension plan calculations involve employee demographic factors such as retirement patterns, mortality, turnover and the rate of compensation increase.
 
The key actuarial assumptions that will be used to calculate pension expense in 2010 for the defined benefit pension plan are a discount rate of 6.15%, a long-term rate of return on pension plan assets of 7% and a rate of compensation increase of 3.50%. Pension expense in 2010 is expected to be approximately $0.8 million, an increase of approximately $0.1 million from 2009. In 2010, a decrease in the discount rate of 50 basis points was estimated to increase pension expense by $0.4 million, while an increase of 50 basis points was estimated to decrease pension expense by the same amount.
 
There are uncertainties associated with the underlying key actuarial assumptions, and the potential exists for significant, and possibly material, impacts on either or both the results of operations and cash flows (e.g., additional pension expense and/or additional pension plan funding, whether expected or required) from changes in the key actuarial assumptions. If the Corporation were to determine that more conservative assumptions are necessary, pension expense would increase and have a negative impact on results of operations in the period in which the increase occurs.
 
The Corporation accounts for its defined benefit pension and other postretirement plans in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 715, Compensation-Retirement Benefits, which requires companies to recognize the over- or under-funded status of a plan as an asset or liability as measured by the difference between the fair value of the plan assets and the projected benefit obligation and requires any unrecognized prior service costs and actuarial gains and losses to be recognized as a component of accumulated other comprehensive income (loss). The impact of pension plan accounting on the statements of financial position at December 31, 2009 and 2008 is included in Note 15 to the consolidated financial statements.
 
Income and Other Taxes
 
The Corporation is subject to the income and other tax laws of the United States and the State of Michigan. These laws are complex and are subject to different interpretations by the taxpayer and the various taxing authorities. In determining the provisions for income and other taxes, management must make judgments and estimates about the application of these inherently complex laws, related regulations and case law. In the process of preparing the Corporation’s tax returns, management attempts to make reasonable interpretations of applicable tax laws. These interpretations are subject to challenge by the taxing authorities upon audit or to reinterpretation based on management’s ongoing assessment of facts and evolving case law.
 
The Corporation and its subsidiaries file a consolidated federal income tax return. The provision for federal income taxes is based on income and expenses, as reported in the consolidated financial statements, rather than amounts reported on the Corporation’s federal income tax return. When income and expenses are recognized in different periods for tax purposes than for book purposes, applicable deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to


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be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.
 
On a quarterly basis, management assesses the reasonableness of its effective federal tax rate based upon its current best estimate of net income and the applicable taxes expected for the full year. Deferred tax assets and liabilities are reassessed on an annual basis, or more frequently, if warranted by business events or circumstances. Reserves for uncertain tax positions are reviewed quarterly for adequacy based upon developments in tax law and the status of examinations or audits. As of December 31, 2009 and 2008, there were no federal income tax reserves recorded for uncertain tax positions.
 
Goodwill
 
At December 31, 2009, the Corporation had $69.9 million of goodwill, that was originated through the acquisition of various banks and bank branches, recorded on the consolidated statement of financial position. In accordance with FASB ASC Topic 350-20, Goodwill, goodwill is not amortized, but rather is tested by management annually for impairment, or more frequently if triggering events occur and indicate potential impairment. The Corporation’s goodwill impairment assessment is reviewed annually, as of September 30, by an independent third-party appraisal firm utilizing the methodology and guidelines established in GAAP, including assumptions regarding the valuation of Chemical Bank.
 
The value of Chemical Bank was measured utilizing the income and market approaches as prescribed in FASB ASC Topic 820, Fair Value Measurements and Disclosures (ASC 820). GAAP identifies the cost approach as another acceptable method; however, the cost approach was not deemed an effective method to value a financial institution. The cost approach estimates value by adjusting the reported values of assets and liabilities to their market values. It is the Corporation’s opinion that financial institutions cannot be liquidated in an efficient manner. Estimating the fair market value of loans is a very difficult process and subject to a wide margin of error unless done on a loan by loan basis. Voluntary liquidations of financial institutions are not typical. More commonly, if a financial institution is liquidated, it is due to being taken over by the FDIC. The value of Chemical Bank was based as a going concern and not as a liquidation.
 
The income approach uses valuation techniques to convert future amounts (cash flows or earnings) to a single, discounted amount. The income approach includes present value techniques, option-pricing models, such as the Black-Scholes formula and lattice models, and the multi-period excess-earnings method. In the valuation of Chemical Bank, the income approach utilized the discounted cash flow method based upon a forecast of growth and earnings. Cash flows are measured by using projected earnings, projected dividends and dividend paying capacity over a five-year period. In addition to estimating periodic cash flows, an estimate of residual value is determined through the capitalization of earnings. The income approach assumed cost savings and earnings enhancements that a strategic acquiror would likely implement based upon typical market participant assumptions of market transactions. The discount rate is critical to the discounted cash flow analysis. The discount rate reflects the risk of uncertainty associated with the cash flows and a rate of return that investors would require from similar investments with similar risks. A discount rate of 14% was utilized in the income approach.
 
The market approach uses observable prices and other relevant information that are generated by market transactions involving identical or comparable assets or liabilities. The fair value measure is based on the value that those transactions indicate utilizing both financial and operating characteristics of the acquired companies. Two of the more significant financial ratios analyzed in completed transactions included price to latest twelve months earnings and price to tangible book value. The market approach utilized a price to latest twelve months earnings ratio of 22 times and a price to tangible book value of 135%.
 
The fair value of Chemical Bank was determined to be slightly above the income approach and in the low to middle of the market approach to value range. The results of the valuation analysis concluded that the fair value of Chemical Bank was greater than its book value, including goodwill, and thus no goodwill impairment was evident at the valuation date of September 30, 2009. The weighted average of the fair values determined under the income and market approaches was a discount compared to the market capitalization of the Corporation at the valuation date. The Corporation is publicly traded and, therefore, The Nasdaq Stock Market® establishes the marketable minority value. Given the volatility of the financial markets, particularly in the equity markets in 2009, it is management’s opinion that the marketable minority value does not always represent the fair value of the reporting unit as a whole and that an adjustment to the marketable minority value for the acquiror’s control is generally considered in the assessment of fair value. The Corporation determined that no triggering events occurred that indicated potential impairment of goodwill from the valuation date through December 31, 2009. The Corporation believes that the assumptions utilized were reasonable. However, the Corporation could incur impairment charges related to goodwill in the future due to changes in financial results or other matters that could affect the valuation assumptions.


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Fair Value Measurements
 
The Corporation determines the fair value of its assets and liabilities in accordance with ASC 820. ASC 820 establishes a standard framework for measuring and disclosing fair value under GAAP. A number of valuation techniques are used to determine the fair value of assets and liabilities in the Corporation’s financial statements. The valuation techniques include quoted market prices for investment securities, appraisals of real estate from independent licensed appraisers and other valuation techniques. Fair value measurements for assets and liabilities where limited or no observable market data exists are based primarily upon estimates, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the valuation results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. Significant changes in the aggregate fair value of assets and liabilities required to be measured at fair value or for impairment are recognized in the income statement under the framework established by GAAP. See Note 12 to the Corporation’s consolidated financial statements for more information on fair value measurements.
 
PENDING ACCOUNTING PRONOUNCEMENTS
 
Transfers of Financial Assets:  In June 2009, the FASB issued guidance amending the accounting for transfers of financial assets. The new guidance amends existing guidance by eliminating the concept of a qualifying special-purpose entity (QSPE), creating more stringent conditions for reporting a transfer of a portion of a financial asset as a sale, clarifying other sale-accounting criteria and changing the initial measurement of a transferor’s interest in transferred financial assets. The amended guidance is effective as of the beginning of a company’s first fiscal year that begins after November 15, 2009 and for subsequent interim and annual periods. The adoption of the amended guidance as of January 1, 2010 did not have a material impact on the Corporation’s consolidated financial condition or results of operations.
 
Variable Interest Entities (VIEs):  In June 2009, the FASB issued guidance amending the accounting for consolidation of VIEs. This new guidance amends existing guidance by eliminating exceptions for consolidating QSPEs, adding new criteria for determining the primary beneficiary and increasing the frequency of required reassessments to determine whether a company is the primary beneficiary of a VIE. The amended guidance also contains a new requirement that any term, transaction or arrangement that does not have a substantive effect on an entity’s status as a VIE, a company’s power over a VIE or a company’s obligation to absorb losses or rights to receive benefits of an entity must be disregarded when evaluating consolidation of a VIE. The amended guidance is effective as of the beginning of a company’s first fiscal year that begins after November 15, 2009 and for subsequent interim and annual periods. The adoption of the amended guidance as of January 1, 2010 did not have a material impact on the Corporation’s consolidated financial condition or results of operations.
 
PENDING ACQUISITION
 
The Corporation’s primary method of expansion into new banking markets has been through acquisitions of other financial institutions and bank branches.
 
On January 7, 2010, the Corporation and O.A.K. Financial Corporation (OAK), the parent company of Byron Bank, a community bank based in Byron Center, Michigan, entered into a definitive agreement whereby OAK will merge with and into the Corporation. Under the terms of the agreement, OAK shareholders will be entitled to receive 1.306 shares of the Corporation’s common stock for each share of OAK common stock outstanding, or approximately 3.5 million shares, subject to adjustment in certain limited circumstances. The merger is designed to be a tax free exchange. Cash will be paid in lieu of fractional shares. Closing of the merger, which is expected to occur in the second quarter of 2010, is subject to certain conditions, including approval by the shareholders of OAK and regulatory approval.
 
FINANCIAL HIGHLIGHTS
 
The following discussion and analysis is intended to cover the significant factors affecting the Corporation’s consolidated statements of financial position and income included in this report. It is designed to provide shareholders with a more comprehensive review of the consolidated operating results and financial position of the Corporation than could be obtained from an examination of the financial statements alone.


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NET INCOME
 
Net income in 2009 was $10.0 million, or $0.42 per diluted share, net income in 2008 was $19.8 million, or $0.83 per diluted share, and net income in 2007 was $39.0 million, or $1.60 per diluted share. Net income in 2009 represented a 49.6% decrease from 2008 net income, while 2008 net income represented a 49.1% decrease from 2007 net income. Net income per share in 2009 was 49.4% less than in 2008, while net income per share in 2008 was 48.1% less than in 2007. The decrease in net income in 2009 was primarily attributable to increases in the provision for loan losses and operating expenses. The decrease in net income in 2008 was primarily attributable to a significant increase in the provision for loan losses that was only partially offset by an increase in net interest income.
 
The Corporation’s return on average assets was 0.25% in 2009, 0.52% in 2008 and 1.03% in 2007. The Corporation’s return on average shareholders’ equity was 2.1% in 2009, 3.9% in 2008 and 7.7% in 2007.
 
ASSETS
 
Average assets were $4.07 billion during 2009, an increase of $281.6 million, or 7.4%, from average assets during 2008 of $3.78 billion. Average assets were $3.78 billion during 2008, a decrease of less than $1 million from average assets during 2007 of $3.79 billion. The increase in average assets during 2009 was primarily attributable to increases in interest-bearing deposits with unaffiliated banks and others, investment securities and loans that were funded by increased deposits generated in the Corporation’s markets.
 
INVESTMENT SECURITIES
 
Information about the Corporation’s investment securities portfolio is summarized in Tables 1 and 2. The following table summarizes the maturities and yields of the carrying value of investment securities by investment category and fair value by investment category, at December 31, 2009:
 
TABLE 1. MATURITIES AND YIELDS* OF INVESTMENT SECURITIES AT DECEMBER 31, 2009
 
                                                                                         
    Maturity**                    
                After One
    After Five
                Total
       
    Within
    but Within
    but Within
    After
    Carrying
    Total
 
    One Year     Five Years     Ten Years     Ten Years     Value     Fair
 
    Amount     Yield     Amount     Yield     Amount     Yield     Amount     Yield     Amount     Yield     Value  
   
    (Dollars in thousands)  
 
Available-for-Sale:
                                                                                       
Government sponsored agencies
  $ 109,472       1.87 %   $ 74,067       1.15 %   $ 6,391       0.84 %   $ 2,055       0.88 %   $ 191,985       1.55 %   $ 191,985  
State and political subdivisions
    1,198       7.38       1,450       7.65       914       5.97                   3,562       7.13       3,562  
Mortgage-backed securities
    56,347       3.77       64,195       3.71       12,483       4.87       21,180       5.04       154,205       4.00       154,205  
Collateralized mortgage obligations
    67,325       1.05       125,290       1.04       21,315       2.16       9,828       3.59       223,758       1.26       223,758  
Corporate bonds
    2,141       4.68       16,870       1.71                               19,011       2.05       19,011  
 
 
Total Investment Securities Available-for-Sale
    236,483       2.14       281,872       1.75       41,103       2.86       33,063       4.35       592,521       2.13       592,521  
 
 
Held-to-Maturity:
                                                                                       
State and political subdivisions
    10,940       4.62       49,659       4.23       32,517       6.27       27,331       4.99       120,447       4.99       121,722  
Mortgage-backed securities
    118       7.43       157       7.67       68       7.77       7       7.13       350       7.60       383  
Trust preferred securities
                                        10,500       4.82       10,500       4.82       3,625  
 
 
Total Investment Securities Held-to-Maturity
    11,058       4.65       49,816       4.24       32,585       6.27       37,838       4.94       131,297       4.98       125,730  
 
 
Total Investment Securities
  $ 247,541       2.25 %   $ 331,688       2.13 %   $ 73,688       4.37 %   $ 70,901       4.66 %   $ 723,818       2.65 %   $ 718,251  
 
 
 
Yields are weighted by amount and time to contractual maturity, are on a taxable equivalent basis using a 35% federal income tax rate and are based on carrying value.
**  Mortgage-backed securities and collateralized mortgage obligations are based on scheduled principal maturity. All other investment securities are based on final contractual maturity.


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The following table summarizes the carrying value of investment securities at December 31, 2009, 2008 and 2007:
 
TABLE 2. SUMMARY OF INVESTMENT SECURITIES
                         
    December 31,  
    2009     2008     2007  
   
    (In thousands)  
Available-for-Sale:
                       
U.S. Treasury
  $     $ 21,494     $ 31,450  
Government sponsored agencies
    191,985       172,234       193,958  
State and political subdivisions
    3,562       4,552       6,514  
Mortgage-backed securities
    154,205       169,214       215,720  
Collateralized mortgage obligations
    223,758       37,285       575  
Corporate bonds
    19,011       45,168       54,552  
Equity securities
                502  
 
 
Total Investment Securities Available-for-Sale
    592,521       449,947       503,271  
 
 
Held-to-Maturity:
                       
Government sponsored agencies
          1,007       18,718  
State and political subdivisions
    120,447       85,495       71,899  
Mortgage-backed securities
    350       509       626  
Trust preferred securities
    10,500       10,500        
 
 
Total Investment Securities Held-to-Maturity
    131,297       97,511       91,243  
 
 
Total Investment Securities
  $ 723,818     $ 547,458     $ 594,514  
 
 
 
The carrying value of investment securities at December 31, 2009 totaled $723.8 million, an increase of $176.4 million, or 32.2%, from December 31, 2008. The increase in investment securities was funded by increased customer deposits. The increased funds were partially invested in collateralized mortgage obligations (CMOs), that were primarily variable rate instruments with average maturities of less than three years. CMO investment securities totaled $223.8 million, or 30.9%, of investment securities at December 31, 2009, compared to $37.3 million, or 6.8%, of investment securities at December 31, 2008. Additionally, during 2009, the Corporation changed the mix of its investment securities portfolio as it re-invested a portion of funds from maturing U.S. Treasury, mortgage-backed securities and corporate bonds into state and political subdivisions investment securities, as opportunities in local municipal markets increased due to a reduction in demand nationally for local municipal securities. State and political subdivisions investment securities, which consist primarily of issuers located in the State of Michigan and are general obligations of the issuers, totaled $124.0 million, or 17.1%, of investment securities at December 31, 2009, compared to $90.0 million, or 16.4%, of investment securities at December 31, 2008.
 
The Corporation records all investment securities in accordance with FASB ASC Topic 320, Investments — Debt and Equity Securities (ASC 320), under which the Corporation is required to assess equity and debt securities that have fair values below their amortized cost basis to determine whether the decline (impairment) is other-than-temporary. Impairment is other-than-temporary if the assessment concludes that it is probable that the holder will be unable to collect all amounts due according to the contractual terms of the debt instrument or in instances where the debt instrument will mature or be disposed of before a full recovery of its amortized cost. An assessment is performed quarterly by the Corporation to determine whether unrealized losses in its investment securities portfolio are temporary or other-than-temporary by carefully considering all available information. The Corporation reviews factors such as financial statements, credit ratings, news releases and other pertinent information of the underlying issuer or company to make its determination.
 
Effective April 1, 2009, in accordance with FASB Staff Position FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (later codified in ASC 320), the Corporation began accounting for declines in the fair value of held-to-maturity and available-for-sale investment securities below their cost that are deemed to be other-than-temporary through earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income, net of income tax. Prior to April 1, 2009, all declines in fair value deemed to be other-than-temporary were reflected in earnings as realized losses. In estimating other-than-temporary impairment (OTTI) losses, management considers, among other things, (i) the length of time and the extent to which the fair value has been less than amortized cost, (ii) the financial condition and near-term prospects of the issuer, (iii) the intent of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery of amortized cost and (iv) whether it is more likely-than-not that the Corporation will be required to sell its investment prior to recovery.
 
The Corporation’s investment securities portfolio with a carrying value of $723.8 million at December 31, 2009, had gross impairment of $8.8 million as of that date. Management believed that the unrealized losses on investment securities were temporary


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in nature and due primarily to changes in interest rates, increased credit spreads and reduced market liquidity and not as a result of credit-related issues. Accordingly, at December 31, 2009, the Corporation believed the impairment in its investment securities portfolio was temporary in nature and, therefore, no impairment loss was realized in the Corporation’s consolidated statement of income for 2009. However, due to market and economic conditions, OTTI may occur as a result of material declines in the fair value of investment securities in the future. A further discussion of the assessment of potential impairment and the Corporation’s process that resulted in the conclusion that the impairment was temporary in nature follows.
 
At December 31, 2009, the Corporation’s investment securities portfolio included government sponsored agency securities with gross impairment of $0.16 million, state and political subdivisions securities with gross impairment of $0.68 million, mortgage-backed securities and collateralized mortgage obligations, combined, with gross impairment of $0.64 million, corporate bonds with gross impairment of $0.46 million and trust preferred securities with gross impairment of $6.88 million. The amortized costs and fair values of investment securities are disclosed in Note 2 to the consolidated financial statements.
 
The government sponsored agencies securities, included in the available-for-sale investment securities portfolio, had an amortized cost totaling $190.9 million with gross impairment of $0.16 million at December 31, 2009. This gross impairment was attributable to impaired government sponsored agency securities with an amortized cost of $47.8 million. All of the impaired investment securities are backed by the full faith and credit of the U.S. government. The Corporation determined that the impairment on these investment securities was attributable to the lack of liquidity for these investments and was temporary in nature at December 31, 2009. At December 31, 2009, the Corporation’s government sponsored agencies securities included $129.6 million of senior bonds that were issued by the twelve regional Federal Home Loan Banks that make up the Federal Home Loan Bank System (FHLBanks). There was no impairment in these FHLBanks investment securities at December 31, 2009. FHLBanks are government-sponsored enterprises created by Congress to ensure access to low-cost funding for their member financial institutions. FHLBanks overall experienced recent declines in profitability during the fourth quarter of 2008 and first quarter of 2009, primarily due to a number of the FHLBanks incurring significant OTTI losses on their portfolios of private-label mortgage-backed securities and home equity loans due to the dramatic decline in interest rates that occurred in 2008. However, the capital of FHLBanks has improved throughout 2009 and at September 30, 2009, the FHLBanks were considered well-capitalized in accordance with regulatory requirements. At December 31, 2009, the Corporation also held $16.2 million of FHLB stock, included in other securities on the consolidated statements of financial position, which was not impaired.
 
The state and political subdivisions securities, included in the held-to-maturity investment securities portfolio, had an amortized cost totaling $120.4 million with gross impairment of $0.68 million at December 31, 2009. The majority of these investment securities are from issuers primarily located in the State of Michigan and are general obligations of the issuer, meaning that the Corporation has the first claim on taxes collected for the repayment of the investment securities. The gross impairment of $0.68 million at December 31, 2009 was attributable to $33.6 million of investment securities, with two-thirds of these investment securities maturing beyond 2013. The Corporation determined that the impairment of $0.68 million at December 31, 2009 was attributable to the change in market interest rates due to the steepness of the interest yield curve at December 31, 2009 and the market’s perception of the Michigan economy. The Corporation determined that the impairment on these investment securities at December 31, 2009 was temporary in nature.
 
