CHEMICAL

FINANCIAL CORPORATIONSM

 

2009

Annual Report

to Shareholders

 

      

CHEMICAL FINANCIAL CORPORATION

 

 

2009 ANNUAL REPORT TO SHAREHOLDERS

 

 

FORWARD-LOOKING STATEMENTS

 

This report contains forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy and Chemical Financial Corporation (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.

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.

 

 

 

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

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

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

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:

 

 

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

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.

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.

 

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

 

 

 

The following table summarizes the carrying value of investment securities at December 31, 2009, 2008 and 2007:

 

TABLE 2. SUMMARY OF INVESTMENT SECURITIES

 

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

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

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

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

 

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.

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

 

 

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.

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.

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.

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

 

 

 

The following schedule provides the composition of nonperforming loans, by major loan category, as of December 31, 2009 and 2008.

 

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

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.

 

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

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:

 

The following schedule provides the composition of other real estate and repossessed assets as of December 31, 2009 and 2008:

 

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

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.

TABLE 6. ANALYSIS OF ALLOWANCE FOR LOAN LOSSES

 

 

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

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.

TABLE 7. ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

 

 

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:

 

 

The following schedule summarizes the allowance as a percentage of nonperforming loans at December 31, 2009 and 2008:

 

 

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.

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

 

 

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.

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