The mortgage-backed securities and collateralized mortgage obligations, included in the available-for-sale investment securities portfolio, had an amortized cost of $374.1 million, with gross impairment of $0.64 million at December 31, 2009. Mortgage-backed securities with an amortized cost of $27.0 million had gross impairment of $0.29 million and collateralized mortgage obligations with an amortized cost of $110.5 million had gross impairment of $0.35 million. Virtually all of the impaired investment securities in these two categories are backed by an explicit guarantee of the U.S. government and are AAA rated. The Corporation assessed the impairment on these investment securities and determined that the impairment was attributable to the general decline in market interest rates and volatile prepayment speeds and that the impairment on these investment securities at December 31, 2009 was temporary in nature.
 
At December 31, 2009, the Corporation’s corporate bond portfolio, included in the available-for-sale investment securities portfolio, had an amortized cost of $19.3 million, with gross impairment of $0.46 million. All of the corporate bonds held at December 31, 2009 were of an investment grade, except one single issue investment security, Lehman Brothers Holdings Inc. (Lehman), and two corporate bonds of American General Finance Corporation (AGFC), a wholly-owned subsidiary of American General Finance Inc. (AGFI), which is wholly-owned indirectly by American International Group (AIG). The investment grade ratings obtained for the balance of the corporate bond portfolio indicated that the obligors’ capacities to meet their financial commitments was “strong.” During the third quarter of 2008, the Corporation recognized an OTTI loss of $0.4 million related to the write-down of the Lehman bond to fair value as the impairment was deemed to be other-than-temporary and entirely credit related. The Corporation’s remaining amortized cost of the Lehman bond was less than $0.1 million at December 31, 2009. The gross impairment of $0.46 million existing at December 31, 2009 was attributable to two corporate bonds from AGFC with a combined amortized cost of $2.7 million at that date. The amortized cost amounts of the two bonds were $0.2 million and $2.5 million with maturity dates of


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September 1, 2010 and December 15, 2011, respectively. The Corporation performed an assessment of the probability that it would collect all of the contractual amounts due under the two AGFC corporate bonds at December 31, 2009. The impairment at December 31, 2009 on the AGFC corporate bonds of $0.46 million improved from $1.6 million of impairment at December 31, 2008. Ratings from Moody’s, Standard & Poor’s and Fitch were B2, BB+ and BB, respectively, at December 31, 2009. Management believes that the analyses used by these rating agencies does not include the likelihood of the parent company’s (AIG) ability and willingness to provide support to its subsidiary.
 
The public filing of AGFC’s Form 10-Q with the SEC for the period ended September 30, 2009 indicated AGFC had net income of $231 million for the three months ended September 30, 2009 compared to a net loss of $236 million during the nine months ended September 30, 2009. AGFC’s total equity at September 30, 2009 was $2.6 billion, or 10.5% of total assets. AGFC’s own assessment of its financial condition at September 30, 2009 indicated that, after consideration of many factors, although primarily due to its ability to obtain funding from its parent company and its ability to severely reduce originations of finance receivables, AGFC believed it would have adequate liquidity to finance and operate its businesses and repay its obligations for at least the next twelve months. However, it is possible that the actual outcome of one or more of AGFC’s significant judgments or estimates could prove to be materially incorrect and AGFC may not have sufficient cash to meet its obligations in the future. All 2009 quarterly and semi-annual interest payments on both AGFC corporate bonds owned by the Corporation were paid in full on the scheduled payment date. The Corporation determined that the impairment of the AGFC corporate bonds was attributable to a lack of liquidity for these investments and that the impairment was temporary in nature at December 31, 2009.
 
At December 31, 2009, the Corporation held two trust preferred securities (TRUPs) in the held-to-maturity investment securities portfolio with a combined amortized cost of $10.5 million that had gross impairment of $6.9 million. One TRUP, with an amortized cost of $10.0 million, represented a 100% interest in a TRUP of a small non-public bank holding company in Michigan (issuer) that was purchased in the second quarter of 2008. At December 31, 2009, the Corporation determined the fair value of this TRUP was $3.5 million. The second TRUP, with an amortized cost of $0.5 million, represented a 10% interest in the TRUP of another small non-public bank holding company in Michigan. At December 31, 2009, the Corporation determined the fair value of this TRUP was $0.1 million. The fair value measurements of the two TRUP investments were developed based upon market pricing observations of much larger banking institutions in an illiquid market adjusted by risk measurements. The fair values of the TRUPs were based on calculations of discounted cash flows, and further based upon both observable inputs and appropriate risk adjustments that market participants would make for performance, liquidity and issuer specifics. See the additional discussion of the development of the fair values of the TRUPs in Note 2 to the consolidated financial statements.
 
Management reviewed financial information of the issuers of the TRUPs at December 31, 2009. Based on this review, the Corporation concluded that the significant decline in fair values of the TRUPs, compared to their amortized cost, was not attributable to materially adverse conditions specifically related to the issuers. The issuer of the $10.0 million TRUP reported net income in 2007, 2008 and 2009. At December 31, 2009, the issuer was categorized as “well-capitalized” under applicable regulatory capital adequacy guidelines and had a liquidity position which included over $100 million in investment securities held as available-for-sale. Based on the Corporation’s analysis at December 31, 2009, it was the Corporation’s opinion that this issuer appeared to be a financially sound institution with sufficient liquidity to meet its financial obligations in 2010. This TRUP is not independently rated. Industry bank ratings for September 30, 2009, obtained from Bauer Financial at www.bauerfinancial.com (Bauer) for subsidiaries of this issuer were rated good and excellent. Common stock cash dividends were paid throughout 2008 and 2009 by the issuer and the Corporation understands that the issuer’s management anticipates cash dividends to continue to be paid in the future. All scheduled interest payments on this TRUP were made on a timely basis in 2009 and 2008. The principal of $10.0 million of this TRUP matures in 2038, with interest payments due quarterly.
 
The issuer of the $0.5 million TRUP reported a net loss in 2009 that was less than the net loss reported in 2008. At December 31, 2009, the issuer was categorized as “well-capitalized” under applicable regulatory capital adequacy guidelines and its subsidiary bank was rated adequate by Bauer based on September 30, 2009 financial data. All scheduled interest payments on this TRUP were made on a timely basis in 2009 and 2008. The principal of $0.5 million of this TRUP matures in 2033, with interest payments due quarterly.
 
Based on the information provided by the issuers of both TRUPs, as of December 31, 2009, it was the Corporation’s opinion that there had been no material adverse changes in the issuers’ financial performance since the TRUPs were issued and purchased by the Corporation and no indication that any material adverse trends were developing that would suggest that the issuers would be unable to make all future principal and interest payments under the TRUPs. Further, based on the information provided by the issuers, the issuers appeared to be financially viable financial institutions with both the credit quality and liquidity necessary to meet financial obligations in 2010. At December 31, 2009, the Corporation was not aware of any regulatory issues, memorandums of understanding or cease and desist orders that had been issued to the issuers or their subsidiaries. In reviewing all available information regarding the issuers, including past performance and their financial and liquidity position, it was the Corporation’s opinion that the future cash flows of the issuers supported the carrying value of the TRUPs at their original cost of $10.5 million at


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December 31, 2009. There can be no assurance that OTTI losses will not be recognized on the TRUPs or on any other investment security in the future. While the total fair value of the TRUPs was $6.9 million below the Corporation’s amortized cost at December 31, 2009, it was the Corporation’s assessment that, based on the overall financial condition of the issuers, the impairment was temporary in nature at December 31, 2009.
 
At December 31, 2009, the Corporation expected to fully recover the entire amortized cost basis of each impaired investment security in its investment securities portfolio at that date. Furthermore, at December 31, 2009, the Corporation did not have the intent to sell any of its impaired investment securities and believed that it was more likely than not that the Corporation would not have to sell any of its impaired investment securities before a full recovery of amortized cost.
 
The Corporation did not realize any investment securities impairment losses in 2009. In 2008, the Corporation recorded a $0.4 million loss related to the write-down of a specific investment debt security to fair value as the impairment was deemed to be other-than-temporary in nature and entirely credit related.
 
LOANS
 
Chemical Bank is a full-service commercial bank and, therefore, the acceptance and management of credit risk is an integral part of the Corporation’s business. At December 31, 2009, the Corporation’s loan portfolio was $2.99 billion and consisted of loans to commercial borrowers (commercial, real estate commercial and real estate construction-commercial) totaling $1.47 billion, or 49.1% of total loans, loans to borrowers for the purpose of acquiring residential real estate (real estate residential and real estate construction-residential) totaling $762 million, or 25.4% of total loans, and loans to consumer borrowers secured by various types of collateral totaling $763 million, or 25.5% of total loans. Loans at fixed interest rates comprised approximately 80% of the Corporation’s loan portfolio at December 31, 2009 and 2008.
 
The Corporation maintains loan policies and credit underwriting standards as part of the process of managing credit risk. Underwriting standards are designed to promote relationship banking rather than transactional banking. These standards include providing loans generally only within the Corporation’s market areas. The Corporation’s lending markets generally consist of communities across the middle to southern and western sections of the lower peninsula of Michigan. The Corporation’s lending market areas do not include the southeastern portion of Michigan. The Corporation has no foreign loans or any loans to finance highly leveraged transactions. The Corporation’s lending philosophy is implemented through strong administrative and reporting controls. The Corporation maintains a centralized independent loan review function, which monitors asset quality of the loan portfolio.
 
Table 3 includes the composition of the Corporation’s loan portfolio, by major loan category, as of December 31, 2009, 2008, 2007, 2006 and 2005.
 
TABLE 3. SUMMARY OF LOANS
                                             
    December 31,
    2009     2008     2007     2006     2005      
       
    (Dollars in thousands)
 
Distribution of Loans:
                                           
Commercial
  $ 584,286     $ 587,554     $ 515,319     $ 545,591     $ 517,852      
Real estate commercial
    785,675       786,404       760,399       726,554       704,684      
Real estate construction
    121,305       119,001       134,828       145,933       158,376      
Real estate residential
    739,380       839,555       838,545       835,263       785,160      
Consumer
    762,514       649,163       550,343       554,319       540,623      
 
 
Total loans
  $ 2,993,160     $ 2,981,677     $ 2,799,434     $ 2,807,660     $ 2,706,695      
 
 
 
Table 4 presents the maturity distribution of commercial, real estate commercial and real estate construction loans. These loans totaled $1.49 billion and represented 50% of total loans at December 31, 2009 and 2008. The percentage of these loans maturing within one year was 40% at December 31, 2009, compared to 36% at December 31, 2008. The percentage of these loans maturing beyond five years remained low at 6% at December 31, 2009, compared to 9% at December 31, 2008. At December 31, 2009 and 2008, commercial, real estate commercial and real estate construction loans with maturities beyond one year totaled $889 million and $962 million, respectively, and were comprised of 97% and 91%, respectively, of fixed interest rate loans and variable interest rate loans that were at their minimum interest rate. The Corporation classifies variable interest rate loans that are at their minimum interest rate as fixed interest rate loans for purposes of interest sensitivity disclosure and regulatory reporting. Variable interest rate loans that were at their minimum interest rate, and therefore reported as fixed rate loans, totaled $128 million at December 31, 2009 and $47 million at December 31, 2008.


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TABLE 4. COMPARISON OF LOAN MATURITIES AND INTEREST SENSITIVITY (Dollars in thousands)
 
                                                                     
    December 31, 2009
    December 31, 2008
     
    Due In     Due In      
 
    1 Year
    1 to 5
    Over 5
          1 Year
    1 to 5
    Over 5
           
    or Less     Years     Years     Total     or Less     Years     Years     Total      
 
 
Loan Maturities:
                                                                   
Commercial
  $ 330,139     $ 207,585     $ 46,562     $ 584,286     $ 303,518     $ 234,795     $ 49,241     $ 587,554      
Real estate commercial
    219,992       528,831       36,852       785,675       169,787       566,503       50,114       786,404      
Real estate construction
    52,262       62,277       6,766       121,305       57,572       25,572       35,857       119,001      
 
 
Total
  $ 602,393     $ 798,693     $ 90,180     $ 1,491,266     $ 530,877     $ 826,870     $ 135,212     $ 1,492,959      
 
 
Percent of Total
    40 %     54 %     6 %     100 %     36 %     55 %     9 %     100 %    
 
 
                                 
    December 31, 2009     December 31, 2008  
    Amount     Percent     Amount     Percent  
   
 
Interest Sensitivity:
                               
Above loans maturing after one year which have:
                               
Fixed interest rates
  $ 861,097       97 %   $ 877,685       91 %
Variable interest rates
    27,776       3       84,397       9  
 
 
Total
  $ 888,873       100 %   $ 962,082       100 %
 
 
 
Total loans at December 31, 2009 were $2.99 billion, an increase of $11.5 million, or 0.4%, from total loans at December 31, 2008, compared to an increase of $182 million, or 6.5%, during 2008. A summary of the changes in the loan portfolio by category follows.
 
Commercial loans consist primarily of loans to varying types of businesses, including municipalities, school districts and nonprofit organizations, for the purpose of supporting working capital and operational needs and term financing of equipment. Repayment of such loans is generally provided through operating cash flows of the business, although the Corporation also generally secures commercial loans with equipment, real estate, personal guarantees of the owner or other sources of repayment.
 
Commercial loans were $584.3 million at December 31, 2009, a decrease of $3.2 million, or 0.6%, from total commercial loans at December 31, 2008 of $587.5 million. The decrease in commercial loans in 2009 was attributable to less demand for new financing by commercial customers that was partially offset by an increase in loans to municipalities and school districts. Loans to municipalities and school districts were $71.7 million at December 31, 2009, a $26.0 million, or 57%, increase from $45.7 million at December 31, 2008. The increase in loans in this category during 2009 was primarily due to a lower level of competition for these types of loans in the Corporation’s lending markets that created additional lending opportunities for the Corporation. Commercial loans increased $72.2 million, or 14.0%, during 2008 from commercial loans at December 31, 2007 of $515.3 million. The increase in commercial loans in 2008 arose throughout the Corporation’s lending markets and across a wide range of industries. Commercial loans represented 19.5% of the Corporation’s loan portfolio at December 31, 2009, compared to 19.7% and 18.4% at December 31, 2008 and 2007, respectively.
 
The average size of commercial loan transactions is generally relatively small, which decreases the risk of loss within the commercial loan portfolio due to the lack of loan concentration. The Corporation’s loan portfolio to commercial borrowers, defined as commercial, real estate commercial and real estate construction-commercial loans, is well diversified across business lines and has no concentration in any one industry. The total loan portfolio to commercial borrowers of $1.47 billion at December 31, 2009 included 83 loan relationships of $2.5 million or greater. These 83 borrowing relationships totaled $432.9 million and represented 29.5% of the loan portfolio to commercial borrowers at December 31, 2009. At December 31, 2009, five of these borrowing relationships had outstanding balances of $10 million or higher, totaling $67.5 million, or 4.6%, of the loan portfolio to commercial borrowers as of that date. Further, the Corporation had nine loan relationships at December 31, 2009 with loan balances greater than $2.5 million and less than $10 million, totaling $47.1 million, that had unfunded credit amounts, that if advanced, could result in a loan relationship exceeding $10 million.
 
Real estate commercial loans include loans that are secured by real estate occupied by the borrower for ongoing operations, non-owner occupied real estate leased to one or more tenants and vacant land that has been acquired for investment or future land development. Real estate commercial loans were $785.7 million at December 31, 2009, a decrease of $0.7 million, or 0.1%, from total real estate commercial loans at December 31, 2008 of $786.4 million. Loans secured by owner occupied properties, non-owner occupied properties and vacant land comprised 74.6%, 21.9% and 3.5%, respectively, of the Corporation’s real estate commercial loans outstanding at December 31, 2009. Real estate commercial loans increased $26.0 million, or 3.4%, during 2008 from real estate commercial loans at December 31, 2007 of $760.4 million. Real estate commercial loans represented 26.2% of the Corporation’s loan portfolio at December 31, 2009, compared to 26.4% and 27.2% at December 31, 2008 and 2007, respectively.


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Real estate commercial lending is generally considered to involve a higher degree of risk than real estate residential lending and typically involves larger loan balances concentrated in a single borrower. In addition, the payment experience on loans secured by income-producing properties and vacant land loans are typically dependent on the success of the operation of the related project and are typically affected by adverse conditions in the real estate market and in the economy.
 
The Corporation generally attempts to mitigate the risks associated with commercial and real estate commercial lending by, among other things, lending primarily in its market areas, lending across industry lines, not developing a concentration in any one line of business and using prudent loan-to-value ratios in the underwriting process. The weakened economy in Michigan has resulted in higher loan delinquencies, customer bankruptcies and real estate foreclosures. Based on current economic conditions in Michigan, management expects real estate foreclosures to remain higher than historical averages. It is also management’s belief that the loan portfolio is generally well-secured, despite declining market values for all types of real estate in the State of Michigan and nationwide.
 
Real estate construction loans are originated for both business and residential properties, including land development. Land development loans are loans made to residential and commercial developers for infrastructure improvements to create finished marketable lots for residential or commercial construction. Real estate construction loans often convert to a real estate commercial or real estate residential loan at the completion of the construction period; however, most land development loans are originated with the intention that the loans will be paid through the sale of finished properties by the developers within twelve months of the completion date. Real estate construction loans were $121.3 million at December 31, 2009, an increase of $2.3 million, or 1.9%, from real estate construction loans at December 31, 2008 of $119.0 million. Real estate construction loans decreased $15.8 million, or 11.7%, during 2008 from real estate construction loans of $134.8 million at December 31, 2007. Real estate construction loans to commercial borrowers represented the majority of these loans and were $98.4 million at December 31, 2009, an increase of $8.6 million, or 9.6%, from December 31, 2008. The increase in real estate construction loans to commercial borrowers during 2009 was attributable to one project to finance the construction and renovation of a private recreational facility. At December 31, 2009, $9.3 million had been advanced by the Corporation on this project and another $9.4 million was committed for future advancements at that date. Real estate construction loans also include loans to consumers for the construction of single family residences that are secured by these properties. Real estate construction loans to consumers were $22.9 million at December 31, 2009, a decrease of $6.3 million, or 21.6%, from December 31, 2008. Real estate construction loans represented 4.1% of the Corporation’s loan portfolio as of December 31, 2009 compared to 4.0% and 4.8% at December 31, 2008 and 2007, respectively.
 
Real estate construction lending involves a higher degree of risk than real estate commercial lending and real estate residential lending because of the uncertainties of construction, including the possibility of costs exceeding the initial estimates and the need to obtain a tenant or purchaser of the property if it will not be owner-occupied. The Corporation generally attempts to mitigate the risks associated with construction lending by, among other things, lending primarily in its market areas, using prudent underwriting guidelines and closely monitoring the construction process. At December 31, 2009, the Corporation’s real estate construction loans to commercial borrowers included $46.6 million of residential real estate development loans. The Corporation’s risk in this area has increased since early 2008 due to the recessionary economic environment within the State of Michigan. The sale of units in residential real estate development projects has slowed significantly, as customer demand significantly decreased, resulting in the inventory of unsold housing units increasing across the State of Michigan. The severe recession in Michigan has resulted in the inability of most developers to sell their finished developed lots and units within their original expected time frames. Accordingly, few of the Corporation’s residential real estate development borrowers sold developed lots or units during 2008 and 2009 due to the poor economic environment. At December 31, 2009, $14.4 million, or 31%, of the Corporation’s residential real estate development loans were not performing in accordance with their contractual terms.
 
Real estate residential loans consist primarily of one- to four-family residential loans with fixed interest rates of fifteen years or less. The loan-to-value ratio at the time of origination is generally 80% or less. Loans with more than an 80% loan-to-value ratio generally require private mortgage insurance. Real estate residential loans were $739.4 million as of December 31, 2009, a decrease of $100.2 million, or 11.9%, from real estate residential loans at December 31, 2008 of $839.6 million. Real estate residential loans increased $1.0 million, or 0.1%, during 2008 from $838.5 million at December 31, 2007. The decrease in real estate residential loans in 2009 was attributable to both a significant decline in Michigan’s housing market due to the overall economic environment and customers refinancing adjustable rate and balloon mortgages to long-term fixed interest rate loans that the Corporation sold in the secondary market. The Corporation’s current general practice is to sell fixed interest rate real estate residential loan originations with maturities of over ten years in the secondary market. Real estate residential loans represented 24.7% of the Corporation’s loan portfolio at December 31, 2009, compared to 28.1% and 30.0% at December 31, 2008 and 2007, respectively.
 
The Corporation’s consumer loan portfolio consists of relatively small loan amounts that are spread across many individual borrowers, which minimizes the risk per loan transaction. Collateral values, particularly those of automobiles, recreational vehicles and boats, are negatively impacted by many factors, such as new car promotions, the physical condition of the collateral and even more significantly, overall economic conditions. Consumer loans also include home equity loans, whereby consumers utilize equity in their personal residence, generally through a second mortgage, as collateral to secure the loan.


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Consumer loans were $762.5 million at December 31, 2009, an increase of $113.4 million, or 17.5%, from consumer loans at December 31, 2008 of $649.2 million. Consumer loans increased $98.8 million, or 18.0%, during 2008 from $550.3 million at December 31, 2007. The increases in consumer loans during 2009 and 2008 were primarily attributable to an increase in indirect consumer loans, due to a combination of an increased sales effort, new technology to support indirect loan application processing and a reduction in the number of competing lenders. In 2008, new electronic application tools were installed that link the Corporation’s loan underwriting department directly to business dealerships. This capability stimulated an increase in lending opportunities during 2009 and 2008. Indirect consumer loans include automobile, recreational vehicle and boat financing purchased from dealerships. At December 31, 2009, approximately 41% of consumer loans were secured by the borrowers’ personal residences, 28% by automobiles, 18% by recreational vehicles, 9% by marine vehicles and the remaining 4% was mostly unsecured. Consumer loans represented 25.5% of the Corporation’s loan portfolio at December 31, 2009, compared to 21.8% and 19.6% at December 31, 2008 and 2007, respectively.
 
Consumer loans generally have shorter terms than mortgage loans but generally involve more credit risk than real estate residential lending because of the type and nature of the collateral. The Corporation approves consumer loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. Consumer lending collections are dependent on the borrowers’ continuing financial stability and are more likely to be affected by adverse personal situations. Overall, credit risk on these loans increases as the unemployment rate increases. The unemployment rate in the State of Michigan was 14.6% at December 31, 2009, up from 10.2% at December 31, 2008, and significantly higher than the national average of 10.0% at December 31, 2009. The credit risk on home equity loans has historically been low as property values of residential real estate have historically increased year over year. However, credit risk has increased on home equity loans since the beginning of 2008 as property values have declined throughout the State of Michigan, thus increasing the risk of insufficient collateral, as the majority of these loans are secured by a second mortgage on the borrowers’ residences.
 
ASSET QUALITY
 
Nonperforming Assets
 
Nonperforming assets consist of loans for which the accrual of interest has been discontinued, loans that are past due as to principal or interest by 90 days or more and are still accruing interest, loans which have been modified due to a decline in the credit quality of the borrower (loans modified under troubled debt restructurings) and assets obtained through foreclosures and repossessions. The Corporation transfers a loan that is 90 days or more past due to nonaccrual status, unless it believes the loan is both well-secured and in the process of collection. Accordingly, the Corporation has determined that the collection of accrued and unpaid interest on any loan that is 90 days or more past due and still accruing interest is probable.
 
Nonperforming assets were $153.3 million at December 31, 2009, compared to $113.3 million at December 31, 2008 and $74.5 million at December 31, 2007, and represented 3.6%, 2.9% and 2.0%, respectively, of total assets. It is management’s belief that the continued increase in nonperforming assets was largely attributable to the severe recessionary economic climate within Michigan, which has resulted in cash flow difficulties being encountered by many business and consumer loan customers. The unemployment rate in Michigan was 14.6% at December 31, 2009, compared to 10.0% nationwide. The increase in the Corporation’s nonperforming assets was not concentrated in any one industry or any one geographical area within Michigan, other than $14.4 million in nonperforming residential real estate development loans (included in real estate construction) made in Chemical Bank’s various lending market areas throughout the state. At December 31, 2009, there were five commercial loan relationships exceeding $2.5 million, totaling $19.5 million, which were in nonperforming status. It continues to be well publicized nationwide that appraised values of residential and commercial real estate have generally declined. The Corporation likewise continued to experience declines in appraised values of both residential and commercial real estate properties in 2009 due to the continued weakness in the economy in Michigan. Based on the declines in both commercial and residential real estate values, management continues to evaluate and discount appraised values and obtain new appraisals to compute estimated fair market values of impaired real estate secured loans and other real estate properties. Due to the economic climate within Michigan, management expects that nonperforming assets will continue to remain at elevated levels into 2010.


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The following table provides a five-year history of nonperforming assets, including the composition of nonaccrual loans and accruing loans contractually past due 90 days or more as to interest or principal payments and loans modified under troubled debt restructurings, by major loan category:
 
TABLE 5. NONPERFORMING ASSETS
 
                                             
    December 31,      
    2009     2008     2007     2006     2005      
 
    (Dollars in thousands)      
 
Nonaccrual loans*:
                                           
Commercial
  $ 19,309     $ 16,324     $ 10,961     $ 4,203     $ 3,133      
Real estate commercial
    49,419       27,344       19,672       9,612       2,950      
Real estate construction
    15,184       15,310       12,979       2,552       3,741      
Real estate residential
    15,508       12,175       8,516       2,887       3,853      
Consumer
    7,169       5,313       3,468       985       884      
 
 
Total nonaccrual loans
    106,589       76,466       55,596       20,239       14,561      
Accruing loans contractually past due 90 days or more as to interest or principal payments:
                                           
Commercial
    1,371       1,652       1,958       1,693       825      
Real estate commercial
    3,971       9,995       4,170       2,232       2,002      
Real estate construction
    1,990       759             174            
Real estate residential
    3,614       3,369       1,470       1,158       1,717      
Consumer
    787       1,087       166       1,414       592      
 
 
Total accruing loans contractually past due 90 days or more as to interest or principal payments
    11,733       16,862       7,764       6,671       5,136      
Loans modified under troubled debt restructurings
    17,433                              
 
 
Total nonperforming loans
    135,755       93,328       63,360       26,910       19,697      
Other real estate and repossessed assets
    17,540       19,923       11,132       8,852       6,801      
 
 
Total nonperforming assets
  $ 153,295     $ 113,251     $ 74,492     $ 35,762     $ 26,498      
 
 
Nonperforming loans as a percent of total loans
    4.54 %     3.13 %     2.26 %     0.96 %     0.73 %    
 
 
Nonperforming assets as a percent of total assets
    3.61 %     2.92 %     1.98 %     0.94 %     0.71 %    
 
 
 
* Interest income totaling $2.1 million was recorded in 2009 on loans in nonaccrual status. At December 31, 2009, additional interest income of $6.1 million would have been recorded during 2009 on these loans had they been current in accordance with their original terms.
 
The following schedule provides the composition of nonperforming loans, by major loan category, as of December 31, 2009 and 2008.
                                 
    December 31,  
    2009     2008  
          Percent
          Percent
 
    Amount     of Total     Amount     of Total  
   
    (Dollars in thousands)  
 
Commercial
  $ 20,680       15 %   $ 17,976       19 %
Real estate commercial
    53,390       39       37,339       40  
Real estate construction
    17,174       13       16,069       17  
 
 
Sub-total
    91,244       67       71,384       76  
Real estate residential
    36,555       27       15,544       17  
Consumer
    7,956       6       6,400       7  
 
 
Total nonperforming loans
  $ 135,755       100 %   $ 93,328       100 %
 
 
 
Total nonperforming loans at December 31, 2009 were $135.8 million, an increase of $42.5 million, or 46%, compared to $93.3 million at December 31, 2008. The increase in nonperforming loans has occurred in both commercial borrower (commercial, real estate commercial and real estate construction) and consumer borrower (real estate residential and consumer) loan categories. Combined, the three commercial borrower nonperforming loan categories totaled $91.2 million, or 67%, of total nonperforming loans at December 31, 2009. Likewise, as disclosed in Table 6 under the subheading “Provision and Allowance for Loan Losses” the majority of the Corporation’s net loan charge-offs during 2009 occurred within these three loan categories, with 75% of net loan charge-offs during 2009 attributable to commercial borrowers, compared to 80% in 2008. The increase in the level of nonperforming


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loans during 2009 was largely attributable to the recessionary economic conditions in the State of Michigan and in the Corporation’s local markets that have been existent since 2006 and continued to deteriorate through 2009, with no clear economic indications of when significant improvement is likely to occur.
 
The following schedule presents additional data related to nonperforming commercial, real estate commercial and real estate construction loans by dollar amount as of December 31, 2009 and 2008.
                                 
    December 31,  
    2009     2008  
    Number of
          Number of
       
    Borrowers     Amount     Borrowers     Amount  
   
    (Dollars in thousands)  
 
$5,000,000 or more
    1     $ 7,532       1     $ 6,083  
$2,500,000 - $4,999,999
    4       11,926       3       10,259  
$1,000,000 - $2,499,999
    17       28,989       12       18,868  
$500,000 - $999,999
    21       14,640       20       14,758  
$250,000 - $499,999
    40       14,042       31       10,125  
Under $250,000
    175       14,115       133       11,291  
 
 
Total
    258     $ 91,244       200     $ 71,384  
 
 
 
Nonperforming commercial loans of $20.7 million at December 31, 2009 were up $2.7 million, or 15%, from nonperforming commercial loans at December 31, 2008 of $18.0 million. The nonperforming commercial loans at December 31, 2009 were not concentrated in any single industry and it is management’s belief that the increase in 2009 was primarily reflective of the recessionary economic conditions in Michigan.
 
Nonperforming real estate commercial loans of $53.4 million at December 31, 2009 were up $16.1 million, or 43%, from $37.3 million at December 31, 2008. At December 31, 2009, the Corporation’s nonperforming real estate commercial loan portfolio was comprised of $29.8 million of loans secured by owner occupied real estate, $14.7 million of loans secured by non-owner occupied real estate and $8.9 million of loans secured by vacant land, resulting in approximately 5% of owner occupied real estate commercial loans, 9% of non-owner occupied real estate commercial loans and 32% of vacant land loans in a nonperforming status at December 31, 2009. At December 31, 2009, the Corporation’s nonperforming real estate commercial loans included a diverse mix of commercial lines of business and were also geographically disbursed throughout the Corporation’s market areas. The largest concentration of the $53.4 million in nonperforming real estate commercial loans at December 31, 2009 was one customer relationship totaling $6.7 million that is secured by a combination of vacant land and non-owner occupied commercial real estate. This same customer relationship also has $0.8 million in nonperforming real estate construction loans (secured by residential real estate development). At December 31, 2009, $7.5 million of the nonperforming real estate commercial loans were in various stages of foreclosure with 43 borrowers. The Michigan economy remains weak, thus creating a difficult business environment for many lines of business across the state.
 
Nonperforming real estate construction loans at December 31, 2009 were $17.2 million, up $1.1 million, or 6.9%, from $16.1 million at December 31, 2008. At December 31, 2009, $14.4 million, or 84%, of nonperforming real estate construction loans were secured by residential development real estate comprised primarily of improved lots and housing units. The $14.4 million of nonperforming loans secured by residential real estate development projects represented 31% of total residential real estate development loans outstanding of $46.6 million at December 31, 2009. The economy in Michigan has adversely impacted housing demand throughout the state and, accordingly, the Corporation has experienced an increase in the number of its residential real estate development borrowers with cash flow difficulties associated with a significant decline in sales of both lots and residential real estate.
 
Nonperforming real estate residential loans, including loans modified under troubled debt restructurings, were $36.6 million at December 31, 2009, an increase of $21.1 million, or 135%, from total nonperforming real estate residential loans of $15.5 million at December 31, 2008. The significant increase in nonperforming real estate residential loans was attributable to a rise in delinquencies, bankruptcies and foreclosures primarily reflective of the elevated unemployment rate in the State of Michigan. At December 31, 2009, a total of $5.9 million of nonperforming real estate residential loans were in various stages of foreclosure.
 
During 2009, the continuing recessionary economic climate in Michigan resulted in an increasing number of customers with cash flow difficulties and thus the inability to maintain their residential mortgage loan balances in a performing status. The Corporation determined that it was probable that certain customers who were past due on their real estate residential loans, if provided a reduction in their monthly payment for a limited time period, would be able to bring their loan relationship to a performing status and was deemed by the Corporation to potentially result in a lower level of loan losses and loan collection costs than if the Corporation proceeded through the foreclosure process with these borrowers. The Corporation began modifying real estate residential loans during the second quarter of 2009. The majority of these modifications consisted of reducing a borrower’s monthly payments by


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decreasing the interest rate charged on the loan to 3% for a period of 24 months. The outstanding loan balances of the Corporation’s loans modified under troubled debt restructurings were $17.4 million at December 31, 2009. Each of these modified loans was current in accordance with their modified terms at December 31, 2009. Each of the Corporation’s modified loans will remain in nonperforming status until six consecutive months of payments have been received under their modified term, at which time the modified loans will be moved to performing status. Under GAAP, these modified loans meet the definition of a troubled debt restructuring and as a result, the Corporation recognized $0.8 million of additional provision for loan losses during 2009 related to impairment on these loans based on the present value of expected future cash flows discounted at the loan’s original effective interest rate.
 
Nonperforming consumer loans were $8.0 million at December 31, 2009, an increase of $1.6 million, or 24%, from total nonperforming consumer loans of $6.4 million at December 31, 2008. The increase in nonperforming consumer loans during 2009 was also primarily reflective of the elevated unemployment rate in the State of Michigan.
 
Other real estate and repossessed assets is a component of nonperforming assets and primarily includes real property acquired through foreclosure or by acceptance of a deed in lieu of foreclosure, and also personal and commercial property held for sale. Other real estate and repossessed assets totaled $17.5 million at December 31, 2009, a decrease of $2.4 million, or 12%, from $19.9 million at December 31, 2008. The decrease in other real estate and repossessed assets during 2009 was due to fair value write-downs as sales activity was offset by additions of other real estate and repossessed assets during the year.
 
The following schedule summarizes other real estate and repossessed asset activity during 2009 and 2008:
                 
    December, 31  
    2009     2008  
   
    (Dollars in thousands)  
 
Balance at beginning of year
  $ 19,923     $ 11,132  
Additions
    18,056       21,282  
Capitalized improvements
    264       214  
Write-downs to fair value
    (4,722 )     (3,186 )
Dispositions
    (15,981 )     (9,519 )
 
 
Balance at end of year
  $ 17,540     $ 19,923  
 
 
 
The following schedule provides the composition of other real estate and repossessed assets as of December 31, 2009 and 2008:
                 
    December 31,  
    2009     2008  
   
    (Dollars in thousands)  
 
Other real estate:
               
Commercial
  $ 4,250     $ 6,202  
Commercial development
    1,265       1,629  
Residential real estate
    7,483       6,960  
Residential development
    4,250       4,667  
 
 
Total other real estate
    17,248       19,458  
Repossessed assets
    292       465  
 
 
Total other real estate and repossessed assets
  $ 17,540     $ 19,923  
 
 
 
At December 31, 2009, total other real estate of $17.2 million was comprised of 49 commercial properties totaling $4.2 million, commercial development properties obtained from four developers totaling $1.3 million, 118 residential real estate properties totaling $7.5 million and 19 residential development projects totaling $4.2 million. The residential development projects were primarily concentrated in five projects totaling $3.1 million. The residential development projects are unfinished in varying stages of completion. The largest residential development project is a high-rise mixed use condominium building with eleven unsold residential units and a carrying value of $1.0 million at December 31, 2009. Only one unit has been sold in this project and that unit was sold in 2005. The carrying value at December 31, 2009 on this high-rise mixed use condominium building of $1.0 million was net of $2.0 million in fair value write-downs since the project has been in other real estate, including $0.8 million during 2009. Repossessed assets of $0.3 million at December 31, 2009, were comprised of commercial equipment, automobiles, boats and recreational vehicles.
 
The historically large inventory of other real estate properties held for sale across the State of Michigan has resulted in an increase in the Corporation’s carrying time and cost of holding other real estate. Consequently, the Corporation had $8.5 million in other real estate properties at December 31, 2009 that had been held in excess of one year as of that date. Due to the redemption period on foreclosures being relatively long in Michigan (six months to one year) and the Corporation having a significant number of


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nonperforming loans that were in the process of foreclosure at December 31, 2009, management anticipates that the level of other real estate and repossessed assets will likely remain elevated for some period of time. Other real estate properties are carried at the lower of cost or fair value less estimated cost to sell.
 
At December 31, 2009, all of the other real estate properties had been written down to fair value through a combination of a loan charge-off at the transfer of the loan to other real estate and/or as a write-down, recorded as an operating expense, to recognize the further market value decline of the property after the initial transfer date. At December 31, 2009, the carrying value of other real estate of $17.2 million, was reflective of $15.5 million in charge-offs/write-downs and represented 53% of the loan balance at the time the property was transferred to other real estate.
 
During 2009, 138 pieces of other real estate properties were sold with net proceeds from sales totaling $13.5 million. On an average basis, the net proceeds from these sales represented 60% of the loan balance at the time the Corporation received title to the properties.
 
Impaired Loans
 
A loan is considered impaired when management determines it is probable that all of the principal and interest due will not be collected according to the original contractual terms of the loan agreement. The Corporation has determined that all of its nonaccrual commercial, real estate commercial, real estate construction-commercial loans and loans modified under troubled debt restructurings meet the definition of an impaired loan. In most instances, the impairment is measured based on the fair market value of the underlying collateral. Impairment may also be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate. A portion of the allowance for loan losses may be specifically allocated to impaired loans.
 
Impaired loans were $101.3 million at December 31, 2009, compared to $59.0 million at December 31, 2008 and $45.9 million at December 31, 2007. The increase in impaired loans during 2009 was primarily attributable to the weak economy in the State of Michigan. After analyzing the various components of the customer relationships and evaluating the underlying collateral of impaired loans, it was determined that impaired commercial, real estate commercial and real estate construction-commercial loans totaling $38.2 million at December 31, 2009 required a valuation allowance, compared to $30.3 million of impaired loans at December 31, 2008 and $22.2 million of impaired loans at December 31, 2007. The valuation allowance on these impaired loans was $10.5 million at December 31, 2009, compared to $9.2 million at December 31, 2008 and $4.6 million at December 31, 2007. At December 31, 2009, loans modified under troubled debt restructurings of $17.4 million also required a valuation allowance of $0.7 million. The process of measuring impaired loans and the allocation of the allowance for loan losses requires judgment and estimation. The eventual outcome may differ from the estimates used on these loans. A discussion of the allowance for loan losses is included under the subheading, “Provision and Allowance for Loan Losses,” below.
 
PROVISION AND ALLOWANCE FOR LOAN LOSSES
 
The provision for loan losses (provision) is an increase to the allowance for loan losses (allowance) to provide for probable losses inherent in the loan portfolio. The allowance provides for probable losses that have been identified with specific customer relationships and for probable losses believed to be inherent in the remainder of the loan portfolio but that have not been specifically identified. The allowance is comprised of specific allowances (assessed for loans that have known credit weaknesses), pooled allowances based on assigned risk ratings and historical loan loss experience for each loan type, and an unallocated allowance for imprecision in the subjective nature of the specific and pooled allowance methodology. Management evaluates the allowance on a quarterly basis in an effort to ensure the level is adequate to absorb probable losses inherent in the loan portfolio. This evaluation process is inherently subjective as it requires estimates that may be susceptible to significant change and has the potential to affect net income materially. The Corporation’s methodology for measuring the adequacy of the allowance includes several key elements, which includes a review of the loan portfolio, both individually and by category, and includes consideration of changes in the mix and volume of the loan portfolio, actual loan loss experience, review of collateral values, the financial condition of the borrowers, industry and geographical exposures within the portfolio, economic conditions and employment levels of the Corporation’s local markets and other factors affecting business sectors. Management believes that the allowance for loan losses is currently maintained at an appropriate level, considering the inherent risk in the loan portfolio. Future significant adjustments to the allowance may be necessary due to changes in economic conditions, delinquencies or the level of loan losses incurred. A summary of the activity in the allowance for loan losses for the last five years is included in Table 6.


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TABLE 6. ANALYSIS OF ALLOWANCE FOR LOAN LOSSES
 
                                         
    Years Ended December 31,  
    2009     2008     2007     2006     2005  
   
    (Dollars in thousands)  
 
Balance at beginning of year
  $ 57,056     $ 39,422     $ 34,098     $ 34,148     $ 34,166  
Provision for loan losses
    59,000       49,200       11,500       5,200       4,285  
Loan charge-offs:
                                       
Commercial
    (12,001 )     (16,787 )     (1,622 )     (1,389 )     (2,126 )
Real estate commercial
    (9,231 )     (6,995 )     (1,675 )     (1,564 )      
Real estate construction
    (6,969 )     (2,963 )     (1,272 )     (1,201 )      
Real estate residential
    (3,694 )     (2,458 )     (484 )     (515 )     (453 )
Consumer
    (6,791 )     (4,739 )     (1,935 )     (1,976 )     (2,407 )
 
 
Total loan charge-offs
    (38,686 )     (33,942 )     (6,988 )     (6,645 )     (4,986 )
Recoveries of loans previously charged off:
                                       
Commercial
    904       1,473       249       370       110  
Real estate commercial
    495       131       21       6       11  
Real estate construction
    307       29       30              
Real estate residential
    614       160       18       98       29  
Consumer
    1,151       583       494       521       533  
 
 
Total loan recoveries
    3,471       2,376       812       995       683  
 
 
Net loan charge-offs
    (35,215 )     (31,566 )     (6,176 )     (5,650 )     (4,303 )
Allowance of branches acquired
                      400        
 
 
Allowance for loan losses at end of year
  $ 80,841     $ 57,056     $ 39,422     $ 34,098     $ 34,148  
 
 
Net loan charge-offs during the year as a percentage of average loans outstanding during the year
    1.18 %     1.10 %     0.22 %     0.20 %     0.16 %
 
 
Allowance for loan losses as a percentage of total loans outstanding at end of year
    2.70 %     1.91 %     1.41 %     1.21 %     1.26 %
 
 
Allowance for loan losses as a percentage of nonperforming loans outstanding at end of year
    60 %     61 %     62 %     127 %     173 %
 
 
 
The provision for loan losses was $59.0 million in 2009, $49.2 million in 2008 and $11.5 million in 2007. The Corporation experienced net loan charge-offs of $35.2 million in 2009, $31.6 million in 2008 and $6.2 million in 2007. Net loan charge-offs in 2008 included $10.3 million attributable to the identification of a fraudulent loan transaction related to a single borrower for which the Corporation recovered $1.2 million in 2008 and $0.3 million in 2009 through the sale of collateral securing the loan. Net loan charge-offs as a percentage of average loans were 1.18% in 2009, 1.10% in 2008 and 0.22% in 2007. The level of net loan charge-offs reflects the general deterioration in credit quality across the entire loan portfolio. Net loan charge-offs of commercial, real estate commercial and real estate construction loans totaled $26.5 million in 2009 and represented 75% of total net loan charge-offs during the year, compared to 80% and 69% of total net loan charge-offs in 2008 and 2007, respectively. The commercial loan type net loan charge-offs in 2009 were not concentrated in any one industry or borrower. The level of the provision each year reflects management’s assessment of the adequacy of the allowance.
 
The Corporation’s provision for loan losses in 2009 of $59.0 million was $23.8 million higher than net loan charge-offs in 2009 and $9.8 million higher than the provision for loan losses in 2008. The level of the provision in 2009 was primarily reflective of continued credit deterioration during the year that was driven by higher net loan charge-offs, increases in nonperforming loans and loan delinquencies and adverse changes in certain risk grade categories of the commercial, real estate commercial and real estate construction loan portfolios. The increase in net loan charge-offs was impacted by declining real estate values within the State of Michigan during 2009, as evidenced by both lower appraised values of real estate and lower sales prices of real estate. It is management’s belief that the overall credit deterioration in the Corporation’s loan portfolio during 2009 was largely reflective of the economic environment in the State of Michigan, as the unemployment rate increased throughout the year to 14.6% at December 31, 2009. The Corporation’s loan portfolio had no concentration in the automotive sector and management has identified its direct exposure to this industry as not material, although the economic impact of the depressed automotive sector affected the general economy within Michigan during 2008 and 2009. It has been publicized nationally that the residential real estate development industry was one of the industries most affected by the recessionary economy during 2008 and 2009 and, accordingly, the Corporation experienced $6.4 million of net loan charge-offs on residential real estate development loans in 2009 and $5.4 million in 2008. In addition, the Corporation’s loan portfolio at December 31, 2009 included 22 residential real estate developers with outstanding loan balances totaling $14.4 million that were experiencing significant cash flow difficulties and resulted in these loan relationships being classified as nonperforming at that date. At December 31, 2009, management evaluated the underlying collateral


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value of the $14.4 million in impaired residential real estate development loans and determined a valuation allowance of $0.6 million was required on $4.0 million of these loans, as the fair value of the underlying collateral was assessed to be less than the carrying value of the loans. Impaired residential real estate development loans at December 31, 2009 of $14.4 million were largely concentrated in loans to five developers having individual loan balances exceeding $1 million that totaled $8.1 million, or 57%, of total impaired residential real estate development loans at that date.
 
In determining the allowance for loan losses and the related provision for loan losses, the Corporation considers four principal elements: (i) valuation allowances based upon probable losses identified during the review of impaired commercial, real estate commercial and real estate construction-commercial loan portfolios, (ii) allocations established for adversely-rated commercial, real estate commercial and real estate construction-commercial loans and nonaccrual real estate residential and nonaccrual consumer loans, (iii) allocations on all other loans based principally on the most recent three years of historical loan loss experience and loan loss trends, and (iv) an unallocated allowance based on the imprecision in the overall allowance methodology.
 
The first element reflects the Corporation’s estimate of probable losses based upon the systematic review of impaired commercial, real estate commercial and real estate construction-commercial impaired loans. These estimates are based upon a number of objective factors, such as payment history, financial condition of the borrower and discounted collateral exposure. The Corporation measures the investment in an impaired loan based on one of three methods: the loan’s observable market price, the fair value of the collateral or the present value of expected future cash flows discounted at the loan’s effective interest rate. At December 31, 2009, all of the Corporation’s impaired loans to commercial borrowers were valued based on the fair value of the collateral securing the loan. It is the Corporation’s general policy to, at least annually, obtain new appraisals on impaired loans that are primarily secured by real estate. At December 31, 2009, the Corporation had a current appraisal on approximately 90% of impaired loans, with 60% of these appraisals being performed during the second half of 2009. When the Corporation determines that the fair value of the collateral is less than the carrying value of an impaired loan and a portion is deemed not collectible, the portion of the impairment that is deemed not collectible is charged-off and deducted from the allowance. The remaining carrying value of the impaired loan is classified as a nonperforming loan. When the Corporation determines that the fair value of the collateral is less than the carrying value of an impaired loan but believes it is probable it will recover this impairment, the Corporation establishes a valuation allowance for such impairment.
 
The second element reflects the application of the Corporation’s loan grading system. This grading system is similar to those employed by state and federal banking regulators. Commercial, real estate commercial and real estate construction-commercial loans that are risk rated below a certain predetermined risk grade and nonaccrual real estate residential and nonaccrual consumer loans are assigned a loss allocation factor that is based upon a historical analysis of losses incurred within the specific risk grade category and a valuation of the type of collateral securing the loans.
 
The third element is determined by assigning allocations based principally upon the three-year average of loss experience for each type of loan. Average losses may be adjusted based on current loan loss experience and delinquency trends. This component considers the lagging impact of historical charge-off ratios in periods where future loan charge-offs are expected to increase or decrease, trends in delinquencies and nonaccrual loans, the changing portfolio mix in terms of collateral, average loan balance, loan growth and the degree of seasoning in the various loan portfolios. Loan loss analyses are performed quarterly.
 
The fourth element is based on factors that cannot be associated with a specific credit or loan category and reflects an attempt to ensure that the overall allowance appropriately reflects a margin for the imprecision necessarily inherent in the estimates of expected loan losses. Management maintains an unallocated allowance to recognize the uncertainty and imprecision underlying the process of estimating projected loan losses. Determination of the probable losses inherent in the portfolio, which are not necessarily captured by the allocation methodology discussed above, involves the exercise of judgment. The unallocated allowance associated with the imprecision in the risk rating system is based on a historical evaluation of the accuracy of the risk ratings associated with loans. This unallocated portion of the allowance is judgmentally determined and generally serves to compensate for the uncertainty in estimating losses, particularly in times of changing economic conditions, and also considers the possibility of improper risk ratings. The unallocated portion of the allowance also takes into consideration economic conditions within the State of Michigan and nationwide, including unemployment levels, industry-wide loan delinquency rates, and declining commercial and residential real estate values and historically high inventory levels of residential lots, condominiums and single family houses held for sale.
 
The allocation of the allowance for loan losses in Table 7 is based upon ranges of estimates and is not intended to imply either limitations on the usage of the allowance or exactness of the specific amounts. The entire allowance is available to absorb future loan losses without regard to the categories in which the loan losses are classified. The allocation of the allowance is based upon a combination of factors, including historical loss factors, credit-risk grading, past-due experiences, and the trends in these, as well as other factors, as discussed above.


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TABLE 7. ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
 
                                                                                 
    December 31,  
    2009     2008     2007     2006     2005  
   
          Percent
          Percent
          Percent
          Percent
          Percent
 
          of Loans
          of Loans
          of Loans
          of Loans
          of Loans
 
          in Each
          in Each
          in Each
          in Each
          in Each
 
          Category
          Category
          Category
          Category
          Category
 
    Allowance
    to Total
    Allowance
    to Total
    Allowance
    to Total
    Allowance
    to Total
    Allowance
    to Total
 
Loan Type   Amount     Loans     Amount     Loans     Amount     Loans     Amount     Loans     Amount     Loans  
   
    (Dollars in millions)  
 
Commercial
  $ 19.1       20 %   $ 12.3       20 %   $ 9.7       19 %   $ 8.9       19 %   $ 9.0       19 %
Real estate commercial
    23.9       26       20.3       26       12.8       27       11.4       26       11.6       26  
Real estate construction
    5.7       4       3.8       4       3.0       5       1.8       5       1.8       6  
Real estate residential
    13.1       25       8.0       28       5.5       30       3.6       30       3.6       29  
Consumer
    17.3       25       10.9       22       6.6       19       6.8       20       6.7       20  
Unallocated
    1.7             1.8             1.8             1.6             1.4        
 
 
Total
  $ 80.8       100 %   $ 57.1       100 %   $ 39.4       100 %   $ 34.1       100 %   $ 34.1       100 %
 
 
 
The Corporation’s allowance was $80.8 million at December 31, 2009 and represented 2.70% of total loans, compared to $57.1 million, or 1.91% of total loans, at December 31, 2008 and $39.4 million, or 1.41% of total loans, at December 31, 2007. The allowance as a percentage of nonperforming loans was 60% at December 31, 2009, compared to 61% at December 31, 2008 and 62% at December 31, 2007.
 
The Corporation’s valuation allowance for impaired commercial, real estate commercial and real estate construction-commercial loans increased $1.3 million to $10.5 million at December 31, 2009 from $9.2 million at December 31, 2008. The increase in the valuation allowance is reflective of the increase in impaired loans during 2009. Additionally, at December 31,2009, the Corporation had a $0.7 million valuation allowance attributable to loans modified under troubled debt restructurings. Impaired loans were $101.3 million, including $17.4 million of real estate residential loans modified under troubled debt restructurings, at December 31, 2009, up $42.3 million, or 72%, from $59.0 million at December 31, 2008.
 
The following schedule summarizes impaired loans to commercial borrowers and the related valuation allowance as of December 31, 2009 and 2008 and partial loan charge-offs taken on these impaired loans:
 
                                 
          Valuation
    Charged
    Cumulative
 
    Amount     Allowance     Off     Loss Percentage  
   
    (Dollars in thousands)  
 
December 31, 2009
                               
Impaired loans with valuation allowance and no charge-offs
  $ 33,052     $ 10,036     $       30 %
Impaired loans with valuation allowance and charge-offs
    5,165       471       908       23 %
Impaired loans with charge-offs and no valuation allowance
    20,800             17,084       45 %
Impaired loans without valuation allowance or charge-offs
    24,895                   0 %
 
 
Total impaired (nonaccrual) loans to commercial borrowers
  $ 83,912     $ 10,507     $ 17,992       28 %
 
 
December 31, 2008
                               
Impaired loans with valuation allowance and no charge-offs
  $ 25,774     $ 8,459     $       33 %
Impaired loans with valuation allowance and charge-offs
    4,532       720       1,125       33 %
Impaired loans with charge-offs and no valuation allowance
    15,216             10,078       40 %
Impaired loans without valuation allowance or charge-offs
    13,456                   0 %
 
 
Total impaired (nonaccrual) loans to commercial borrowers
  $ 58,978     $ 9,179     $ 11,203       29 %
 
 
 
The following schedule summarizes the allowance as a percentage of nonperforming loans at December 31, 2009 and 2008:
 
                 
    December 31,  
    2009     2008  
   
 
Allowance for loan losses
  $     80,841     $     57,056  
Nonperforming loans
    135,755       93,328  
Allowance as a percent of nonperforming loans
    60 %     61 %
Allowance as a percent of nonperforming loans, net of impaired loans for which the full loss has been charged-off
    70 %     73 %
 
 
 


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At December 31, 2009 and 2008, impaired loans of $33.1 million and $25.8 million, respectively, had a valuation allowance of $10.0 million and $8.5 million, respectively, at these dates. The valuation allowance as a percentage of the impaired loan balances at December 31, 2009 and 2008 represented a cumulative loss percentage on these loans at these dates of 30% and 33%, respectively.
 
Additionally, impaired loans of $5.2 million and $4.5 million at December 31, 2009 and 2008, respectively, that had been partially charged off $0.9 million and $1.1 million, respectively, had a valuation allowance of $0.5 million and $0.7 million, respectively, at these dates. The combination of the partial loan charge-off amounts and the valuation allowance as a percentage of the impaired loan balances prior to the partial charge-off amounts represented a cumulative loss percentage on these loans at December 31, 2009 and 2008 of 23% and 33%, respectively.
 
Further, at December 31, 2009 and 2008, the Corporation, after individually reviewing its impaired loans to commercial borrowers determined $45.7 million and $28.7 million, respectively, of impaired loans were deemed to have sufficient collateral values so as to not require a valuation allowance, due in part to significant write-downs on a portion of these loans. At December 31, 2009, the Corporation had $20.8 million of impaired loans with no valuation allowance as a result of these loans being partially charged off in the amount of $17.1 million, primarily as a result of declining real estate values, with $14.3 million of charge-offs occurring in 2009 and $2.8 million of charge-offs occurring in 2008. The partial charge-offs of $17.1 million on these loans represented a cumulative loss percentage of 45% based on the total outstanding loan balances of these loans prior to the charged off amounts. At December 31, 2008, the Corporation had $15.2 million of impaired loans with no valuation allowance, as a result of these loans being partially charged off $10.1 million as of that date, with $8.9 million of charge-offs occurring in 2008 and $1.2 million occurring in 2007. The partial charge-offs of $10.1 million on these loans represented a cumulative loss percentage of 40% based on the total outstanding loan balances of these loans prior to the charged off amounts. At December 31, 2009 and 2008, the Corporation had impaired loans totaling $24.9 million and $13.5 million, respectively, for which the Corporation determined the fair value of the underlying collateral securing the loan exceeded the contractual loan balance and, therefore, a valuation allowance was not required for these loans. These impaired loans had no partial charge-offs.
 
The process of measuring the fair value of impaired loans and the allocation of the allowance for loan losses requires judgment and estimation; therefore, the eventual outcome may differ from the estimates used on these loans. Continued severe economic conditions and/or declining property values could result in higher loan losses, which could result in the need for a higher allowance for loan losses. Economic conditions in the Corporation’s markets, all within Michigan, were generally less favorable than those nationwide during 2009. Forward-looking indicators suggest these unfavorable economic conditions will continue in 2010. Accordingly, management believes net loan losses, delinquencies and nonperforming loans will remain at elevated levels during 2010.
 
The underlying credit quality of the Corporation’s real estate residential and consumer loan portfolios is dependent primarily on each borrower’s ability to continue to make required loan payments and, in the event a borrower is unable to continue to do so, the value of the collateral, if any, securing the loan. The continued declines in real estate values nationally, and particularly in Michigan, have resulted in lower fair values of collateral securing real estate residential loans. A borrower’s ability to pay typically is dependent primarily on employment and other sources of income, which in turn is impacted by general economic conditions, although other factors may also impact a borrower’s ability to pay. During 2009, the unemployment rate in the State of Michigan increased to 14.6% at December 31, 2009 from 10.2% at December 31, 2008. Consequently, the Corporation experienced increases in nonperforming real estate residential and consumer loans and higher real estate residential and consumer loan losses in 2009 than in 2008. Net loan losses on real estate residential loans in 2009 were $3.1 million, or 39 basis points of average real estate residential loans outstanding during 2009, compared to net loan losses in 2008 of $2.3 million, or 28 basis points of average real estate residential loans outstanding during 2008. Net loan losses on consumer loans in 2009 were $5.6 million, or 77 basis points of average consumer loans outstanding during 2009, compared to net loan losses in 2008 of $4.2 million, or 71 basis points of average consumer loans outstanding during 2008.
 
DEPOSITS
 
Total deposits at December 31, 2009 were $3.42 billion, an increase of $439.3 million, or 14.7%, from total deposits at December 31, 2008 of $2.98 billion. Total deposits increased $103.2 million, or 3.6%, during 2008. The increase in total deposits in 2009 was primarily attributable to growth in consumer time deposits, municipal customer account balances and business money market accounts.
 
The Corporation’s average deposit balances and average rates paid on deposits for the past three years are included in Table 9 under the subheading “Net Interest Income”. Average total deposits in 2009 were $3.20 billion, an increase of $271.1 million, or 9.3%, over average deposits in 2008. Average total deposits in 2008 were $2.92 billion, an increase of $1.4 million, or less than 1%, over average deposits in 2007. There was no significant change in the mix of average deposits during 2009 or 2008, nor did the Corporation have any brokered deposits as of December 31, 2009, 2008 or 2007.


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It is the Corporation’s strategy to develop customer relationships that will drive core deposit growth and stability. While competition for core deposits remained strong throughout the Corporation’s markets, the Corporation’s increased efforts to expand its deposit relationships with existing customers and the Corporation’s financial strength resulted in the Corporation experiencing a historically high increase in deposits during 2009 in both amount and percentage.
 
The growth of the Corporation’s deposits can be impacted by competition from other investment products, such as mutual funds and various annuity products. These investment products are sold by a wide spectrum of organizations, such as brokerage and insurance companies, as well as by financial institutions. The Corporation also competes with credit unions in most of its markets. These institutions are challenging competitors, as credit unions are exempt from federal income taxes, allowing them to potentially offer higher deposit rates and lower loan rates to customers.
 
In response to the competition for other investment products, Chemical Bank, through its CFC Investment Center program, offers a wide array of mutual funds, annuity products and marketable securities through an alliance with an independent, registered broker/dealer. During 2009 and 2008, customers purchased $110 million and $106 million, respectively, of annuity products, mutual fund and other investments through the CFC Investment Center program.
 
Table 8 presents the maturity distribution of time deposits of $100,000 or more at the end of each of the last three years. Time deposits of $100,000 or more increased $73.0 million, or 21.7%, during 2009 to $409.0 million at December 31, 2009 and increased $38.0 million, or 12.8%, during 2008 to $336.0 million at December 31, 2008. Time deposits of $100,000 or more represented 12.0%, 11.3% and 10.4% of total deposits at December 31, 2009, 2008 and 2007, respectively.
 
TABLE 8. MATURITY DISTRIBUTION OF TIME DEPOSITS OF $100,000 OR MORE
 
                                                 
    December 31,  
    2009     2008     2007  
    Amount     Percent     Amount     Percent     Amount     Percent  
   
    (Dollars in thousands)  
 
Maturity:
                                               
Within 3 months
  $ 128,661       31 %   $ 156,577       47 %   $ 129,801       44 %
After 3 but within 6 months
    80,491       20       48,511       14       50,191       17  
After 6 but within 12 months
    111,296       27       58,134       17       68,308       23  
After 12 months
    88,507       22       72,736       22       49,636       16  
 
 
Total
  $ 408,955       100 %   $ 335,958       100 %   $ 297,936       100 %
 
 
 
BORROWED FUNDS
 
Borrowed funds include short-term borrowings and long-term FHLB advances. Short-term borrowings are comprised of securities sold under agreements to repurchase with customers and short-term FHLB advances that have original maturities of one year or less. Securities sold under agreements to repurchase are funds deposited by customers that were exchanged for investment securities that are owned by Chemical Bank, as these deposits are not covered by FDIC insurance. These funds have been a stable source of liquidity for Chemical Bank, much like its core deposit base. Short-term FHLB advances are generally used to fund short-term liquidity needs. FHLB advances, both short-term and long-term, are secured under a blanket security agreement of real estate residential first lien loans with an aggregate book value equal to at least 155% of the advances and FHLB stock owned by the Corporation. Short-term borrowings are highly interest rate sensitive. Total short-term borrowings were $240.6 million at December 31, 2009, $233.7 million at December 31, 2008 and $197.4 million at December 31, 2007 and were comprised solely of securities sold under agreements to repurchase at these dates. A summary of short-term borrowings for 2009, 2008 and 2007 is included in Note 9 to the consolidated financial statements.
 
Long-term borrowings, comprised solely of FHLB advances, were $90 million at December 31, 2009 and $135 million at December 31, 2008. Long-term FHLB advances are borrowings that are generally used to fund loans and a portion of the investment securities portfolio. At December 31, 2009, long-term FHLB advances that will mature in 2010 totaled $40 million. A summary of FHLB advances outstanding at December 31, 2009 and 2008 is included in Note 10 to the consolidated financial statements.


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CONTRACTUAL OBLIGATIONS AND LOAN COMMITMENTS
 
The Corporation has various financial obligations, including contractual obligations and commitments, which may require future cash payments. The following contractual obligations schedule summarizes the Corporation’s noncancelable contractual obligations and future required minimum payments at December 31, 2009. Refer to Notes 8, 9, 10 and 18 to the consolidated financial statements for a further discussion of these contractual obligations.
 
Contractual Obligations
 
                                         
    December 31, 2009
 
    Minimum Payments Due by Period  
    Less than
                More than
       
    1 year     1-3 years     3-5 years     5 years     Total  
   
    (In thousands)  
 
Deposits with no stated maturity*
  $ 2,131,082     $     $     $     $ 2,131,082  
Certificates of deposit with a stated maturity*
    962,797       243,862       37,368       43,016       1,287,043  
Short-term borrowings*
    240,568                         240,568  
FHLB advances — long-term*
    40,000       25,000       25,000             90,000  
Commitment to fund a low income housing partnership
    223       127                   350  
Commitment to fund a private equity capital investment
    970                         970  
Operating leases and noncancelable contracts
    7,373       7,586       984       37       15,980  
 
 
Total contractual obligations
  $ 3,383,013     $ 276,575     $ 63,352     $ 43,053     $ 3,765,993  
 
 
 
* Deposits and borrowings exclude accrued interest.
 
The Corporation also has loan commitments that may impact liquidity. The following schedule summarizes the Corporation’s loan commitments and expiration dates by period at December 31, 2009. Since many of these commitments historically have expired without being drawn upon, the total amount of these commitments does not necessarily represent future cash requirements of the Corporation. Refer to Note 18 to the consolidated financial statements for a further discussion of these obligations.
 
Loan Commitments
 
                                         
    December 31, 2009
 
    Expiration Dates by Period  
    Less than
                More than
       
    1 year     1-3 years     3-5 years     5 years     Total  
   
                (In thousands)              
 
Unused commitments to extend credit
  $ 276,459     $ 49,969     $ 60,323     $ 26,170     $ 412,921  
Undisbursed loans
    74,888                         74,888  
Standby letters of credit
    31,837       4,507       5,072       25       41,441  
 
 
Total loan commitments
  $ 383,184     $ 54,476     $ 65,395     $ 26,195     $ 529,250  
 
 
 
CASH DIVIDENDS
 
The Corporation’s annual cash dividends paid per common share over the past five years were as follows:
                                         
    2009   2008   2007   2006   2005
 
 
Annual Cash Dividend (per common share)
  $ 1.18     $ 1.18     $ 1.14     $ 1.10     $ 1.06  
 
The Corporation has paid regular cash dividends every quarter since it began operating as a bank holding company in 1973. The compound annual growth rate of the Corporation’s cash dividends paid per common share over the past five-and ten-year periods ended December 31, 2009 was 3.2% and 5.5%, respectively. The earnings of Chemical Bank have been the principal source of funds to pay cash dividends to shareholders. Over the long-term, cash dividends to shareholders are dependent upon earnings, as well as capital requirements, regulatory restraints and other factors affecting Chemical Bank. Due to the strength of the Corporation’s capital position, the Corporation has the financial ability to continue to pay cash dividends to shareholders in excess of the current earnings


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of Chemical Bank. The length of time the Corporation can sustain cash dividends to shareholders in excess of the current earnings of Chemical Bank is dependent on the magnitude of any earnings shortfall, the capital levels of both Chemical Bank and the Corporation and regulatory approval. As of December 31, 2009, Chemical Bank could not pay additional dividends to the Corporation without approval from the Board of Governors of the Federal Reserve System (Federal Reserve), as dividends paid during 2008 exceeded net income of Chemical Bank in 2008 and 2009, combined.
 
CAPITAL
 
Capital supports current operations and provides the foundation for future growth and expansion. Total shareholders’ equity was $474.3 million at December 31, 2009, a decrease of $17.2 million, or 3.5%, from total shareholders’ equity of $491.5 million at December 31, 2008. The decrease in shareholders’ equity in 2009 was attributable to cash dividends paid to shareholders exceeding net income by $18.2 million. Book value per common share at December 31, 2009 and 2008 was $19.85 and $20.58, respectively.
 
Shareholders’ equity decreased $16.9 million in 2008 with $8.3 million of the decrease attributable to cash dividends paid to shareholders exceeding net income of the Corporation. Shareholders’ equity decreased another $11.0 million in 2008 attributable to a net increase in accumulated other comprehensive loss, a component of shareholders’ equity. The increase in accumulated other comprehensive loss was primarily due to a decline in the fair value of pension plan assets. See Notes 1 and 15 to the consolidated financial statements for more information regarding accumulated other comprehensive loss.
 
The ratio of shareholders’ equity to total assets was 11.2% at December 31, 2009, compared to 12.7% at December 31, 2008 and 13.5% at December 31, 2007. The Corporation’s tangible equity to assets ratio was 9.6%, 11.0% and 11.7% at December 31, 2009, 2008 and 2007, respectively.
 
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 Corporation’s various asset categories. These guidelines assign risk weights to on- and off-balance sheet items in arriving at total risk-adjusted assets. Regulatory capital is divided by the computed total of risk-adjusted assets to arrive at the risk-based capital ratios.
 
The Corporation continues to maintain a strong capital position which significantly exceeded the minimum levels prescribed by the Federal Reserve at December 31, 2009, as shown in the following schedule:
                         
    December 31, 2009  
          Risk-Based
 
    Leverage
    Capital Ratios  
    Ratio     Tier 1     Total  
   
 
Chemical Financial Corporation’s capital ratios
    10.1 %     14.2 %     15.5 %
Regulatory capital ratios — minimum requirements
    4.0       4.0       8.0  
 
As of December 31, 2009, the Corporation’s and Chemical Bank’s capital ratios exceeded the minimum required for an institution to be categorized as “well-capitalized,” as defined by applicable regulatory requirements. See Note 19 to the consolidated financial statements for more information regarding the Corporation’s and Chemical Bank’s regulatory capital ratios.
 
From time to time, the board of directors of the Corporation approves common stock repurchase programs allowing management to repurchase shares of the Corporation’s common stock in the open market. The repurchased shares are available for later reissuance in connection with potential future stock dividends, the Corporation’s dividend reinvestment plan, employee benefit plans and other general corporate purposes. Under these programs, the timing and actual number of shares subject to repurchase are at the discretion of management and are contingent on a number of factors, including the projected parent company cash flow requirements and the Corporation’s share price.
 
During 2007, the board of directors of the Corporation authorized management to repurchase 1,000,000 shares of the Corporation’s common stock under a stock repurchase program and accordingly, during 2007, 1,023,000 shares, including 23,000 shares from a previous authorization, were repurchased under the Corporation’s repurchase programs for an aggregate purchase price of $25.5 million. In January 2008, the board of directors of the Corporation authorized management to repurchase up to 500,000 shares of the Corporation’s common stock under a stock repurchase program. Since the January 2008 authorization, no shares have been repurchased. At December 31, 2009, there were 500,000 remaining shares available for repurchase under the Corporation’s stock repurchase programs.


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All repurchases during 2007 were made in compliance with Rule 10b-18 under the Securities Exchange Act of 1934, as amended, which provides a safe harbor for purchases in a given day if an issuer of equity securities satisfies the manner, timing, price and volume conditions of the rule when purchasing its own common shares in the open market.
 
During 2008 and 2007, 38,416 shares and 9,017 shares, respectively, of the Corporation’s common stock were delivered or attested in satisfaction of the exercise price and/or tax withholding obligations by holders of employee stock options. The Corporation’s stock compensation plans permit employees to use stock to satisfy such obligations based on the market value of the stock on the date of exercise. There was no such activity during 2009.
 
NET INTEREST INCOME
 
Interest income is the total amount earned on funds invested in loans, investment and other securities, federal funds sold and other interest-bearing deposits with unaffiliated banks and others. Interest expense is the amount of interest paid on interest-bearing checking and savings accounts, time deposits, short-term borrowings and FHLB advances. Net interest income, on a fully taxable equivalent (FTE) basis, is the difference between interest income and interest expense adjusted for the tax benefit received on tax-exempt commercial loans and investment securities. Net interest margin is calculated by dividing net interest income (FTE) by average interest-earning assets. Net interest spread is the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Because noninterest-bearing sources of funds, or free funds (principally demand deposits and shareholders’ equity), also support earning assets, the net interest margin exceeds the net interest spread.
 
The presentation of net interest income on a FTE basis is not in accordance with GAAP but is customary in the banking industry. This non-GAAP measure ensures comparability of net interest income arising from both taxable and tax-exempt loans and investment securities. The adjustments to determine tax equivalent net interest income were $2.90 million, $2.37 million and $2.25 million for 2009, 2008 and 2007, respectively. These adjustments were computed using a 35% federal income tax rate.
 
Net interest income is the most important source of the Corporation’s earnings and thus is critical in evaluating the results of operations. Changes in the Corporation’s net interest income are influenced by a variety of factors, including changes in the level and mix of interest-earning assets and interest-bearing liabilities, the level and direction of interest rates, the difference between short-term and long-term interest rates (the steepness of the yield curve) and the general strength of the economies in the Corporation’s markets. Risk management plays an important role in the Corporation’s level of net interest income. The ineffective management of credit risk, and more significantly interest rate risk, can adversely impact the Corporation’s net interest income. Management monitors the Corporation’s consolidated statement of financial position to reduce the potential adverse impact on net interest income caused by significant changes in interest rates. The Corporation’s policies in this regard are further discussed under the subheading “Market Risk.”
 
The Federal Reserve influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. The prime interest rate, which is the rate offered on loans to borrowers with strong credit, began 2008 at 7.25% and decreased 200 basis points in the first quarter of 2008, 25 basis points in the third quarter of 2008 and 175 basis points in the fourth quarter of 2008 to end the year at 3.25%. During 2009, the prime interest rate remained at 3.25% for the entire period. The intended federal funds rate has moved in a similar manner to the prime interest rate. The federal funds rates began 2008 at 4.25% and decreased 200 basis points in the first quarter of 2008, 25 basis points in the third quarter of 2008 and 175 to 200 basis points in the fourth quarter of 2008 to end the year at zero to 0.25%. During 2009, the intended federal funds rates remained at zero to 0.25% for the entire period.
 
Net interest income (FTE) in 2009, 2008 and 2007 was $150.3 million, $147.6 million and $132.3 million, respectively. Net interest income (FTE) in 2009 was $2.7 million, or 1.8%, higher than net interest income (FTE) of $147.6 million in 2008. The increase in net interest income (FTE) in 2009 primarily resulted from an increase in the average volume of interest-earning assets, particularly in investments and loans, that was partially offset by a decrease in net interest margin. The average volume of interest-earning assets in 2009 increased $296.4 million, or 8.3%, compared to 2008. Over the same time frame, net interest margin decreased 25 basis points from 4.16% in 2008 to 3.91% in 2009. The decline in net interest margin of 25 basis points during 2009, compared to 2008, was partially attributable to the Corporation’s decision to maintain a higher level of liquidity coupled with a significant increase in nonaccrual loans during 2009. The average yield on interest-earning assets decreased 84 basis points to 5.09% in 2009, from 5.93% in 2008. The average cost of interest-bearing liabilities decreased 82 basis points to 1.51% in 2009, from 2.33% in 2008. The decreases in the yield on interest-earning assets and the cost of interest-bearing liabilities were primarily attributable to the lag effect of the decline in market interest rates during 2008. The yield on the loan portfolio and net interest margin were also slightly adversely impacted in 2009 by an increase in nonaccrual loans of $30.1 million, or 39.4%, during the year to $106.6 million at December 31, 2009.


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Net interest income (FTE) of $147.6 million in 2008 was $15.3 million, or 11.5%, higher than net interest income (FTE) of $132.3 million in 2007. The increase in net interest income (FTE) in 2008, compared to 2007, was primarily attributable to the positive impact of lower short-term interest rates reducing interest expense more than interest income and to a lesser extent attributable to the growth in loans. Net interest margin was 4.16% in 2008, compared to 3.73% in 2007. The increase in net interest margin during 2008, compared to 2007, was primarily attributable to the decrease in the average cost of interest-bearing liabilities significantly exceeding the decrease in the average yield on interest-earning assets. During 2008, the average cost of interest-bearing liabilities decreased 119 basis points to 2.33% while the average yield on interest-earning assets decreased 49 basis points to 5.93%. The significant decrease in the cost of interest-bearing liabilities was attributable to the overall decrease in short-term market interest rates in 2008. The yield on the Corporation’s loan portfolio decreased only 54 basis points in 2008, compared to 2007, due to the loan portfolio being comprised predominately of fixed interest rate loans or loans with interest rates fixed for at least five years. The increase in the net interest margin was also positively impacted by an increase in average loans of $67.3 million, or 2.4%, during 2008. The net interest margin was slightly adversely impacted in 2008 due to an increase in nonaccrual loans of $20.9 million, or 37.5%, during the year to $76.5 million at December 31, 2008.
 
The Corporation’s balance sheet has historically been liability sensitive, meaning that interest-bearing liabilities generally repriced more quickly than interest-earning assets. Therefore, the Corporation’s net interest margin has historically increased in sustained periods of declining interest rates and decreased in sustained periods of increasing interest rates. This interest rate sensitivity position resulted in a significant increase in net interest income in 2008, as compared to 2007. The Corporation is primarily funded by core deposits, and this lower-cost funding base has historically had a positive impact on the Corporation’s net interest income and net interest margin in a declining interest rate environment. However, based on the historically low level of market interest rates and the Corporation’s current low levels of interest rates on its core deposit transaction accounts, further market interest rate reductions would likely not result in a significant decrease in interest expense. The Corporation’s loan portfolio is predominately comprised of fixed interest rate loans. At December 31, 2009 and 2008, approximately 80% of the Corporation’s loans were at fixed rates.
 
The Corporation’s competitive position within many of its market areas has historically limited its ability to materially increase core deposits without adversely impacting the weighted average cost of the deposit portfolio. While competition for core deposits remained strong throughout the Corporation’s markets during 2009, the Corporation’s increased efforts to expand its deposit relationships with existing customers and the Corporation’s financial strength resulted in the Corporation experiencing an increase in deposits during 2009. Total deposits increased $439.3 million, or 14.7%, during the twelve months ended December 31, 2009, while during the same time frame the Corporation experienced a decrease in the average cost of its deposits.
 
During 2009, the Corporation increased its holdings of variable rate investment securities to lessen the impact on net interest income and the net interest margin of rising interest rates. At December 31, 2009, the Corporation held $297 million in variable rate investment securities at carrying value, compared to $155 million at December 31, 2008.
 
Table 9 presents for 2009, 2008 and 2007 average daily balances of the Corporation’s major categories of assets and liabilities, interest income and expense on a FTE basis, average interest rates earned and paid on the assets and liabilities, net interest income (FTE), net interest spread and net interest margin.
 
Table 10 allocates the dollar change in net interest income (FTE) between the portion attributable to changes in the average volume of interest-earning assets and interest-bearing liabilities, including changes in the mix of assets and liabilities and changes in average interest rates earned and paid.


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TABLE 9. AVERAGE BALANCES, TAX EQUIVALENT INTEREST AND EFFECTIVE YIELDS AND RATES* (Dollars in thousands)
 
                                                                         
          Years Ended December 31,
       
    2009     2008     2007  
          Tax
    Effective
          Tax
    Effective
          Tax
    Effective
 
    Average
    Equivalent
    Yield/
    Average
    Equivalent
    Yield/
    Average
    Equivalent
    Yield/
 
    Balance     Interest     Rate     Balance     Interest     Rate     Balance     Interest     Rate  
   
 
ASSETS
                                                                       
Interest-Earning Assets:
                                                                       
Loans**
  $ 2,997,277     $ 173,456       5.79 %   $ 2,873,151     $ 181,568       6.32 %   $ 2,805,880     $ 192,433       6.86 %
Taxable investment securities
    532,844       15,385       2.89       511,109       21,793       4.26       551,806       24,927       4.52  
Tax-exempt investment securities
    93,350       5,425       5.81       69,076       4,309       6.24       62,319       4,013       6.44  
Other securities
    22,128       821       3.71       22,141       1,167       5.27       22,133       1,116       5.04  
Federal funds sold and Interest-bearing deposits with unaffiliated banks and others
    201,407       541       0.27       75,134       1,865       2.48       109,729       5,652       5.15  
 
 
Total interest-earning assets
    3,847,006       195,628       5.09       3,550,611       210,702       5.93       3,551,867       228,141       6.42  
Less: Allowance for loan losses
    70,028                       42,185                       36,224                  
Other Assets:
                                                                       
Cash and cash due from banks
    91,829                       96,094                       93,715                  
Premises and equipment
    53,054                       50,222                       48,908                  
Interest receivable and other assets
    144,368                       129,875                       126,768                  
 
 
Total Assets
  $ 4,066,229                     $ 3,784,617                     $ 3,785,034                  
 
 
                                                                         
LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                        
Interest-Bearing Liabilities:
                                                                       
Interest-bearing demand deposits
  $ 559,026     $ 2,538       0.45 %   $ 509,256     $ 5,226       1.03 %   $ 516,170     $ 12,551       2.43 %
Savings deposits
    925,588       6,230       0.67       792,449       10,804       1.36       744,624       17,816       2.39  
Time deposits
    1,169,201       30,732       2.63       1,084,531       38,733       3.57       1,130,189       50,867       4.50  
Securities sold under agreements to repurchase
    232,185       906       0.39       196,413       2,144       1.09       181,773       6,859       3.77  
FHLB advances — short-term
                      8,593       79       0.92       8,822       468       5.30  
FHLB advances — long-term
    116,050       4,881       4.21       120,171       6,097       5.07       137,236       7,244       5.28  
 
 
Total interest-bearing liabilities
    3,002,050       45,287       1.51       2,711,413       63,083       2.33       2,718,814       95,805       3.52  
Noninterest-bearing deposits
    541,596                       538,125                       532,021                  
 
 
Total deposits and borrowed funds
    3,543,646                       3,249,538                       3,250,835                  
Interest payable and other liabilities
    39,549                       25,979                       28,284                  
Shareholders’ equity
    483,034                       509,100                       505,915                  
 
 
Total Liabilities and Shareholders’ Equity
  $ 4,066,229                     $ 3,784,617                     $ 3,785,034                  
 
 
Net Interest Spread (Average yield earned minus average rate paid)
                    3.58 %                     3.60 %                     2.90 %
 
 
Net Interest Income (FTE)
          $ 150,341                     $ 147,619                     $ 132,336          
 
 
Net Interest Margin
                                                                       
(Net interest income (FTE)/total average interest-earning assets)
                    3.91 %                     4.16 %                     3.73 %
 
 
 
* Taxable equivalent basis using a federal income tax rate of 35%.
 
** Nonaccrual loans and loans held-for-sale are included in average balances reported and are included in the calculation of yields. Also, tax equivalent interest includes net loan fees.


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TABLE 10. VOLUME AND RATE VARIANCE ANALYSIS* (In thousands)
 
                                                 
    2009 Compared to 2008     2008 Compared to 2007  
    Increase (Decrease)
          Increase (Decrease)
       
    Due to Changes in     Combined
    Due to Changes in     Combined
 
    Average
    Average
    Increase
    Average
    Average
    Increase
 
    Volume**     Yield/Rate**     (Decrease)     Volume**     Yield/Rate**     (Decrease)  
   
 
Changes in Interest Income on Interest-Earning Assets:
                                               
Loans
  $ 7,814     $ (15,926 )   $ (8,112 )   $ 4,963     $ (15,828 )   $ (10,865 )
Taxable investment/other securities
    766       (7,520 )     (6,754 )     (1,779 )     (1,304 )     (3,083 )
Tax-exempt investment securities
    1,436       (320 )     1,116       425       (129 )     296  
Federal funds sold and Interest-bearing deposits with unaffiliated banks and others
    1,307       (2,631 )     (1,324 )     (1,411 )     (2,376 )     (3,787 )
 
 
Total change in interest income on interest-earning assets
    11,323       (26,397 )     (15,074 )     2,198       (19,637 )     (17,439 )
 
 
Changes in Interest Expense on Interest-Bearing Liabilities:
                                               
Interest-bearing demand deposits
    615       (3,303 )     (2,688 )     (209 )     (7,116 )     (7,325 )
Savings deposits
    1,365       (5,939 )     (4,574 )     1,920       (8,932 )     (7,012 )
Time deposits
    4,177       (12,178 )     (8,001 )     (1,766 )     (10,368 )     (12,134 )
Short-term borrowings
    255       (1,572 )     (1,317 )     502       (5,606 )     (5,104 )
Federal Home Loan Bank (FHLB) advances
    (204 )     (1,012 )     (1,216 )     (873 )     (274 )     (1,147 )
 
 
Total change in interest expense on interest-bearing liabilities
    6,208       (24,004 )     (17,796 )     (426 )     (32,296 )     (32,722 )
 
 
Total Increase (Decrease) in Net Interest Income (FTE)
  $ 5,115     $ (2,393 )   $ 2,722     $ 2,624     $ 12,659     $ 15,283  
 
 
 
* Taxable equivalent basis using a federal income tax rate of 35%.
 
** The change in interest income and interest expense due to both volume and rate has been allocated to the volume and rate change in proportion to the relationship of the absolute dollar amount of the change in each.
 
NONINTEREST INCOME
 
Noninterest income totaled $41.1 million in 2009, $41.2 million in 2008 and $43.3 million in 2007. Noninterest income in 2009 was consistent with 2008 and declined $2.1 million, or 4.8%, in 2008 compared to 2007. Noninterest income as a percentage of net revenue (net interest income plus noninterest income) was 21.8% in 2009, 22.1% in 2008 and 25.0% in 2007.
 
The following schedule includes the major components of noninterest income during the past three years:
                         
    Years Ended December 31,  
    2009     2008     2007  
   
          (In thousands)        
 
Service charges on deposit accounts
  $ 19,116     $ 20,048     $ 20,549  
Trust and investment services revenue
    9,273       10,625       11,325  
Other fees for customer services
    2,454       2,511       3,031  
ATM and network user fees
    4,023       3,341       2,968  
Insurance commissions
    1,259       1,042       773  
Mortgage banking revenue
    4,412       1,836       2,117  
Investment securities gains
    95       1,722       4  
Other-than-temporary impairment loss on investment security
          (444 )      
Gains on sales of branch bank properties
    58       295       912  
Insurance settlement
    208             1,122  
Other
    221       221       487  
 
 
Total Noninterest Income
  $ 41,119     $ 41,197     $ 43,288  
 
 
 
Service charges on deposit accounts were $19.1 million in 2009, $20.0 million in 2008 and $20.5 million in 2007. The decline of $0.9 million, or 4.6%, in 2009 and the decline of $0.5 million, or 2.4%, in 2008 were primarily attributable to a lower level of customer activity in areas where fees and service charges are applicable and customers choosing alternative non-fee based accounts.


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Trust and investment services revenue was $9.3 million in 2009, $10.6 million in 2008 and $11.3 million in 2007. The declines of $1.4 million, or 12.7%, in 2009 and $0.7 million, or 6.2%, in 2008 were partially due to a reduction in the market value of assets under management, which resulted from general declines in U.S. equity markets. Average assets under management of $1.7 billion during 2009 declined 16.6% from $2.0 billion during 2008. Average assets under management declined 11.9% during 2008 from $2.3 billion during 2007. Trust and investment services revenue also includes fees from sales of investment products offered through the CFC Investment Center program. Fees under this program totaled $2.3 million, $2.8 million and $3.0 million in 2009, 2008 and 2007, respectively.
 
Other fees for customer services were approximately $2.5 million in 2009 and 2008 and $3.0 million in 2007. While 2009 was unchanged from 2008, an increase in safe deposit box revenue, resulting primarily from an increase in 2009 rental rates, was offset by a decrease in the amount of fees earned on outstanding bank money orders. During 2009, the Corporation began processing its bank money orders internally. Prior to this, the Corporation outsourced processing to a third-party vendor, which paid the Corporation fees based on the level of outstanding bank money orders. The decline of $0.5 million, or 17.2%, in 2008, compared with 2007, was primarily attributable to a $0.5 million decrease in the amount of fees earned on outstanding bank money orders.
 
ATM and network user fees were $4.0 million in 2009, $3.3 million in 2008 and $3.0 million in 2007. ATM and network user fees increased $0.7 million, or 20.4%, in 2009 due primarily to an increase in the ATM user fee for non-customers. ATM and network user fees increased $0.4 million, or 12.6%, in 2008 due primarily to increased debit card activity.
 
Insurance commissions were $1.2 million in 2009, $1.0 million in 2008 and $0.8 million in 2007. Insurance commissions increased $0.2 million, or 20.8%, in 2009, compared to 2008, and $0.2 million, or 34.8%, in 2008 from 2007, due to higher closing fees and title insurance premium income from increases in mortgage loan closing activity. This increase in mortgage loan closing activity occurred due to lower market interest rates on residential real estate loans compared to the prior year.
 
Mortgage banking revenue (MBR) was $4.4 million in 2009, $1.8 million in 2008 and $2.1 million in 2007. The increase in mortgage banking revenue in 2009 was primarily due to the increased volume of loans sold in the secondary market compared to 2008 and an increase in the average net gain per loan associated with the sale of these loans. The Corporation originated $467 million of real estate residential loans during 2009, of which $361 million, or 77%, were sold in the secondary market, compared to the origination of $341 million of real estate residential loans during 2008, of which $145 million, or 43%, were sold in the secondary market. In 2007, the Corporation originated $307 million of real estate residential loans, of which $136 million, or 44%, were sold in the secondary market. The decline in MBR in 2008, compared to 2007, was primarily attributable to a decrease in the average net gain per loan sold and an increase in costs associated with selling loans in the secondary market. At December 31, 2009, the Corporation was servicing $755 million of real estate residential loans that had been originated by the Corporation in its market areas and subsequently sold in the secondary mortgage market, up from $604 million at December 31, 2008. The increase in the Corporation’s servicing portfolio in 2009 was due to the significant increase in the volume of loans sold in the secondary market with servicing rights retained.
 
In 2009, the Corporation realized a $0.1 million gain related to the sale of the remaining balance of the Corporation’s MasterCard Class B shares, which had no cost basis. During 2008, the Corporation realized a $1.7 million gain related to the sale of 92% of the Corporation’s MasterCard Class B shares, which had no cost basis.
 
In 2008, the Corporation recognized a $0.4 million other-than-temporary impairment loss on a single issue corporate bond in the Corporation’s available-for-sale investment securities portfolio. The Corporation had no other-than-temporary impairment losses during 2009 or 2007.
 
Gains on sales of branch bank properties totaled $0.1 million in 2009, $0.3 million in 2008 and $0.9 million in 2007. The Corporation sold one building in 2009 and two buildings in 2008. In 2007, the Corporation realized $0.9 million in gains on the sales of a branch office building and a parcel of excess land contiguous to an existing branch office. At December 31, 2009, the Corporation had two branch bank properties held for sale with a total carrying value of $0.1 million.
 
In 2009, the Corporation recognized $0.2 million in nonrecurring noninterest income as the final installment of an insurance settlement for damage incurred to a branch building in 2007 resulting from a fire in an adjacent structure. The Corporation recognized $1.1 million in insurance settlement income in 2007 related to the same event.
 
Noninterest income, excluding revenue from investment securities net gains and losses, gains on sales of branch bank properties and the insurance settlement, was $40.8 million in 2009, $39.6 million in 2008 and $41.2 million in 2007. Noninterest income, excluding these items, increased $1.2 million, or 2.8%, in 2009 and decreased $1.6 million, or 3.9%, in 2008. The increase in 2009, compared to 2008, was primarily attributable to increases in ATM and network user fees, insurance commissions and mortgage banking revenue being partially offset by decreases in service charges on deposit accounts and trust and investment services revenue. The decrease in 2008, compared to 2007, was primarily attributable to decreases in service charges on deposit accounts, trust and investment services revenue, other fees for customer services, mortgage banking revenue and other miscellaneous income being partially offset by increases in ATM and network user fees and insurance commissions.


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OPERATING EXPENSES
 
Total operating expenses were $117.6 million in 2009, $109.1 million in 2008 and $104.7 million in 2007. Total operating expenses as a percentage of total average assets were 2.89% in 2009, 2.88% in 2008 and 2.77% in 2007.
 
The following schedule includes the major categories of operating expenses during the past three years:
                             
    Years Ended December 31,
    2009     2008     2007      
 
    (Dollars in thousands)
 
Salaries and wages
  $ 49,227     $ 48,713     $ 48,651      
Employee benefits
    10,991       10,514       10,357      
Occupancy
    10,359       10,221       10,172      
Equipment
    9,723       9,230       8,722      
Postage and courier
    2,951       3,169       2,841      
Supplies
    1,526       1,482       1,544      
Professional fees
    4,165       3,554       4,382      
Outside processing/service fees
    3,231       3,219       3,495      
Michigan business taxes
    (620 )     (806 )     1,132      
Advertising and marketing
    2,396       2,492       1,854      
Intangible asset amortization
    718       1,543       1,786      
Telephone
    1,840       2,186       1,829      
FDIC insurance premiums
    7,013       899       427      
Other real estate and repossessed asset expenses
    6,031       4,680       2,207      
Loan and collection costs
    3,056       1,592       702      
Non-loan losses
    291       1,473       605      
Other
    4,712       4,947       3,965      
 
 
Total Operating Expenses
  $ 117,610     $ 109,108     $ 104,671      
 
 
Full-time equivalent staff (at December 31)
    1,427       1,416       1,368      
Efficiency ratio
    61.4 %     57.8 %     59.6 %    
 
 
 
Operating expenses were $117.6 million in 2009, an increase of $8.5 million, or 7.8%, compared to 2008. Operating expenses were $109.1 million in 2008, an increase of $4.4 million, or 4.2%, compared to 2007. The increase in 2009, compared to 2008, was primarily due to increases in personnel costs, FDIC insurance premiums, other real estate and repossessed asset expenses and loan and collection costs partially offset by decreases in intangible asset amortization and non-loan losses. The increase in 2008, compared to 2007, was primarily due to increases in other real estate and repossessed asset expenses, loan and collection expenses and other operating expenses that were partially offset by decreases in professional fees and Michigan business taxes.
 
Salaries and wages were $49.2 million in 2009, $48.7 million in 2008 and $48.7 million in 2007. Salaries and wages expense in 2009 was $0.5 million higher than 2008 due to higher costs attributable to merit salary increases and new positions, partially offset by a decrease in mortgage loan originator commissions. Mortgage loan originator commissions decreased as a component of salary expense due to a decrease in the volume of mortgage loans originated for the bank’s loan portfolio in 2009, compared to 2008. Salaries and wages expense in 2008 increased only slightly over 2007 as higher costs attributable to merit salary increases, new positions, higher mortgage loan originator commissions and higher share-based compensation expense were almost entirely offset by savings associated with a 2007 internal reorganization.
 
Employee benefits expense was $11.0 million in 2009, $10.5 million in 2008 and $10.4 million in 2007. Employee benefits expense increased $0.5 million, or 4.5%, in 2009, compared to 2008, due to higher retirement and group health insurance plan costs. Employee benefits expense increased $0.2 million, or 1.5%, in 2008, compared to 2007, due to higher group health insurance costs.
 
Compensation expenses, which include salaries and wages and employee benefits, as a percentage of total operating expenses were 51.2% in 2009, 54.3% in 2008 and 56.4% in 2007. In April 2007, the Corporation announced an internal reorganization that centralized six operational departments and reduced back-office and management staff. The reorganization was complete at December 31, 2007. The Corporation recognized $1.7 million in compensation related expense during 2007 for severance and early retirement costs in conjunction with the internal reorganization. The $1.7 million in reorganization expense was comprised of $1.3 million in severance costs, $0.3 million of early retirement pension cost and $0.1 million of payroll taxes. In December 2005, the board of directors of the Corporation accelerated the vesting of certain unvested “out-of-the-money” nonqualified stock options previously awarded to employees. The acceleration of the vesting of these options reduced non-cash compensation expense in 2009, 2008 and 2007 by $0.1 million, $0.2 million and $0.4 million, respectively, as all unvested awards existing as of January 1, 2006, were required to be recognized as compensation expense on a straight-line basis over the vesting period.


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Occupancy expense was $10.4 million in 2009 and $10.2 million in both 2008 and 2007. The increase in 2009, as compared to 2008, was due to slight increases in building depreciation expense and property taxes on real estate used for bank operations. While occupancy expense in 2008 was unchanged from 2007, building repair and maintenance costs increased $0.4 million in 2008, compared to 2007, which were offset by a $0.3 million decline in losses on the disposal of branches during 2008, compared to 2007. Depreciation expense on buildings included in occupancy expense was $2.4 million, $2.3 million and $2.4 million in 2009, 2008 and 2007, respectively.
 
Equipment expense was $9.7 million in 2009, $9.2 million in 2008 and $8.7 million in 2007. Equipment expense increased $0.5 million, or 5.3%, in 2009, compared to 2008, primarily due to higher depreciation expense associated with equipment upgrades completed in 2008. Equipment expense increased $0.5 million, or 5.8%, in 2008, compared to 2007, due to higher depreciation expense and higher teleprocessing line costs in association with significant upgrades made to telephone, teleprocessing and computer network equipment. Equipment depreciation expense included in equipment expense was $4.0 million, $3.5 million and $3.3 million in 2009, 2008 and 2007, respectively.
 
Professional fees were $4.2 million in 2009, $3.6 million in 2008 and $4.4 million in 2007. Professional fees were $0.6 million, or 17.2%, higher in 2009 than in 2008 due to an increase in consulting expenses attributable to the pending acquisition of OAK totaling $0.8 million, which were partially offset by a decrease in external auditing fees. Professional fees were $0.8 million, or 18.9%, lower in 2008 than in 2007 due to lower consulting and legal fees.
 
Outside processing/service fees were $3.2 million in both 2009 and 2008 and $3.5 million in 2007. The nature and amount of expense components in 2009 were consistent with the prior year. The decrease in outside processing/service fees in 2008, compared to 2007, of $0.3 million, or 7.9%, was primarily attributable to slightly higher costs in 2007 related to a mainframe migration project that increased the capacity, flexibility and functionality of the bank’s core processing system, and also attributable to additional network organization and security costs.
 
Michigan business taxes were $(0.6) million in 2009, $(0.8) million in 2008 and $1.1 million in 2007. The Michigan Single Business Tax (SBT), which expired December 31, 2007, was replaced by the Michigan Business Tax (MBT). The MBT includes a provision for a Financial Institutions Tax (FIT), which applies to all banks, savings banks, bank holding companies and all of their affiliated companies and was effective January 1, 2008. The FIT is a tax on a financial institution’s consolidated capital less both goodwill and certain debt obligations held by the financial institution using a five-year average. The MBT resulted in a reduction of the Corporation’s Michigan business tax expense in 2009 and 2008, compared to SBT expense recorded in 2007. The decline in Michigan business tax expense in both 2009 and 2008, compared to 2007, was also due to the reversal of contingent reserves recorded for the SBT which were no longer required due to the expiration of the statutory audit period. These reserve reversals totaled $0.8 million in 2009, $0.9 million in 2008 and $0.4 million in 2007. In 2008, an additional $0.5 million of previously recorded SBT expenses were reversed based on the successful results of a state tax audit.
 
Other real estate and repossessed assets (ORE) expenses were $6.0 million in 2009, $4.7 million in 2008 and $2.2 million in 2007. ORE expenses include costs to carry ORE such as property taxes, insurance and maintenance costs as well as fair value write-downs after the property was transferred to ORE and net gains/losses from the disposition of ORE. As property values in Michigan declined in late 2008 and 2009, the Corporation recorded write-downs to the carrying value of ORE to fair value, which were recognized as operating costs. Write-downs and net gains/losses from dispositions of ORE were $3.7 million in 2009, compared to $2.9 million in 2008 and $1.2 million in 2007. Property taxes on ORE were $1.1 million in 2009, $0.6 million in 2008 and $0.3 million in 2007. Other operating costs on ORE were $1.2 million in both 2009 and 2008 and $0.7 million in 2007. The increase in other operating costs on ORE in 2008, compared to 2007, was due to increased levels of ORE holdings.
 
Loan and collection expenses were $3.1 million in 2009, $1.6 million in 2008 and $0.7 million in 2007. These costs included legal fees, appraisal fees and other costs realized in the collection of problem loans. The significant increases in these expenses in both 2009 and 2008 were attributable to the continued deterioration in the credit quality of the loan portfolio and corresponding increased costs associated with foreclosing on properties and obtaining title to properties securing loans from customers that defaulted on payments.
 
Advertising and marketing expenses were $2.4 million in 2009, $2.5 million in 2008 and $1.9 million in 2007. Advertising and marketing expenses were similar in 2009 compared to 2008. While the Corporation increased its expenditures for targeted direct mail campaigns in 2009, the Corporation similarly reduced expenditures for more traditional advertising expenses such as newspaper, radio and television. Advertising and marketing expenses of $2.5 million in 2008 were $0.6 million, or 34.4%, higher than in 2007. The increase in advertising and marketing expenses was primarily due to an increase in market research expenses and print and television ad campaign costs.
 
Intangible asset amortization was $0.7 million in 2009, $1.5 million in 2008 and $1.8 million in 2007. Intangible asset amortization declined $0.8 million, or 53.5%, in 2009, compared to 2008. The decrease was due to a number of core deposit intangibles that


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became fully amortized during the latter half of 2008 and early 2009. Intangible asset amortization in 2008, compared to 2007, declined $0.2 million, or 13.6%.
 
FDIC insurance premiums were $7.0 million in 2009, $0.9 million in 2008 and $0.4 million in 2007. The increase in FDIC insurance premiums in 2009 was attributable to an industry-wide FDIC special assessment as of June 30, 2009 and an increase in fee assessment rates that took effect at the beginning of 2009. The special assessment to the Corporation was $1.8 million. FDIC insurance premiums were also higher due to an increase in insurable deposits resulting from deposit growth. The increase in deposit insurance expense during 2009, compared to 2008, was also partially related to the Corporation’s utilization of available credits to offset assessments during 2008, which were fully utilized as of December 31, 2008, and to an additional 10 basis point assessment paid on covered transaction accounts exceeding $0.25 million under the TLGP. The increase in FDIC insurance premiums in 2008, compared to 2007, was attributable to a lower amount of FDIC insurance credits available to reduce the FDIC premium assessments in 2008 than in 2007.
 
Non-loan losses were $0.3 million in 2009, $1.5 million in 2008 and $0.6 million in 2007. Non-loan losses in 2008 included a branch office loss of $0.8 million.
 
All other categories of operating expenses were $11.0 million in 2009, $11.8 million in 2008 and $10.2 million in 2007. The decrease of $0.8 million, or 6.8%, in all other categories of operating expenses in 2009, as compared to 2008, was largely attributable to decreases in postage and courier and telephone expenses. The increase of $1.6 million, or 15.7%, in all other categories of operating expenses in 2008, as compared to 2007, was attributable to increases in postage and courier, telephone and other expenses.
 
The Corporation’s efficiency ratio, which measures total operating expenses divided by the sum of net interest income (FTE) and noninterest income, was 61.4% in 2009, 57.8% in 2008 and 59.6% in 2007. The increase in 2009, compared to 2008, was attributable to higher operating expenses. The decrease in 2008, compared to 2007, was attributable to significantly higher net interest income.
 
INCOME TAXES
 
The Corporation’s effective federal income tax rate was 16.3% in 2009, 29.5% in 2008 and 31.8% in 2007. The fluctuations in the Corporation’s effective federal income tax rate reflect changes each year in the proportion of interest income exempt from federal taxation, nondeductible interest expense and other nondeductible expenses relative to pretax income and tax credits. Based on the Corporation’s assessment of uncertain tax positions during 2009, 2008 and 2007, no adjustments to the federal income tax provision were required. The significant change in the Corporation’s effective federal income tax rate for 2009, compared to 2008, was due to a decrease in the Corporation’s pre-tax income and an increase in interest income exempt from federal taxation, while nondeductible interest expense, other nondeductible expenses and tax credits remained similar to the previous year amounts.
 
Tax-exempt income (FTE), net of related nondeductible interest expense, totaled $8.0 million in 2009, $6.5 million in 2008 and $6.3 million in 2007. Tax-exempt income (FTE) as a percentage of total interest income (FTE) was 4.1% in 2009, 3.1% in 2008 and 2.7% in 2007.
 
Income before income taxes (FTE) was $14.9 million in 2009, $30.5 million in 2008 and $59.5 million in 2007.
 
LIQUIDITY RISK
 
Liquidity risk is the possibility of the Corporation being unable to meet current and future financial obligations in a timely manner and the adverse impact on net interest income if the Corporation was unable to meet its funding requirements at a reasonable cost.
 
Liquidity is managed to ensure stable, reliable and cost-effective sources of funds are available to satisfy deposit withdrawals and lending and investment opportunities. The Corporation’s largest source of liquidity on a consolidated basis is the deposit base that comes from consumer, business and municipal customers within the Corporation’s local markets, principal payments on loans, cash held at the Federal Reserve Bank of Chicago (FRB), unpledged investment securities available-for-sale and federal funds sold. For the year ended December 31, 2009, total deposits increased $439.3 million, or 14.7%, compared to increasing $103.2 million, or 3.6%, during the year ended December 31, 2008. The Corporation’s loan to deposit ratio decreased to 87.6% at December 31, 2009 from 100.1% at December 31, 2008. At December 31, 2009, the Corporation had $223 million of cash deposits held at the FRB that were not invested in federal funds sold due to the low interest rate environment. In addition, at December 31, 2009, the Corporation had $163 million of unpledged investment securities available-for-sale. The Corporation also has available unused wholesale sources of liquidity, including FHLB advances and borrowings from the discount window of the FRB.
 
Chemical Bank is a member of the FHLB and as such has access to short-term and long-term advances from the FHLB secured generally by real estate residential first lien loans. The Corporation considers advances from the FHLB as its primary wholesale source


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of liquidity. FHLB advances decreased $45.1 million during 2009 to $90 million at December 31, 2009. At December 31, 2009, the Corporation’s additional borrowing availability from the FHLB, subject to certain requirements, was $234 million. See the Borrowed Funds section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 10 to the consolidated financial statements for more information on advances from the FHLB. Chemical Bank can also borrow from the FRB’s discount window to meet short-term liquidity requirements. These borrowings are required to be secured by investment securities and/or certain loan types, with each category of assets carrying various borrowing capacity percentages. At December 31, 2009, Chemical Bank maintained an unused borrowing capacity of $30 million with the FRB’s discount window based upon pledged collateral as of that date, although it is management’s opinion that this borrowing capacity could be expanded, if deemed necessary, as Chemical Bank has a significant amount of additional assets that could be used as collateral at the FRB’s discount window.
 
The Corporation manages its liquidity primarily through dividends from Chemical Bank. The Corporation manages its liquidity position to provide the cash necessary to pay dividends to shareholders, invest in new subsidiaries, enter new banking markets, pursue investment opportunities and satisfy other operating requirements. The long-term ability of the Corporation to pay cash dividends to shareholders is dependent on the adequacy of capital and earnings of Chemical Bank.
 
Federal and state banking laws place certain restrictions on the amount of dividends that a bank may pay to its parent company. During 2009, Chemical Bank did not pay any dividends to the Corporation. The Corporation paid cash dividends to shareholders of $28.2 million in 2009. The Corporation’s cash decreased $28.5 million during 2009 to $7.8 million at December 31, 2009, which it held in a deposit account at Chemical Bank as of that date. During 2008, Chemical Bank paid dividends to the Corporation of $59 million, including a one-time $30 million dividend in the fourth quarter for which it was necessary to receive approval from the Federal Reserve. The Corporation paid cash dividends to shareholders of $28.1 million in 2008. The Corporation’s cash increased $32 million during 2008 to $36.3 million at December 31, 2008. The Corporation utilized the $30 million dividend received from Chemical Bank in the fourth quarter of 2008 to pay cash dividends to shareholders during 2009. Dividends paid by Chemical Bank to the Corporation in 2008 exceeded Chemical Bank’s earnings in 2008 and 2009, combined, by $25.8 million and, at December 31, 2009, Chemical Bank could not pay additional dividends to the Corporation without Federal Reserve approval. The earnings of Chemical Bank have been the principal source of funds to pay cash dividends to the Corporation’s shareholders. Over the long term, cash dividends to shareholders are dependent upon earnings, as well as capital requirements, regulatory restraints and other factors affecting Chemical Bank. Due to the strength of the Corporation’s capital position, the Corporation has the financial ability to continue to pay cash dividends to shareholders in excess of the earnings of Chemical Bank. The length of time the Corporation can sustain cash dividends to shareholders in excess of the earnings of Chemical Bank is dependent on the magnitude of any earnings shortfall, the capital levels of both Chemical Bank and the Corporation and regulatory approval.
 
The Corporation maintains a liquidity contingency plan that outlines the process for addressing a liquidity crisis. The plan provides for an evaluation of funding sources under various market conditions. It also assigns specific roles and responsibilities for effectively managing liquidity through a problem period.
 
MARKET RISK
 
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due primarily to changes in interest rates. Interest rate risk is the Corporation’s primary market risk and results from timing differences in the repricing of interest rate sensitive assets and liabilities and changes in relationships between rate indices due to changes in interest rates. The Corporation’s net interest income is largely dependent upon the effective management of interest rate risk. The Corporation’s goal is to avoid a significant decrease in net interest income, and thus an adverse impact on the profitability of the Corporation, in periods of changing interest rates. Sensitivity of earnings to interest rate changes arises when yields on assets change differently from the interest costs on liabilities. Interest rate sensitivity is determined by the amount of interest-earning assets and interest-bearing liabilities repricing within a specific time period and the magnitude by which interest rates change on the various types of interest-earning assets and interest-bearing liabilities. The management of interest rate sensitivity includes monitoring the maturities and repricing opportunities of interest-earning assets and interest-bearing liabilities. The Corporation’s interest rate risk is managed through policies and risk limits approved by the boards of directors of the Corporation and Chemical Bank and an Asset and Liability Committee (ALCO). The ALCO, which is comprised of executive management from various areas of the Corporation and Chemical Bank, including finance, lending, investments and deposit gathering, meets regularly to execute asset and liability management strategies. The ALCO establishes guidelines and monitors the sensitivity of earnings to changes in interest rates. The goal of the ALCO process is to maximize net interest income and the net present value of future cash flows within authorized risk limits.
 
The primary technique utilized by the Corporation to measure its interest rate risk is simulation analysis. Simulation analysis forecasts the effects on the balance sheet structure and net interest income under a variety of scenarios that incorporate changes in interest rates, the shape of the Treasury yield curve, interest rate relationships and the mix of assets and liabilities and loan prepayments. These forecasts are compared against net interest income projected in a stable interest rate environment. While many assets and liabilities reprice either at maturity or in accordance with their contractual terms, several balance sheet components demonstrate characteristics


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that require an evaluation to more accurately reflect their repricing behavior. Key assumptions in the simulation analysis include prepayments on loans, probable calls of investment securities, changes in market conditions, loan volumes and loan pricing, deposit sensitivity and customer preferences. These assumptions are inherently uncertain as they are subject to fluctuation and revision in a dynamic environment. As a result, the simulation analysis cannot precisely forecast the impact of rising and falling interest rates on net interest income. Actual results will differ from simulated results due to many other factors, including changes in balance sheet components, interest rate changes, changes in market conditions and management strategies.
 
The Corporation’s interest rate sensitivity is estimated by first forecasting the next twelve months of net interest income under an assumed environment of constant market interest rates. The Corporation then compares the results of various simulation analyses to the constant interest rate forecast. At December 31, 2009 and 2008, the Corporation projected the change in net interest income during the next twelve months assuming short-term market interest rates were to uniformly and gradually increase or decrease by up to 200 basis points in a parallel fashion over the entire yield curve during the same time period. These projections were based on the Corporation’s assets and liabilities remaining static over the next twelve months, while factoring in probable calls and prepayments of certain investment securities and real estate residential mortgage and consumer loans. The ALCO regularly monitors the Corporation’s forecasted net interest income sensitivity to ensure that it remains within established limits.
 
A summary of the Corporation’s interest rate sensitivity at December 31, 2009 and 2008 is as follows:
                                                 
December 31, 2009
                                               
Twelve Month Interest Rate Change
Projection (in basis points)
    −200       −100       0       +100       +200          
 
 
                                                 
Percent change in net interest income vs. constant rates
    (3.0 )%     (1.6 )%           0.6 %     0.0 %        
                                                 
December 31, 2008
                                               
Twelve Month Interest Rate Change Projection (in basis points)
    −200       −100       0       +100       +200          
 
 
Percent change in net interest income vs. constant rates
    (3.9 )%     (1.8 )%           1.1 %     1.1 %        
 
At December 31, 2009, the Corporation’s model simulations projected that 100 and 200 basis point increases in interest rates would result in positive variances in net interest income of 0.6% and 0.0%, respectively, relative to the base case over the next 12 month period, while a decrease in interest rates of 100 and 200 basis points would result in a negative variance in net interest income of 1.6% and 3.0%, respectively, relative to the base case over the next 12 month period. At December 31, 2008, the model simulations projected that 100 and 200 basis point increases in interest rates would result in positive variances in net interest income of 1.1% under both scenarios relative to the base case over the next 12 month period, while a decrease in interest rates of 100 and 200 basis points would result in a negative variance in net interest income of 1.8% and 3.9%, respectively, relative to the base case over the next 12 month period. The likelihood of a decrease in interest rates beyond 100 basis points as of December 31, 2009 and 2008 was considered to be unlikely given prevailing interest rate levels.
 
The Corporation’s mix of interest-earning assets and interest-bearing liabilities has historically resulted in its interest rate position being liability sensitive. The Corporation modestly adjusted its liability sensitive position by significantly increasing the amount of variable rate investment securities in its investment securities portfolio. Variable rate investment securities of $297 million comprised 41% of total investment securities at December 31, 2009, compared to $155 million, or 28% of total investment securities, at December 31, 2008.


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MANAGEMENT’S ASSESSMENT AS TO THE EFFECTIVENESS
OF INTERNAL CONTROL OVER FINANCIAL REPORTING
 
Management of the Corporation is responsible for establishing and maintaining effective internal control over financial reporting that is designed to provide reasonable assurance regarding reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. The system of internal control over financial reporting as it relates to the financial statements is evaluated for effectiveness by management and tested for reliability through a program of internal audits. Actions are taken to correct potential deficiencies as they are identified. Any system of internal control, no matter how well designed, has inherent limitations, including the possibility that a control can be circumvented or overridden and misstatements due to error or fraud may occur and not be detected. Also, because of changes in conditions, internal control effectiveness may vary over time. Accordingly, even an effective system of internal control will provide only reasonable assurance with respect to financial reporting and financial statement preparation.
 
Management assessed the Corporation’s system of internal control over financial reporting as of December 31, 2009, as required by Section 404 of the Sarbanes-Oxley Act of 2002. Management’s assessment is based on the criteria for effective internal control over financial reporting as described in “Internal Control — Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management has concluded that, as of December 31, 2009, its system of internal control over financial reporting was effective and meets the criteria of the “Internal Control — Integrated Framework.” The Corporation’s independent registered public accounting firm that audited the Corporation’s consolidated financial statements included in this annual report has issued an attestation report on the Corporation’s internal control over financial reporting as of December 31, 2009.
 
     
-s- David B. Ramaker   -s- Lori A. Gwizdala
David B. Ramaker
  Lori A. Gwizdala
Chairman, Chief Executive Officer
  Executive Vice President, Chief Financial Officer
and President
  and Treasurer
     
February 25, 2010
  February 25, 2010


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
The Board of Directors and Shareholders
Chemical Financial Corporation:
 
We have audited Chemical Financial Corporation’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). Chemical Financial Corporation’s management is responsible 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 Management’s Assessment as to the Effectiveness of Internal Control over Financial Reporting. Our responsibility is to express an opinion on Chemical Financial Corporation’s internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit 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 audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
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, Chemical 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.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial position of Chemical Financial Corporation and subsidiaries as of December 31, 2009 and 2008, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2009, and our report dated February 25, 2010 expressed an unqualified opinion on those consolidated financial statements.
 
-s- KPMG LLp
 
 
Detroit, Michigan
February 25, 2010


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
The Board of Directors and Shareholders
Chemical Financial Corporation:
 
We have audited the accompanying consolidated statements of financial position of Chemical Financial Corporation and subsidiaries (the Corporation) as of December 31, 2009 and 2008, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the years in the three year period ended December 31, 2009. These consolidated financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Chemical Financial Corporation and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Chemical Financial Corporation’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, and our report dated February 25, 2010 expressed an unqualified opinion on the effectiveness of the Corporation’s internal control over financial reporting.
 
-s- KPMG LLp
 
 
Detroit, Michigan
February 25, 2010


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CONSOLIDATED FINANCIAL STATEMENTS
 
CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
 
                 
    December 31,  
    2009     2008  
   
    (In thousands, except share data)  
 
ASSETS
               
Cash and cash equivalents:
               
Cash and cash due from banks
  $ 131,383     $ 168,650  
Interest-bearing deposits with unaffiliated banks and others
    229,326       4,572  
 
 
Total cash and cash equivalents
    360,709       173,222  
Investment securities:
               
Available-for-sale at fair value
    592,521       449,947  
Held-to-maturity (fair value — $125,730 at December 31, 2009 and 90,556 at December 31, 2008)
    131,297       97,511  
 
 
Total investment securities
    723,818       547,458  
Other securities
    22,128       22,128  
Loans held for sale
    8,362       8,463  
Loans
    2,993,160       2,981,677  
Allowance for loan losses
    (80,841 )     (57,056 )
 
 
Net loans
    2,912,319       2,924,621  
Premises and equipment
    53,934       53,036  
Goodwill
    69,908       69,908  
Other intangible assets
    5,408       5,241  
Interest receivable and other assets
    94,126       70,236  
 
 
TOTAL ASSETS
  $ 4,250,712     $ 3,874,313  
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Deposits:
               
Noninterest-bearing
  $ 573,159     $ 524,464  
Interest-bearing
    2,844,966       2,454,328  
 
 
Total deposits
    3,418,125       2,978,792  
Interest payable and other liabilities
    27,708       35,214  
Short-term borrowings
    240,568       233,738  
Federal Home Loan Bank (FHLB) advances
    90,000       135,025  
 
 
Total liabilities
    3,776,401       3,382,769  
Shareholders’ equity:
               
Preferred stock, no par value:
               
Authorized — 200,000 shares, none issued
           
Common stock, $1 par value per share:
               
Authorized — 30,000,000 shares
               
Issued and outstanding — 23,891,321 shares at December 31, 2009 and 23,880,593 shares at December 31, 2008
    23,891       23,881  
Additional paid in capital
    347,676       346,916  
Retained earnings
    115,391       133,578  
Accumulated other comprehensive loss
    (12,647 )     (12,831 )
 
 
Total shareholders’ equity
    474,311       491,544  
 
 
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
  $ 4,250,712     $ 3,874,313  
 
 
 
See accompanying notes to consolidated financial statements.


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CONSOLIDATED STATEMENTS OF INCOME
 
                         
    Years Ended December 31,  
    2009     2008     2007  
   
    (In thousands, except per share data)  
 
INTEREST INCOME
                       
Interest and fees on loans
  $ 172,388     $ 180,629     $ 191,480  
Interest on investment securities:
                       
Taxable
    15,385       21,793       24,927  
Tax-exempt
    3,596       2,882       2,719  
Dividends on other securities
    821       1,167       1,116  
Interest on federal funds sold
          1,666       5,135  
Interest on deposits with unaffiliated banks and others
    541       199       517  
 
 
TOTAL INTEREST INCOME
    192,731       208,336       225,894  
INTEREST EXPENSE
                       
Interest on deposits
    39,500       54,763       81,234  
Interest on short-term borrowings
    906       2,223       7,327  
Interest on FHLB advances
    4,881       6,097       7,244  
 
 
TOTAL INTEREST EXPENSE
    45,287       63,083       95,805  
 
 
NET INTEREST INCOME
    147,444       145,253       130,089  
Provision for loan losses
    59,000       49,200       11,500  
 
 
NET INTEREST INCOME after provision for loan losses
    88,444       96,053       118,589  
NONINTEREST INCOME
                       
Service charges on deposit accounts
    19,116       20,048       20,549  
Trust and investment services revenue
    9,273       10,625       11,325  
Other charges and fees for customer services
    7,736       6,894       6,772  
Mortgage banking revenue
    4,412       1,836       2,117  
Investment securities gains
    95       1,722       4  
Other-than-temporary impairment loss on investment security
          (444 )      
Other
    487       516       2,521  
 
 
TOTAL NONINTEREST INCOME
    41,119       41,197       43,288  
OPERATING EXPENSES
                       
Salaries, wages and employee benefits
    60,218       59,227       59,008  
Occupancy
    10,359       10,221       10,172  
Equipment
    9,723       9,230       8,722  
Other
    37,310       30,430       26,769  
 
 
TOTAL OPERATING EXPENSES
    117,610       109,108       104,671  
 
 
INCOME BEFORE INCOME TAXES
    11,953       28,142       57,206  
Federal income tax expense
    1,950       8,300       18,197  
 
 
NET INCOME
  $ 10,003     $ 19,842     $ 39,009  
 
 
NET INCOME PER COMMON SHARE
                       
Basic
  $ 0.42     $ 0.83     $ 1.60  
Diluted
    0.42       0.83       1.60  
CASH DIVIDENDS PAID PER COMMON SHARE
    1.18       1.18       1.14  
 
See accompanying notes to consolidated financial statements.


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CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
 
                                         
    Years Ended December 31, 2009, 2008 and 2007  
       
                      Accumulated
       
                      Other
       
    Common
    Additional
    Retained
    Comprehensive
       
(In thousands, except per share data)   Stock     Paid in Capital     Earnings     Loss     Total  
   
 
BALANCES AT JANUARY 1, 2007
  $ 24,828     $ 368,554     $ 123,454     $ (8,950 )   $ 507,886  
Impact of adoption of new accounting guidance (see Note 17)
                    40               40  
Comprehensive income:
                                       
Net income for 2007
                    39,009                  
Other:
                                       
Net unrealized gains on investment securities available-for-sale, net of tax expense of $2,991
                            5,556          
Reclassification adjustment for realized net gain on call of investment securities included in net income, net of tax expense of $1
                            (3 )        
Adjustment for pension and other postretirement benefits, net of tax expense of $861
                            1,600          
Comprehensive income
                                    46,162  
Cash dividends declared and paid of $0.855 per share
                    (20,636 )             (20,636 )
Shares issued — stock options
    2       31                       33  
Shares issued — directors’ stock purchase plan
    7       216                       223  
Shares issued — share awards
    1       44                       45  
Repurchases of shares
    (1,023 )     (24,488 )                     (25,511 )
Share-based compensation
            222                       222  
 
 
BALANCES AT DECEMBER 31, 2007
    23,815       344,579       141,867       (1,797 )     508,464  
Comprehensive income:
                                       
Net income for 2008
                    19,842                  
Other:
                                       
Net unrealized gains on investment securities available-for-sale, net of tax expense of $606
                            1,125          
Reclassification adjustment for other-than-temporary impairment loss realized on investment security included in net income, net of tax benefit of $156
                            289          
Adjustment for pension and other postretirement benefits, net of tax benefit of $6,703
                            (12,448 )        
Comprehensive income
                                    8,808  
Cash dividends declared and paid of $1.18 per share
                    (28,131 )             (28,131 )
Shares issued — stock options
    58       1,450                       1,508  
Shares issued — directors’ stock purchase plan
    8       223                       231  
Share-based compensation
            664                       664  
 
 
BALANCES AT DECEMBER 31, 2008
    23,881       346,916       133,578       (12,831 )     491,544  
Comprehensive income:
                                       
Net income for 2009
                    10,003                  
Other:
                                       
Net unrealized gains on investment securities available-for-sale, net of tax expense of $42
                            79          
Reclassification adjustment for realized gain on call of investment security — available-for-sale included in net income, net of tax expense of $6
                            (11 )        
Adjustment for pension and other postretirement benefits, net of tax expense of $63
                            116          
Comprehensive income
                                    10,187  
Cash dividends declared and paid of $1.18 per share
                    (28,190 )             (28,190 )
Shares issued — stock options
    1       35                       36  
Shares issued — directors’ stock purchase plan
    9       235                       244  
Share-based compensation
            490                       490  
 
 
BALANCES AT DECEMBER 31, 2009
  $ 23,891     $ 347,676     $ 115,391     $ (12,647 )   $ 474,311  
 
 
 
See accompanying notes to consolidated financial statements.


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CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                                 
    Years Ended December 31,        
    2009     2008     2007        
         
    (In thousands)        
 
OPERATING ACTIVITIES
                               
Net income
  $ 10,003     $ 19,842     $ 39,009          
Adjustments to reconcile net income to net cash provided by operating activities:
                               
Provision for loan losses
    59,000       49,200       11,500          
Gains on sales of loans
    (6,431 )     (1,790 )     (1,289 )        
Proceeds from sales of loans
    367,796       147,172       137,056          
Loans originated for sale
    (361,264 )     (145,943 )     (137,983 )        
Investment securities net gains
    (95 )     (1,722 )     (4 )        
Other-than-temporary impairment loss on investment security
          444                
Net gains on sales of other real estate and repossessed assets
    (969 )     (283 )     (181 )        
Gains on sales of branch bank properties
    (58 )     (295 )     (912 )        
Gain on insurance settlement
    (208 )           (1,122 )        
Net losses on disposal of premises and equipment
    104       53       406          
Depreciation of premises and equipment
    6,429       5,878       5,688          
Amortization of intangible assets
    2,569       2,613       2,781          
Net amortization of premiums and discounts on investment securities
    815       625       516          
Share-based compensation expense
    490       664       222          
Deferred income tax provision
    (6,977 )     (6,882 )     (2,981 )        
Contributions to defined benefit pension plan
    (7,500 )                    
Net (increase) decrease in interest receivable and other assets
    (17,973 )     (12,284 )     4,884          
Net increase in interest payable and other liabilities
    306       12,378       907          
 
 
NET CASH PROVIDED BY OPERATING ACTIVITIES
    46,037       69,670       58,497          
INVESTING ACTIVITIES
                               
Investment securities — available-for-sale:
                               
Proceeds from maturities, calls and principal reductions
    264,998       161,375       137,486          
Proceeds from sales
    78       1,724                
Purchases
    (408,344 )     (107,417 )     (111,702 )        
Investment securities — held-to-maturity:
                               
Proceeds from maturities, calls and principal reductions
    41,511       67,560       28,847          
Purchases
    (75,219 )     (73,356 )     (25,682 )        
Other securities:
                               
Proceeds from redemption
          14                
Purchases
          (7 )     (5 )        
Net increase in loans
    (64,754 )     (235,110 )     (6,825 )        
Proceeds from sales of other real estate and repossessed assets
    16,950       9,802       4,298          
Proceeds from insurance settlement
    208             1,122          
Proceeds from sales of branch bank properties
    225       554       1,825          
Purchases of premises and equipment, net
    (7,431 )     (9,262 )     (7,012 )        
 
 
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES
    (231,778 )     (184,123 )     22,352          
FINANCING ACTIVITIES
                               
Net increase in noninterest-bearing and interest-bearing demand deposits and savings accounts
    222,222       111,554       38,468          
Net increase (decrease) in time deposits
    217,111       (8,351 )     (60,964 )        
Net increase in securities sold under agreements to repurchase
    6,830       36,375       18,394          
Increase in short-term FHLB advances
          250,000                
Repayment of short-term FHLB advances
          (250,000 )     (30,000 )        
Increase in long-term FHLB advances
          65,000       35,000          
Repayment of long-term FHLB advances
    (45,025 )     (80,024 )     (30,023 )        
Cash dividends paid
    (28,190 )     (28,131 )     (27,712 )        
Proceeds from directors’ stock purchase plan
    244       231       223          
Tax benefits from share-based awards
          140       12          
Proceeds from exercise of stock options
    36       1,368       21          
Repurchases of common shares
                (25,511 )        
 
 
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
    373,228       98,162       (82,092 )        
 
 
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    187,487       (16,291 )     (1,243 )        
Cash and cash equivalents at beginning of year
    173,222       189,513       190,756          
 
 
CASH AND CASH EQUIVALENTS AT END OF YEAR
  $ 360,709     $ 173,222     $ 189,513          
 
 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
                               
Interest paid
  $ 46,232     $ 64,629     $ 96,039          
Federal income taxes paid
    9,725       16,881       20,165          
Loans transferred to other real estate and repossessed assets
    18,056       21,282       8,875          
Investment securities — available-for-sale transferred to
Investment securities — held-to-maturity
          502                
Closed branch bank properties transferred to other assets
          225                
 
See accompanying notes to consolidated financial statements.


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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Nature of Operations:
 
Chemical Financial Corporation (the Corporation) operates in a single operating segment — commercial banking. The Corporation is a financial holding company, headquartered in Midland, Michigan, that operates through one commercial bank, Chemical Bank. Chemical Bank operates within the State of Michigan as a state-chartered commercial bank. Chemical Bank operates through an internal organizational structure of four regional banking units and offers a full range of commercial banking and fiduciary products and services to the residents and business customers in the bank’s geographical market areas. The products and services offered by the regional banking units, through branch banking offices, are generally consistent throughout the Corporation, as is the pricing of those products and services. The marketing of products and services throughout the Corporation’s regional banking units is generally uniform, as many of the markets served by the regional banking units overlap. The distribution of products and services is uniform throughout the Corporation’s regional banking units and is achieved primarily through retail branch banking offices, automated teller machines and electronically accessed banking products.
 
The Corporation’s primary sources of revenue are from its loan products and investment securities.
 
Accounting Standards Codification:
 
The Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) became effective on July 1, 2009. At that date, the ASC became FASB’s officially recognized source of authoritative U.S. generally accepted accounting principles (GAAP) applicable to all public and non-public non-governmental entities, superseding existing FASB, American Institute of Certified Public Accountants (AICPA), Emerging Issues Task Force (EITF) and related literature. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under the authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. All other accounting literature is considered non-authoritative. The switch to the ASC affects the way companies refer to GAAP in financial statements and accounting policies.
 
Basis of Presentation and Principles of Consolidation:
 
The accounting and reporting policies of the Corporation and its subsidiaries conform to GAAP and prevailing practices within the banking industry. The consolidated financial statements of the Corporation include the accounts of the Corporation and its wholly owned subsidiaries. All significant income and expenses are recorded on the accrual basis. Intercompany accounts and transactions have been eliminated in preparing the consolidated financial statements.
 
The Corporation consolidates variable interest entities (VIEs) in which it is the primary beneficiary. In general, a VIE is an entity that either (1) has an insufficient amount of equity to carry out its principal activities without additional subordinated financial support, (2) has a group of equity owners that are unable to make significant decisions about its activities or (3) has a group of equity owners that do not have the obligation to absorb losses or the right to receive return as generated by its operations. If any of these characteristics are present, the entity is subject to a variable interests consolidation model, and consolidation is based on variable interests, not on ownership of the entity’s outstanding voting stock. Variable interests are defined as contractual, ownership, or other monetary interests in an entity that change with fluctuations in the entity’s net asset value. The primary beneficiary consolidates the VIE; the primary beneficiary is defined as the enterprise that absorbs a majority of expected losses or receives a majority of residual returns (if the losses or returns occur), or both.
 
The Corporation is a significant limited partner in one low income housing tax credit partnership. This entity meets the definition of a VIE. The Corporation is not the primary beneficiary of the VIE in which it holds an interest, and therefore the equity investment in the VIE is not consolidated in the financial statements. Exposure to loss as a result of its involvement with this entity at December 31, 2009 was limited to approximately $0.7 million recorded as the Corporation’s investment, which includes unfunded obligations to this project of $0.4 million. The Corporation’s investment in the project is recorded in interest receivable and other assets and the future financial obligation to this project is recorded in interest payable and other liabilities in the consolidated statement of financial position at December 31, 2009.


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Use of Estimates:
 
Management makes estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying footnotes. Estimates that are particularly susceptible to significant change include the determination of the allowance for loan losses, pension expense, income taxes, goodwill and those assets that require fair value measurement. Actual results could differ from these estimates. Significant accounting policies of the Corporation and its subsidiaries are described below:
 
Cash and Cash Equivalents:
 
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, interest-bearing deposits with unaffiliated banks and others and federal funds sold. Generally, federal funds are sold for one-day periods. Amounts reported under interest-bearing deposits with unaffiliated banks and others include interest-bearing savings and time deposits held at other financial institutions and overnight funds held at the Federal Reserve Bank in lieu of federal funds sold.
 
Investment Securities:
 
Investment securities include investments in debt and trust preferred securities. Investment securities are accounted for in accordance with FASB ASC Topic 320, Investments-Debt and Equity Securities (ASC 320), which requires investments to be classified within one of three categories (trading, held-to-maturity or available-for-sale), based on the type of security and management’s intent with regard to selling the security. The Corporation held no trading investment securities during the three-year period ended December 31, 2009.
 
Designation as an investment security held-to-maturity is based on the Corporation’s intent and ability to hold the security to maturity. Investment securities held-to-maturity are stated at cost, adjusted for purchase price premiums and discounts. Investment securities that are not held-to-maturity are accounted for as securities available-for-sale, and are stated at estimated fair value, with the aggregate unrealized gains and losses, not deemed other-than-temporary, classified as a component of accumulated other comprehensive income (loss), net of income taxes. Realized gains and losses on the sale of investment securities and other-than-temporary impairment (OTTI) charges are determined using the specific identification method and are included within noninterest income in the consolidated statements of income. Premiums and discounts on investment securities are amortized over the estimated lives of the related investment securities based on the effective interest yield method and are included in interest income in the consolidated statements of income.
 
The Corporation assesses equity and debt securities that have fair values below amortized cost basis to determine whether declines (impairment) are other-than-temporary. Impairment is other-than-temporary if the assessment concludes that it is probable that the holder will be unable to collect all amounts due according to the contractual terms of the debt instrument or in instances where the debt instrument will mature or be disposed of before a full recovery of its amortized cost.
 
Effective April 1, 2009, in accordance with FASB Staff Position FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (later codified in ASC 320), the Corporation began accounting for declines in the fair value of held-to-maturity and available-for-sale investment securities below their cost that are deemed to be other-than-temporary through earnings as realized losses to the extent the impairment is related to credit losses. The amount of the impairment related to other factors is recognized in other comprehensive income (loss), net of income taxes. Prior to April 1, 2009, all declines in fair value deemed to be other-than-temporary were reflected in earnings as realized losses. In estimating OTTI losses, management considers, among other things, (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, (iii) the intent of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery of amortized cost and (iv) whether it is more likely-than-not that the Corporation will be required to sell its investment prior to recovery.
 
Other Securities:
 
Other securities consisted of Federal Home Loan Bank of Indianapolis (FHLB) stock of $16.2 million at December 31, 2009 and 2008, and Federal Reserve Bank (FRB) stock of $5.9 million at December 31, 2009 and 2008. Other securities are recorded at cost or par, which is deemed to be the net realizable value of these assets. The Corporation is required to own FHLB stock and FRB stock in accordance with its membership in these organizations. The FHLB requires its members to provide a five-year advance notice of any request to redeem FHLB stock.


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Loans:
 
Loans are stated at their principal amount outstanding. Interest income on loans is reported based on the level-yield method and includes amortization of deferred loan fees and costs over the loan term. Net loan commitment fees for commitment periods greater than one year are deferred and amortized into fee income on a straight-line basis over the commitment period.
 
Loan interest income is recognized on the accrual basis. The past due status of a loan is based on the loan’s contractual terms. A loan is placed in the nonaccrual category when principal or interest is past due 90 days or more, unless the loan is both well-secured and in the process of collection, or earlier when, in the opinion of management, there is sufficient reason to doubt the collectibility of principal or interest. Interest previously accrued, but not collected, is reversed and charged against interest income at the time the loan is placed in nonaccrual status. The subsequent recognition of interest income on a nonaccrual loan is then recognized only to the extent cash is received and where future collection of principal is probable. Loans are returned to accrual status when principal and interest payments are brought current, payments have been received consistently for a period of time and collectibility is no longer in doubt.
 
Nonperforming loans are comprised of those loans accounted for on a nonaccrual basis, accruing loans contractually past due 90 days or more as to interest or principal payments and loans modified under troubled debt restructurings.
 
All nonaccrual commercial, real estate commercial and real estate construction-commercial loans and loans modified under troubled debt restructurings have been determined by the Corporation to meet the definition of an impaired loan. In addition, other commercial, real estate commercial and real estate construction-commercial loans may be considered an impaired loan. A loan is defined to be impaired when it is probable that payment of principal and interest will not be made in accordance with the contractual terms of the loan agreement. Impaired loans are carried at the present value of expected cash flows discounted at the loan’s effective interest rate or at the estimated fair value of the collateral, if the loan is collateral dependent. A portion of the allowance for loan losses may be allocated to impaired loans. All impaired loans are evaluated individually to determine whether or not a valuation allowance is required.
 
Allowance for Loan Losses:
 
The allowance for loan losses (allowance) is presented as a reserve against loans. The allowance represents management’s assessment of probable losses inherent in the Corporation’s loan portfolio.
 
Management’s evaluation of the adequacy of the allowance is based on a continuing review of the loan portfolio, actual loan loss experience, the underlying value of the collateral, risk characteristics of the loan portfolio, the level and composition of nonperforming loans, the financial condition of the borrowers, the balance of the loan portfolio, loan growth, economic conditions, employment levels in the Corporation’s local markets, and special factors affecting specific business sectors. The Corporation maintains formal policies and procedures to monitor and control credit risk.
 
The allowance provides for probable losses that have been identified with specific customer relationships and for probable losses believed to be inherent in the loan portfolio, but that have not been specifically identified. The Corporation utilizes its own loss experience to estimate inherent losses on loans. Internal risk ratings are assigned to each commercial, real estate commercial and real estate construction-commercial loan at the time of approval and are subject to subsequent periodic reviews by senior management. The Corporation performs a detailed credit quality review quarterly on all large loans that have deteriorated below certain levels of credit risk, and may allocate a specific portion of the allowance to such loans based upon this review. A portion of the allowance is allocated to the remaining loans by applying projected loss ratios, based on numerous factors. Projected loss ratios incorporate factors such as recent charge-off experience, trends with respect to adversely risk-rated commercial, real estate commercial and real estate construction-commercial loans, trends with respect to past due and nonaccrual loans, changes in economic conditions and trends, changes in the value of underlying collateral and other credit risk factors. This evaluation involves a high degree of uncertainty.
 
Management maintains an unallocated allowance to recognize the uncertainty and imprecision underlying the process of estimating projected loan losses. Determination of the probable losses inherent in the portfolio, which are not necessarily captured by the allocation methodology discussed above, involves the exercise of judgment. The unallocated allowance associated with the imprecision in the risk rating system is based generally on a historical evaluation of the accuracy of the risk ratings associated with loans.
 
Although the Corporation allocates portions of the allowance to specific loans and loan portfolios, the entire allowance is available for any loan losses that occur. Loans that are deemed not collectible are charged off and deducted from the allowance. The provision for loan losses and recoveries on loans previously charged off are added to the allowance. Collection efforts may continue and recoveries may occur after a loan is charged off against the allowance.
 
Various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses. Such agencies may require additions to the allowance based on their judgment reflecting information available to them at the time of their examinations.


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Mortgage Banking Operations:
 
The origination of real estate residential (mortgage) loans is an integral component of the business of the Corporation. The Corporation generally sells its originations of long-term fixed interest rate residential mortgage loans in the secondary market. Gains and losses on the sales of these loans are determined using the specific identification method. The Corporation sells mortgage loans in the secondary market on either a servicing retained or released basis.
 
Mortgage loans held for sale are carried at the lower of aggregate cost or market. The value of mortgage loans held for sale and other residential mortgage loan commitments to customers are hedged by utilizing best efforts forward commitments to sell loans to investors in the secondary market. Such forward commitments are generally entered into at the time when applications are taken to protect the value of the mortgage loans from increases in market interest rates during the period held. Mortgage loan commitments to customers totaled $18.2 million at December 31, 2009 and $66.2 million at December 31, 2008. Mortgage loans originated for sale are generally sold within 45 days after closing.
 
The Corporation recognizes revenue associated with the expected future cash flows of servicing loans at the time a forward loan sales commitment is made, as required under Securities and Exchange Commission Staff Accounting Bulletin No. 109 “Written Loan Commitments Recorded at Fair Value Through Earnings.”
 
The Corporation accounts for mortgage servicing rights (MSRs) by separately recognizing servicing assets. An asset is recognized for the rights to service mortgage loans that are created by the origination of mortgage loans that are sold with the servicing retained by the Corporation. The recognition of the asset results in an increase in the gains recognized upon the sale of the mortgage loans sold. The Corporation amortizes MSRs in proportion to and over the period of net servicing income and assesses MSRs for impairment based on fair value at each reporting date. Prepayments of mortgage loans result in increased amortization of MSRs, as the remaining book value of the MSRs is expensed at the time of prepayment. Any impairment of MSRs is recognized as a valuation allowance, resulting in a reduction of mortgage banking revenue. The valuation allowance is recovered when impairment that is believed to be temporary no longer exists. Other-than-temporary impairments are recognized if the recoverability of the carrying value is determined to be remote. When this occurs, the unrecoverable portion of the valuation allowance is recorded as a direct write-down to the carrying value of MSRs. This direct write-down permanently reduces the carrying value of the MSRs, precluding recognition of subsequent recoveries. For purposes of measuring fair value, the Corporation utilizes a third-party modeling software program. Servicing income is recognized in noninterest income when earned and expenses are recognized when incurred.
 
Premises and Equipment:
 
Land is recorded at cost. Premises and equipment are stated at cost less accumulated depreciation. Premises and equipment are depreciated over the estimated useful lives of the assets. The estimated useful lives are generally 25 to 39 years for buildings and three to ten years for all other depreciable assets. Depreciation is computed on the straight-line method. Maintenance and repairs are charged to expense as incurred.
 
Other Real Estate:
 
Other real estate (ORE) is comprised of commercial and residential real estate properties, including development properties, obtained in partial or total satisfaction of loan obligations. ORE is recorded at the lower of cost or the estimated fair value less anticipated selling costs based upon the property’s appraised value at the date of transfer to ORE and management’s estimate of the fair value of the collateral, with any difference between the fair value of the property and the carrying value of the loan charged to the allowance for loan losses. Subsequent changes in fair value of ORE are recognized as adjustments to the carrying amount, not to exceed the initial carrying value of the assets at the time of transfer. Changes in the fair value of ORE subsequent to transfer to ORE are recorded in other operating expenses on the consolidated statements of income. Gains or losses not previously recognized resulting from the sale of ORE are also recognized in other operating expenses on the date of sale. ORE totaling $17.2 million and $19.5 million at December 31, 2009 and 2008, respectively, is included in the consolidated statements of financial position in interest receivable and other assets.
 
Intangible Assets:
 
Intangible assets consist of goodwill, core deposit intangible assets and MSRs. Goodwill is not amortized, but rather is subject to annual impairment tests or more frequently if triggering events occur and indicate potential impairment. Core deposit intangible assets are amortized over periods ranging from 10 to 15 years on a straight-line or accelerated basis, as applicable. MSRs are amortized in proportion to, and over the life of, the estimated net future servicing income of the underlying loans.


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Share-based Compensation:
 
The Corporation accounts for share-based compensation using the modified-prospective transition method. Under that method, compensation cost is recognized for all of the Corporation’s share-based awards granted after December 31, 2005, based on the estimated grant date fair value as computed using the Black-Scholes option pricing model. The resulting fair value of share-based awards is recognized as compensation expense on a straight-line basis over the requisite service period.
 
Cash flows realized from the tax benefits of exercised stock option awards that result from actual tax deductions that are in excess of the recorded tax benefits related to the compensation expense recognized for those options (excess tax benefits) are classified as financing activities on the consolidated statements of cash flows.
 
Short-term Borrowings: