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EX-99.1 - CHEMICAL FINANCIAL CORPORATION EXHIBIT 99.1 TO FORM 10-K - CHEMICAL FINANCIAL CORPchemex991_022511.htm
EX-24 - CHEMICAL FINANCIAL CORPORATION EXHIBIT 24 TO FORM 10-K - CHEMICAL FINANCIAL CORPchemex24_022511.htm
EX-31.1 - CHEMICAL FINANCIAL CORPORATION EXHIBIT 31.1 TO FORM 10-K - CHEMICAL FINANCIAL CORPchemex311_022511.htm
EX-31.2 - CHEMICAL FINANCIAL CORPORATION EXHIBIT 31.2 TO FORM 10-K - CHEMICAL FINANCIAL CORPchemex312_022511.htm
EX-23.2 - CHEMICAL FINANCIAL CORPORATION EXHIBIT 23.2 TO FORM 10-K - CHEMICAL FINANCIAL CORPchemex232_022511.htm
EX-99.2 - CHEMICAL FINANCIAL CORPORATION EXHIBIT 99.2 TO FORM 10-K - CHEMICAL FINANCIAL CORPchemex992_022511.htm
EX-23.1 - CHEMICAL FINANCIAL CORPORATION EXHIBIT 23.1 TO FORM 10-K - CHEMICAL FINANCIAL CORPchemex231_022511.htm
EX-32 - CHEMICAL FINANCIAL CORPORATION EXHIBIT 32 TO FORM 10-K - CHEMICAL FINANCIAL CORPchemex32_022511.htm
EX-21 - CHEMICAL FINANCIAL CORPORATION EXHIBIT 21 TO FORM 10-K - CHEMICAL FINANCIAL CORPchemex21_022511.htm
Table of Contents

(CHEMICAL FINANCIAL CORPORATION LOGO)
 
2010
Annual Report
to Shareholders

 


 

CHEMICAL FINANCIAL CORPORATION
 
 
2010 ANNUAL REPORT TO SHAREHOLDERS
 
         
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Table of Contents

 
FORWARD-LOOKING STATEMENTS
 
This report contains forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy and Chemical Financial Corporation (Chemical). Words such as “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “judgment,” “plans,” “predicts,” “projects,” “should,” “will,” and variations of such words and similar expressions are intended to identify such forward-looking statements. Such statements are based upon current beliefs and expectations and involve substantial risks and uncertainties which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These statements include, among others, statements related to real estate valuation, future levels of nonperforming loans, the rate of asset dispositions, future capital levels, future dividends, future growth and funding sources, future liquidity levels, future profitability levels, future deposit insurance premiums, the effects on earnings of future changes in interest rates and the future level of other revenue sources. All statements referencing future time periods are forward-looking. Management’s determination of the provision and allowance for loan losses; the carrying value of acquired loans, goodwill and mortgage servicing rights; the fair value of investment securities (including whether any impairment on any investment security is temporary or other-than-temporary and the amount of any impairment); and management’s assumptions concerning pension and other postretirement benefit plans involve judgments that are inherently forward-looking. There can be no assurance that future loan losses will be limited to the amounts estimated. All of the information concerning interest rate sensitivity is forward-looking. The future effect of changes in the financial and credit markets and the national and regional economy on the banking industry, generally, and on Chemical, specifically, are also inherently uncertain. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“risk factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. Chemical undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise.
 
Risk factors include, but are not limited to, the risk factors described in Item 1A of this report. These and other factors are representative of the risk factors that may emerge and could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.


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SELECTED FINANCIAL DATA
 
 
                                           
  Years Ended December 31,      
  2010(a)     2009     2008     2007     2006      
  (In thousands, except per share data)      
Earnings Summary
                                         
Net interest income
$ 171,120     $ 147,444     $ 145,253     $ 130,089     $ 132,236      
Provision for loan losses
  45,600       59,000       49,200       11,500       5,200      
Noninterest income
  42,472       41,119       41,197       43,288       40,147      
Operating expenses
  136,802       117,610       109,108       104,671       97,874      
Net income
  23,090       10,003       19,842       39,009       46,844      
Per Common Share Data
                                         
Net income:
                                         
Basic
$ 0.88     $ 0.42     $ 0.83     $ 1.60     $ 1.88      
Diluted
  0.88       0.42       0.83       1.60       1.88      
Cash dividends paid
  0.80       1.18       1.18       1.14       1.10      
Book value at end of period
  20.41       19.85       20.58       21.35       20.46      
Market value at end of period
  22.15       23.58       27.88       23.79       33.30      
Common shares outstanding at end of period
  27,440       23,891       23,881       23,815       24,828      
Year End Balances
                                         
Total assets
$ 5,246,209     $ 4,250,712     $ 3,874,313     $ 3,754,313     $ 3,789,247      
Total loans
  3,681,662       2,993,160       2,981,677       2,799,434       2,807,660      
Total deposits
  4,331,765       3,418,125       2,978,792       2,875,589       2,898,085      
Federal Home Loan Bank advances/other borrowings
  316,833       330,568       368,763       347,412       354,041      
Total shareholders’ equity
  560,078       474,311       491,544       508,464       507,886      
Average Balances
                                         
Total assets
$ 4,913,310     $ 4,066,229     $ 3,784,617     $ 3,785,034     $ 3,763,067      
Total earning assets
  4,618,012       3,847,006       3,550,611       3,551,867       3,521,489      
Total loans
  3,438,550       2,980,126       2,873,151       2,805,880       2,767,114      
Total interest-bearing liabilities
  3,685,186       3,002,050       2,711,413       2,718,814       2,692,410      
Total deposits
  4,017,230       3,195,411       2,924,361       2,923,004       2,861,916      
Federal Home Loan Bank advances/other borrowings
  336,782       348,235       325,177       327,831       362,990      
Total shareholders’ equity
  530,819       483,034       509,100       505,915       510,255      
Financial Ratios
                                         
Net interest margin
  3.80 %     3.91 %     4.16 %     3.73 %     3.82 %    
Return on average assets
  0.47       0.25       0.52       1.03       1.24      
Return on average shareholders’ equity
  4.3       2.1       3.9       7.7       9.2      
Efficiency ratio
  62.8       61.4       57.8       59.6       56.1      
Average shareholders’ equity as a percentage
of average assets
  10.8       11.9       13.5       13.4       13.6      
Tangible shareholders’ equity as a percentage
of total assets
  8.6       9.6       11.0       11.7       11.6      
Tier 1 risk-based capital ratio
  11.7       14.2       15.1       16.1       16.2      
Total risk-based capital ratio
  12.9       15.5       16.4       17.3       17.5      
Dividend payout ratio
  91.1       281.0       142.2       71.2       58.5      
Credit Quality
                                         
Allowance for loan losses
$ 89,530     $ 80,841     $ 57,056     $ 39,422     $ 34,098      
Total nonperforming originated loans
  147,729       135,755       93,328       63,360       26,910      
Total nonperforming assets
  175,239       153,295       113,251       74,492       35,762      
Net loan charge-offs
  36,911       35,215       31,566       6,176       5,650      
Allowance for loan losses as a percentage of total originated loans
  2.86 %     2.70 %     1.91 %     1.41 %     1.21 %    
Allowance for loan losses as a percentage of nonperforming originated loans
  61       60       61       62       127      
Nonperforming originated loans as a percentage of total originated loans
  4.72       4.54       3.13       2.26       0.96      
Nonperforming assets as a percentage of total assets
  3.34       3.61       2.92       1.98       0.94      
Net loan charge-offs as a percentage of average total loans
  1.07       1.18       1.10       0.22       0.20      
 
(a) Includes the impact of the acquisition of O.A.K. Financial Corporation on April 30, 2010. See Note 2 to the consolidated financial statements in Item 8 of this Report for information on the acquisition of O.A.K. Financial Corporation.


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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
BUSINESS OF THE CORPORATION
 
Chemical Financial Corporation (Corporation) is a financial holding company headquartered in Midland, Michigan with its business concentrated in a single industry segment — commercial banking. The Corporation, through its subsidiary bank, Chemical Bank, offers a full range of traditional banking and fiduciary products and services. These products and services include business and personal checking accounts, savings and individual retirement accounts, time deposit instruments, electronically accessed banking products, residential and commercial real estate financing, commercial lending, consumer financing, debit cards, safe deposit box services, money transfer services, automated teller machines, access to insurance and investment products, corporate and personal wealth management services and other banking services.
 
The principal markets for the Corporation’s products and services are communities within Michigan in which the branches of Chemical Bank are located and the areas immediately surrounding those communities. As of December 31, 2010, Chemical Bank served 90 communities through 142 banking offices located in 32 counties across Michigan’s lower peninsula. In addition to its banking offices, Chemical Bank operated three loan production offices and 162 automated teller machines, both on- and off-bank premises. Chemical Bank operates through an internal organizational structure of four regional banking units. Chemical Bank’s regional banking units are collections of branch banking offices organized by geographical regions within the State of Michigan.
 
The principal source of revenue for the Corporation is interest and fees on loans, which accounted for 76% of total revenue in 2010, 74% of total revenue in 2009 and 72% of total revenue in 2008. Interest on investment securities is also a significant source of revenue, accounting for 6% of total revenue in 2010, 8% of total revenue in 2009 and 10% of total revenue in 2008. Revenue is influenced by overall economic factors including market interest rates, business and consumer spending, consumer confidence and competitive conditions in the marketplace.
 
BANK INDUSTRY DEVELOPMENTS
 
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) was signed into law by President Obama on July 21, 2010. The Dodd-Frank Act permanently increased the Federal Deposit Insurance Corporation (FDIC) insurance coverage to $250,000 per depositor. In addition, the Dodd-Frank Act resulted in a comprehensive overhaul of the financial services industry within the United States, established the new federal Bureau of Consumer Financial Protection (BCFP), and requires the BCFP and other federal agencies to implement many new and significant rules and regulations. At this time, it is difficult to predict the extent to which the Dodd-Frank Act or the resulting rules and regulations will impact the Corporation’s and Chemical Bank’s business. Compliance with these new laws and regulations will likely result in additional costs, which could be significant and could adversely impact the Corporation’s results of operations, financial condition or liquidity.
 
In November 2010, the FDIC, as mandated by the Dodd-Frank Act, issued a rule that provides unlimited insurance coverage on noninterest-bearing transaction accounts at all insured institutions beginning December 31, 2010 and expiring December 31, 2012. Under the rule, a noninterest-bearing transaction account is defined as a deposit account where interest is neither accrued nor paid, depositors are permitted to make an unlimited number of transfers and withdrawals and the institution does not reserve the right to advance notice of an intended withdrawal. Money market deposit accounts and Negotiable Orders of Withdrawal (NOW) accounts are not eligible for the unlimited insurance coverage, regardless of the interest rate. Further, there will not be a separate fee assessment on noninterest-bearing transaction accounts after December 31, 2010. Prior to December 31, 2010, unlimited insurance coverage was available on noninterest-bearing transaction accounts under the FDIC’s Transaction Account Guarantee Program (TAGP). The TAGP, which was adopted by the FDIC in November 2008 and expired December 31, 2010, provided full FDIC deposit insurance coverage for covered accounts, which were defined as noninterest-bearing transaction deposit accounts, NOW accounts paying less than 0.5% (0.25% after June 30, 2010) interest per annum and Interest on Lawyers Trust Accounts (IOLTA) held at participating FDIC-insured institutions through December 31, 2010. The fee assessment for deposit insurance coverage was an annualized 10 basis points assessed quarterly on amounts in covered accounts exceeding $250,000. The Corporation’s additional FDIC fee assessment related to the full deposit coverage for TAGP eligible accounts was $0.6 million in 2010 and $0.1 million in 2009.
 
In February 2011, the FDIC adopted a rule which changes the assessment base and assessment rates used to compute quarterly FDIC insurance assessments beginning April 1, 2011. Under the rule, the assessment base for all insured institutions, as mandated by the Dodd-Frank Act, will change to average consolidated total assets less average tangible equity. In addition, the initial base assessment rates for Risk Category 1 institutions will range from 5 to 9 basis points, on an annualized basis, and from 2.5 to 9 basis points after the effect of potential base-rate adjustments. Chemical Bank was, by definition, a Risk Category 1 institution during 2010 and 2009.


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Chemical Bank’s FDIC insurance assessments totaled $7.4 million in 2010, $7.0 million in 2009 and $0.9 million in 2008. Based upon the adopted rule that takes effect April 1, 2011 and the Corporation’s average assessment base (under the adopted rule) at December 31, 2010, the Corporation’s FDIC premiums are expected to be lower in 2011 than in 2010.
 
In February 2009, the FDIC issued rules to amend the Deposit Insurance Fund (DIF) restoration plan, change the risk-based assessment system and set increased assessment rates for Risk Category 1 institutions beginning in the second quarter of 2009. Effective April 1, 2009, for Risk Category 1 institutions, the assessment rate methodology was established to determine the initial base assessment rate by using a weighted combination of weighted-average regulatory examination component ratings, long-term debt issuer ratings (converted to numbers and averaged) and certain financial ratios. The initial base assessment rates for Risk Category 1 institutions ranged from 12 to 16 basis points, on an annualized basis, and from 7 to 24 basis points after the effect of potential base-rate adjustments. In May 2009, the FDIC issued a rule which levied a special assessment applicable to all FDIC insured depository institutions totaling 5 basis points of each institution’s total assets less Tier 1 capital as of June 30, 2009, not to exceed 10 basis points of domestic deposits. The special assessment was part of the FDIC’s efforts to restore the DIF reserves. The Corporation recognized $1.8 million of additional deposit insurance expense in the second quarter of 2009 related to the special assessment. Deposit insurance expense during 2009 totaled $7.0 million, including the $1.8 million recognized in the second quarter related to the special assessment. In November 2009, the FDIC issued a rule that required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The prepayment calculation was based on an institution’s assessment rate in effect on September 30, 2009 and assumed a 5% annual growth rate in the assessment base. On December 30, 2009, the Corporation prepaid $19.7 million in risk-based assessments. In conjunction with the adoption of the prepaid assessment, the FDIC adopted a uniform 3 basis point increase in assessment rates effective on January 1, 2011. In October 2010, the FDIC adopted a new DIF restoration plan to ensure the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. Under the new restoration plan, the FDIC elected to forego the uniform 3 basis point increase scheduled to take place on January 1, 2011. As previously discussed, in February 2011, the FDIC adopted a rule that further changed future assessment rates beginning April 1, 2011.
 
At December 31, 2010, the Corporation held $18.7 million of Federal Home Loan Bank of Indianapolis (FHLB) stock. The Corporation carries FHLB stock at cost, or par value, and evaluates FHLB stock for impairment based on the ultimate recoverability of par value rather than by recognizing temporary declines in value. As part of the impairment assessment of FHLB stock, management considers, among other things, (i) the significance and length of time of any declines in net assets of the FHLB compared to its capital stock, (ii) commitments by the FHLB to make payments required by law or regulations and the level of such payments in relation to its operating performance, (iii) the impact of legislative and regulatory changes on financial institutions and, accordingly, the customer base of the FHLB and (iv) the liquidity position of the FHLB. The Corporation received $0.3 million of cash dividend payments on its FHLB stock during 2010, down from $0.5 million received during 2009. The FHLB was profitable through the first three quarters of 2010, with net income of $70 million, despite recognizing $68 million of other-than-temporary impairment losses on the credit-loss portion of its private-label residential mortgage-backed securities portfolio. At September 30, 2010, the FHLB was considered well-capitalized in accordance with regulatory requirements and its capital was 4.2% of total assets, compared to 3.7% at December 31, 2009. Standard & Poor’s has given the FHLB a rating of AAA since December 2009. Given all of the factors available, it was the Corporation’s assessment that the overall financial condition of the FHLB did not indicate an impairment of its FHLB stock at December 31, 2010.
 
On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was signed into law in response to the financial crisis affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions. The EESA created the Troubled Asset Relief Program (TARP), under which the United States Department of the Treasury (Treasury) was given the authority to, among other things, purchase up to $700 billion of mortgages, residential mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. EESA also temporarily increased the amount of deposit insurance coverage available on customer deposit accounts from $100,000 per depositor to $250,000 per depositor until December 31, 2009. In May 2009, the Helping Families Save Their Homes Act was signed into law, which extended the temporary deposit insurance increase of $250,000 per depositor through December 31, 2013. With the passage of the Dodd-Frank Act in 2010, the deposit insurance increase to $250,000 per depositor was made permanent.
 
In October 2008, the Treasury announced that it would purchase equity stakes in a wide variety of banks and thrifts. Under the program, known as the Capital Purchase Program (CPP), the Treasury made $250 billion of the $700 billion authorized under TARP available to U.S. financial institutions through the purchase of preferred stock. In conjunction with the purchase of preferred stock, the Treasury received, from participating financial institutions, warrants to purchase common stock with an aggregate market price equal to 15% of the preferred stock investment. Participating financial institutions were required to agree to restrictions on future dividends and share repurchases during the period in which the preferred stock remained outstanding. On December 18, 2008, the Corporation announced that it had elected not to accept the $84 million capital investment approved by the Treasury as part of the


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CPP. The board of directors and management of the Corporation determined that the potential dilution to the Corporation’s shareholders and various restrictions outweighed any potential benefits from the Corporation’s participation in the CPP.
 
In November 2008, the FDIC adopted the Temporary Liquidity Guarantee Program (TLGP). The TLGP, an initiative to counter the system-wide crisis in the nation’s financial sector, was amended by the FDIC in August 2009 and again in April 2010 to extend maturity dates originally adopted. Under the TLGP, the FDIC guaranteed, through the earlier of maturity or December 31, 2012, certain newly-issued senior unsecured debt issued by participating institutions on or after October 14, 2008 and through April 30, 2010. The fee assessment for coverage of senior unsecured debt ranged from 50 basis points to 300 basis points per annum, depending on the initial maturity of the debt. The Corporation did not issue any FDIC guaranteed debt during the three years ended December 31, 2010.
 
ACQUISITION OF O.A.K. FINANCIAL CORPORATION
 
On April 30, 2010, the Corporation acquired 100% of O.A.K. Financial Corporation (OAK) for total consideration of $83.7 million. The total consideration consisted of the issuance of 3,529,772 shares of the Corporation’s common stock with a total value of $83.7 million based upon a market price per share of the Corporation’s common stock of $23.70 at the acquisition date, the exchange of 26,425 stock options for the outstanding vested stock options of OAK with a value of the exchange equal to approximately $41,000 at the acquisition date, and approximately $8,000 of cash in lieu of fractional shares.
 
OAK, a bank holding company, owned Byron Bank, which provided traditional banking services and products through 14 banking offices serving communities in Ottawa, Allegan and Kent counties in west Michigan. Byron Bank owned two operating subsidiaries, Byron Investment Services, which offered mutual fund products, securities, brokerage services, retirement planning services, and investment management and advisory services, and O.A.K. Title Insurance Agency, which offered title insurance to buyers and sellers of residential and commercial properties. At April 30, 2010, OAK had total assets of $820 million, total loans of $627 million and total deposits of $693 million. The Corporation operated Byron Bank as a separate subsidiary from the acquisition date until July 23, 2010, the date Byron Bank was consolidated with and into Chemical Bank, and at which time Byron Investment Services and O.A.K. Title Insurance Agency became subsidiaries of Chemical Bank. O.A.K. Title Insurance Agency was subsequently dissolved effective August 31, 2010 and Byron Investment Services is expected to be dissolved in 2011.
 
In connection with the acquisition of OAK, the Corporation recorded $43.5 million of goodwill. Goodwill recorded was primarily attributable to the synergies and economies of scale expected from combining the operations of the Corporation and OAK. In addition, the Corporation recorded $9.8 million of other intangible assets in conjunction with the acquisition. The other intangible assets represent the value attributable to core deposits of $8.4 million, mortgage servicing rights of $0.7 million and non-compete agreements of $0.7 million.
 
The Corporation developed exit plans for involuntary employee terminations associated with the OAK acquisition, of which the Corporation recognized $0.6 million during 2010 for these exit costs and employee termination benefits. In addition to these costs, the Corporation incurred other acquisition related transaction expenses of $3.7 million in 2010. Acquisition-related transaction expenses associated with the OAK acquisition totaled $4.3 million during 2010, which reduced net income per common share by $0.12 in 2010.
 
Additional information regarding the acquisition of OAK can be found in the notes to the consolidated financial statements contained in this Report and the Corporation’s Current Reports on Form 8-K filed with the Securities and Exchange Commission (SEC) on May 7, 2010, May 3, 2010 and January 8, 2010.
 
CRITICAL ACCOUNTING POLICIES
 
The Corporation’s consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (GAAP), SEC rules and interpretive releases and general practices within the industry in which the Corporation operates. Application of these principles requires management to make estimates, assumptions and complex judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the consolidated financial statements could reflect different estimates, assumptions and judgments. Actual results could differ significantly from those estimates. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value or when a decline in the value of an asset not carried at fair value on the financial statements warrants an impairment write-down or a valuation reserve to be established. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third-party sources,


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when available. When third-party information is not available, valuation adjustments are estimated by management primarily through the use of internal discounted cash flow analyses.
 
The most significant accounting policies followed by the Corporation are presented in Note 1 to the consolidated financial statements. These policies, along with the disclosures presented in the other notes to the consolidated financial statements and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, estimates and assumptions underlying those amounts, management has identified the determination of the allowance for loan losses, accounting for loans acquired in business combinations, pension plan accounting, income and other taxes, the evaluation of goodwill impairment and fair value measurements to be the accounting areas that require the most subjective or complex judgments, and as such, could be most subject to revision as new or additional information becomes available or circumstances change, including overall changes in the economic climate and/or market interest rates. Management reviews its critical accounting policies with the Audit Committee of the board of directors at least annually.
 
Allowance for Loan Losses
 
The allowance for loan losses (allowance) is calculated with the objective of maintaining a reserve sufficient to absorb inherent loan losses in the loan portfolio. The loan portfolio represents the largest asset type on the consolidated statements of financial position. The determination of the amount of the allowance is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected cash flows and collateral values on impaired loans, estimated losses on commercial, real estate commercial, real estate construction and land development loans and on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The principal assumption used in deriving the allowance is the estimate of a loss percentage for each type of loan. In determining the allowance and the related provision for loan losses, the Corporation considers four principal elements: (i) specific impairment reserve allocations (valuation allowances) based upon probable losses identified during the review of impaired commercial, real estate commercial, real estate construction and land development loan portfolios, (ii) allocations established for adversely-rated commercial, real estate commercial, real estate construction and land development loans and nonaccrual real estate residential and consumer loans, (iii) allocations on all other loans based principally on the most recent three years of historical loan loss experience and loan loss trends, and (iv) an unallocated allowance based on the imprecision in the overall allowance methodology. It is extremely difficult to accurately measure the amount of losses that are inherent in the Corporation’s loan portfolio. The Corporation uses a defined methodology to quantify the necessary allowance and related provision for loan losses, but there can be no assurance that the methodology will successfully identify and estimate all of the losses that are inherent in the loan portfolio. As a result, the Corporation could record future provisions for loan losses that may be significantly different than the levels that have been recorded in the three-year period ended December 31, 2010. Notes 1 and 4 to the consolidated financial statements further describe the methodology used to determine the allowance. In addition, a discussion of the factors driving changes in the amount of the allowance is included under the subheading “Allowance for Loan Losses” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
 
The Corporation has a loan review function that is independent of the loan origination function and that reviews management’s evaluation of the allowance at least annually. The Corporation’s loan review function performs a detailed credit quality review at least annually on commercial, real estate commercial, real estate construction and land development loans, particularly focusing on larger balance loans and loans that have deteriorated below certain levels of credit risk.
 
Accounting for Loans Acquired in Business Combinations
 
Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (ASC 310-30), provides the GAAP guidance for accounting for loans acquired in a business combination that have experienced a deterioration of credit quality from origination to acquisition for which it is probable that the investor will be unable to collect all contractually required payments receivable, including both principal and interest.
 
Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered to be impaired. In the assessment of credit quality deterioration, the Corporation must make numerous assumptions, interpretations and judgments using internal and third-party credit quality information to determine whether it is probable that the Corporation will be able to collect all contractually required payments. This is a point in time assessment and inherently subjective due to the nature of the available information and judgment involved. Evidence of credit quality deterioration as of the purchase date may include statistics such as past due and nonaccrual status, recent borrower credit scores and loan-to-value percentages. Those loans that qualify under ASC 310-30 are recorded at fair value at acquisition, which involves estimating the expected cash flows to be received. Accordingly, the associated allowance for loan losses related to these loans is not


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carried over at the acquisition date. ASC 310-30 also allows investors to aggregate loans acquired into loan pools that have common risk characteristics and thereby use a composite interest rate and expectation of cash flows to be collected for the loan pools. The Corporation understands, as outlined in the American Institute of Certified Public Accountants’ open letter to the Office of the Chief Accountant of the SEC dated December 18, 2009 and pending further standard setting, that for acquired loans that do not meet the scope criteria of ASC 310-30, a company may elect to account for such acquired loans pursuant to the provisions of either ASC 310-20, Nonrefundable Fees and Other Costs, or ASC 310-30. The Corporation elected to apply ASC 310-30 by analogy to loans acquired in the OAK transaction that were determined not to have deteriorated credit quality, and therefore, did not meet the scope criteria of ASC 310-30. Accordingly, the Corporation will follow the accounting and disclosure guidance of ASC 310-30 for these loans.
 
The excess of cash flows of a loan, or pool of loans, expected to be collected over the estimated fair value is referred to as the accretable yield and is recognized into interest income over the remaining life of the loan, or pool of loans, on a level-yield basis. The difference between the contractually required payments of a loan, or pool of loans, and the cash flows expected to be collected at acquisition, considering the impact of prepayments and estimates of future credit losses expected to be incurred over the life of the loan, or pool of loans, is referred to as the nonaccretable difference.
 
Subsequent to acquisition, the Corporation is required to quarterly evaluate its estimates of cash flows expected to be collected. These evaluations require the continued usage of key assumptions and estimates, similar to the initial estimate of fair value. Given the current economic environment, the Corporation must apply judgment to develop its estimates of cash flows for acquired loans given the impact of changes in property values, default rates, loss severities and prepayment speeds. Decreases in the estimates of expected cash flows will generally result in a charge to the provision for loan losses and a resulting increase to the allowance for loan losses. Increases in the estimates of expected cash flows will generally result in adjustments to the accretable yield which will increase amounts recognized in interest income in subsequent periods. Disposals of loans, which may include sales of loans to third parties, receipt of payments in full or in part by the borrower and foreclosure of the collateral, result in removal of the loan from the acquired loan portfolio at its carrying amount. As a result of the significant amount of judgment involved in estimating future cash flows expected to be collected for acquired loans, the adequacy of the allowance for loan losses is particularly sensitive to changes due to decreases in expected cash flows resulting from changes in loan credit quality.
 
Acquired loans that were classified as nonperforming loans prior to being acquired are not classified as nonperforming at acquisition because the loans are recorded in pools at fair value based on the principal and interest the Corporation expects to collect on such loans. Accordingly, at the acquisition date, the Corporation expects to fully collect the carrying value of acquired loans. Judgment is required to classify acquired loans as performing and is dependent on having a reasonable expectation about the timing and amount of cash flows expected to be collected, even if the loans are contractually past due.
 
Loans acquired in the acquisition of OAK (“acquired loans”) were initially recorded at fair value without a carryover of OAK’s allowance for loan losses. The calculation of fair value of the acquired loans entailed estimating the amount and timing of cash flows attributable to both principal and interest expected to be collected on such loans and then discounting those cash flows at market interest rates. The Corporation aggregated acquired loans into 14 pools based upon common risk characteristics and estimated the cash flows expected to be collected at acquisition using its internal credit risk grading model, interest rate risk and prepayment models, which incorporated its best estimate of current key assumptions, such as property values, default rates, loss severity and prepayment speeds. The fair value of the acquired loans included discounts attributable to both credit quality and market interest rates, which were recorded as a reduction of the loans’ outstanding principal balance at the acquisition date. Upon acquisition, the acquired loan portfolio had contractually required principal and interest payments of $683 million and $97 million, respectively, expected principal and interest cash flows of $636 million and $88 million, respectively, and a fair value of $627 million. The difference between the contractually required payments receivable and the expected cash flows represents the nonaccretable difference, which totaled $56 million at the acquisition date, with $47 million attributable to expected credit losses. The difference between the expected cash flows and the fair value represents the accretable yield, which totaled $97 million at the acquisition date.
 
Pension Plan Accounting
 
The Corporation has a defined benefit pension plan for certain salaried employees. Effective June 30, 2006, benefits under the defined benefit pension plan were frozen for approximately two-thirds of the Corporation’s salaried employees as of that date. Pension benefits continued unchanged for the remaining salaried employees. At December 31, 2010, 257 employees, or 16% of total employees, on a full-time equivalent basis, were earning pension benefits under the defined benefit pension plan. The Corporation’s pension benefit obligations and related costs are calculated using actuarial concepts and measurements. Benefits under the plan are based on years of vested service, age and amount of compensation. Assumptions are made concerning future events that will determine the amount and timing of required benefit payments, funding requirements and pension expense.


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The key actuarial assumptions used in the pension plan are the discount rate and long-term rate of return on plan assets. These assumptions have a significant effect on the amounts reported for net periodic pension expense, as well as the respective benefit obligation amounts. The Corporation evaluates these critical assumptions annually.
 
At December 31, 2010, 2009 and 2008, the Corporation calculated the discount rate for the pension plan using the results from a bond matching technique, which matched cash flows of the pension plan against a portfolio of bonds of Aa quality to determine the discount rate. At December 31, 2010, 2009 and 2008, the discount rate was established at 5.65%, 6.15% and 6.50%, respectively, to reflect market interest rate conditions.
 
The assumed long-term rate of return on pension plan assets represents an estimate of long-term returns on an investment portfolio consisting primarily of equity and fixed income investments. When determining the expected long-term return on pension plan assets, the Corporation considers long-term rates of return on the asset classes in which the Corporation expects the pension funds to be invested. The expected long-term rate of return is based on both historical and forecasted returns of the overall stock and bond markets and the actual portfolio. The following rates of return by asset class were considered in setting the assumptions for long-term return on pension plan assets:
 
                         
    December 31,
    2010   2009   2008
 
Equity securities
    6% – 9%       7% – 9%       7% – 8%  
Debt securities
    3% – 7%       4% – 6%       4% – 6%  
Other
    2% – 3%       2% – 5%       2% – 5%  
 
The assumed long-term return on pension plan assets is developed through an analysis of forecasted rates of return by asset class and forecasted asset allocations. It is used to compute the subsequent year’s expected return on assets, using the “market-related value” of pension plan assets. The difference between the expected return and the actual return on pension plan assets during the year is either an asset gain or loss, which is deferred and amortized over future periods when determining net periodic pension expense. The Corporation’s projection of the long-term return on pension plan assets was 7% in 2010, 2009 and 2008.
 
Other assumptions made in the pension plan calculations involve employee demographic factors, such as retirement patterns, mortality, turnover and the rate of compensation increase.
 
The key actuarial assumptions that will be used to calculate pension expense in 2011 for the defined benefit pension plan are a discount rate of 5.65%, a long-term rate of return on pension plan assets of 7% and a rate of compensation increase of 3.50%. Pension expense in 2011 is expected to be approximately $0.7 million, a decrease of approximately $0.1 million from 2010. In 2011, a decrease in the discount rate of 50 basis points was estimated to increase pension expense by $0.4 million, while an increase of 50 basis points was estimated to decrease pension expense by the same amount.
 
There are uncertainties associated with the underlying key actuarial assumptions, and the potential exists for significant, and possibly material, impacts on either or both the results of operations and cash flows (e.g., additional pension expense and/or additional pension plan funding, whether expected or required) from changes in the key actuarial assumptions. If the Corporation were to determine that more conservative assumptions are necessary, pension expense would increase and have a negative impact on results of operations in the period in which the increase occurs.
 
The Corporation accounts for its defined benefit pension and other postretirement plans in accordance with FASB ASC Topic 715, Compensation-Retirement Benefits, which requires companies to recognize the over- or under-funded status of a plan as an asset or liability as measured by the difference between the fair value of the plan assets and the projected benefit obligation and requires any unrecognized prior service costs and actuarial gains and losses to be recognized as a component of accumulated other comprehensive income (loss). The impact of pension plan accounting on the statements of financial position at December 31, 2010 and 2009 is further discussed in Note 16 to the consolidated financial statements.
 
Income and Other Taxes
 
The Corporation is subject to the income and other tax laws of the United States and the State of Michigan. These laws are complex and are subject to different interpretations by the taxpayer and the various taxing authorities. In determining the provisions for income and other taxes, management must make judgments and estimates about the application of these inherently complex laws, related regulations and case law. In the process of preparing the Corporation’s tax returns, management attempts to make reasonable interpretations of applicable tax laws. These interpretations are subject to challenge by the taxing authorities upon audit or to reinterpretation based on management’s ongoing assessment of facts and evolving regulations and case law.


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The Corporation and its subsidiaries file a consolidated federal income tax return. The provision for federal income taxes is based on income and expenses, as reported in the consolidated financial statements, rather than amounts reported on the Corporation’s federal income tax return. When income and expenses are recognized in different periods for tax purposes than for book purposes, applicable deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.
 
On a quarterly basis, management assesses the reasonableness of its effective federal tax rate based upon its current best estimate of net income and the applicable taxes expected for the full year. Deferred tax assets and liabilities are reassessed on an annual basis, or more frequently, if warranted by business events or circumstances. Reserves for uncertain tax positions are reviewed quarterly for adequacy based upon developments in tax law and the status of examinations or audits. As of December 31, 2010 and 2009, there were no federal income tax reserves recorded for uncertain tax positions.
 
Goodwill
 
At December 31, 2010, the Corporation had $113.4 million of goodwill, which was originated through the acquisition of various banks and bank branches, recorded on the consolidated statement of financial position. Goodwill is not amortized, but rather is tested by management annually for impairment, or more frequently if triggering events occur and indicate potential impairment, in accordance with FASB ASC Topic 350-20, Goodwill. The Corporation’s goodwill impairment assessment is reviewed annually, as of September 30, by an independent third-party appraisal firm utilizing the methodology and guidelines established in GAAP, including assumptions regarding the valuation of Chemical Bank.
 
The value of Chemical Bank was measured utilizing the income and market approaches as prescribed in FASB ASC Topic 820, Fair Value Measurements and Disclosures (ASC 820). GAAP identifies the cost approach as another acceptable method; however, the cost approach was not deemed an effective method to value a financial institution. The cost approach estimates value by adjusting the reported values of assets and liabilities to their market values. It is the Corporation’s opinion that financial institutions cannot be liquidated in an efficient manner. Estimating the fair market value of loans is a very difficult process and subject to a wide margin of error unless done on a loan by loan basis. Voluntary liquidations of financial institutions are not typical. More commonly, if a financial institution is liquidated, it is due to being taken over by the FDIC. The value of Chemical Bank was based as a going concern and not as a liquidation.
 
The income approach uses valuation techniques to convert future amounts (cash flows or earnings) to a single, discounted amount. The income approach includes present value techniques, option-pricing models, such as the Black-Scholes formula and lattice models, and the multi-period excess-earnings method. In the valuation of Chemical Bank, the income approach utilized the discounted cash flow method based upon a forecast of growth and earnings. Cash flows are measured by using projected earnings, projected dividends and dividend paying capacity over a five-year period. In addition to estimating periodic cash flows, an estimate of residual value is determined through the capitalization of earnings. The income approach assumed cost savings and earnings enhancements that a strategic acquiror would likely implement based upon typical participant assumptions of market transactions. The discount rate is critical to the discounted cash flow analysis. The discount rate reflects the risk of uncertainty associated with the cash flows and a rate of return that investors would require from similar investments with similar risks. At the valuation date of September 30, 2010, a discount rate of 14% was utilized in the income approach.
 
The market approach uses observable prices and other relevant information that are generated by market transactions involving identical or comparable assets or liabilities. The fair value measure is based on the value that those transactions indicate utilizing both financial and operating characteristics of the acquired companies. Two of the more significant financial ratios analyzed in completed transactions included price to latest twelve months earnings and price to tangible book value. At the valuation date of September 30, 2010, the market approach utilized a price to latest twelve months earnings ratio of 35 times and a price to tangible book value of 145%.
 
The fair value of Chemical Bank was determined to be slightly above the income approach and within the range of values in the market approach value range. The results of the valuation analysis concluded that the fair value of Chemical Bank was greater than its book value, including goodwill, and thus no goodwill impairment was evident at the valuation date of September 30, 2010. The weighted average of the fair values determined under the income and market approaches was a discount compared to the market capitalization of the Corporation at the valuation date. The Corporation is publicly traded and, therefore, the price per share of its common stock as reported on The Nasdaq Stock Market® establishes the marketable minority value. Given the volatility of the financial markets, particularly in the equity markets in 2010, it is management’s opinion that the marketable minority value does not always represent the fair value of the reporting unit as a whole and that an adjustment to the marketable minority value for the


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acquiror’s control is generally considered in the assessment of fair value. The Corporation determined that no triggering events occurred that indicated potential impairment of goodwill from the valuation date through December 31, 2010. The Corporation believes that the assumptions utilized were reasonable. However, the Corporation could incur impairment charges related to goodwill in the future due to changes in financial results or other matters that could affect the valuation assumptions.
 
Fair Value Measurements
 
The Corporation determines the fair value of its assets and liabilities in accordance with ASC 820. ASC 820 establishes a standard framework for measuring and disclosing fair value under GAAP. A number of valuation techniques are used to determine the fair value of assets and liabilities in the Corporation’s financial statements. The valuation techniques include quoted market prices for investment securities, appraisals of real estate from independent licensed appraisers and other valuation techniques. Fair value measurements for assets and liabilities where limited or no observable market data exists are based primarily upon estimates, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the valuation results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. Significant changes in the aggregate fair value of assets and liabilities required to be measured at fair value or for impairment are recognized in the income statement under the framework established by GAAP. See Note 13 to the Corporation’s consolidated financial statements for more information on fair value measurements.
 
PENDING ACCOUNTING PRONOUNCEMENTS
 
Fair Value Measurements and Disclosures:  In January 2010, the FASB issued Accounting Standards Update (ASU) No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements (ASU 2010-06). ASU 2010-06 requires reporting entities to make new disclosures about recurring and nonrecurring fair value measurements, including significant transfers into and out of Level 1 and Level 2 fair value measurements and information on purchases, sales, issuances and settlements, on a gross basis, in the reconciliation of Level 3 fair value measurements. ASU 2010-06 also requires disclosure of fair value measurements by “class” instead of by “major category” as well as any changes in valuation techniques used during the reporting period. For disclosures of Level 1 and Level 2 activity, fair value measurements by “class” and changes in valuation techniques, ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009, with disclosures for previous comparative periods prior to adoption not required. The adoption of this portion of ASU 2010-06 on January 1, 2010 did not have a material impact on the Corporation’s consolidated financial condition or results of operations. For the reconciliation of Level 3 fair value measurements, ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2010. The adoption of this portion of ASU 2010-06 on January 1, 2011 did not have a material impact on the Corporation’s consolidated financial condition or results of operations.
 
Goodwill Impairment Testing:  In December 2010, the FASB issued ASU No. 2010-28, Intangibles (Topic 350): When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts (ASU 2010-28). ASU 2010-28 provides guidance on (i) the circumstances under which step 2 of the goodwill impairment test must be performed for reporting units with zero or negative carrying amounts, and (ii) the qualitative factors to be taken into account when performing step 2 in determining whether it is more likely than not that an impairment exists. ASU 2010-28 is effective for public entities with fiscal years beginning after December 15, 2010, with early adoption prohibited. Upon initial application, all entities having reporting units with zero or negative carrying amounts are required to assess whether it is more likely than not that impairment exists and any resulting goodwill impairment should be recognized as a cumulative-effect adjustment to opening retained earnings in the period of adoption. The adoption of ASU 2010-28 on January 1, 2011 did not have a material impact on the Corporation’s consolidated financial condition or results of operations.
 
Pro Forma Disclosure Requirements for Business Combinations:  In December 2010, the FASB issued ASU No. 2010-29, Business Combinations (Topic 805): Disclosure of Supplementary Pro Forma Information for Business Combinations (ASU 2010-29). ASU 2010-29 clarifies that pro forma revenue and earnings for a business combination occurring in the current year should be presented as though the business combination occurred as of the beginning of the year or, if comparative financial statements are presented, as though the business combination took place as of the beginning of the comparative year. ASU 2010-29 also amends existing guidance to expand the supplemental pro forma disclosures to include a description of the nature and amount of material, nonrecurring adjustments directly attributable to the business combination included in the pro forma revenue and earnings. ASU 2010-29 is effective prospectively for business combinations consummated on or after the start of the first annual reporting period beginning after December 15, 2010, with early adoption permitted. The adoption of ASU 2010-29 on January 1, 2011 did not have a material impact on the Corporation’s consolidated financial condition or results of operations.


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Deferral of Troubled Debt Restructuring Disclosures:  In January 2011, the FASB issued ASU No. 2011-01, Receivables (Topic 310): Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20 (ASU 2011-01). For public entities, ASU 2011-01 delays the effective date for certain disclosures about loans modified under troubled debt restructurings included in ASU No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses (ASU 2010-20). The new effective date for the loans modified under troubled debt restructuring disclosures will be concurrent with the effective date of FASB’s proposed ASU, Receivables (Topic 310): Clarifications to Accounting for Troubled Debt Restructurings by Creditors. ASU 2011-01 does not change the effective date for other disclosures required by public entities in ASU 2010-20. The adoption of ASU 2011-01 once effective is not expected to have a material impact on the Corporation’s consolidated financial condition or results of operations.
 
FINANCIAL HIGHLIGHTS
 
The following discussion and analysis is intended to cover the significant factors affecting the Corporation’s consolidated statements of financial position and income included in this report. It is designed to provide shareholders with a more comprehensive review of the consolidated operating results and financial position of the Corporation than could be obtained from an examination of the financial statements alone.
 
NET INCOME
 
Net income in 2010 was $23.1 million, or $0.88 per diluted share, compared to net income in 2009 of $10.0 million, or $0.42 per diluted share, and net income in 2008 of $19.8 million, or $0.83 per diluted share. Net income in 2010 represented a 131% increase from 2009 net income, while 2009 net income represented a 50% decrease from 2008 net income. Net income per share in 2010 was 110% more than in 2009, while net income per share in 2009 was 49% less than in 2008. The increases in net income and net income per share in 2010, compared to 2009, were primarily attributable to a decrease in the provision for loan losses and the acquisition of OAK. The decreases in net income and net income per share in 2009, compared to 2008, were primarily attributable to increases in the provision for loan losses and operating expenses.
 
The Corporation’s return on average assets was 0.47% in 2010, 0.25% in 2009 and 0.52% in 2008. The Corporation’s return on average shareholders’ equity was 4.3% in 2010, 2.1% in 2009 and 3.9% in 2008.
 
ASSETS
 
Total assets were $5.25 billion at December 31, 2010, an increase of $1.00 billion, or 23%, from total assets at December 31, 2009 of $4.25 billion. Average assets were $4.91 billion during 2010, an increase of $847.1 million, or 21%, from average assets during 2009 of $4.07 billion. Average assets were $4.07 billion during 2009, an increase of $281.6 million, or 7%, from average assets during 2008 of $3.78 billion. The increases in total assets and average assets during 2010 were primarily attributable to the acquisition of OAK.


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INVESTMENT SECURITIES
 
Information about the Corporation’s investment securities portfolio is summarized in Tables 1 and 2. The following table summarizes the maturities and yields of the carrying value of investment securities by investment category and fair value by investment category, at December 31, 2010:
 
TABLE 1. MATURITIES AND YIELDS* OF INVESTMENT SECURITIES AT DECEMBER 31, 2010
 
                                                                                         
    Maturity**                    
                After One
    After Five
                Total
       
    Within
    but Within
    but Within
    After
    Carrying
    Total
 
    One Year     Five Years     Ten Years     Ten Years     Value     Fair
 
    Amount     Yield     Amount     Yield     Amount     Yield     Amount     Yield     Amount     Yield     Value  
    (Dollars in thousands)  
 
Available-for-Sale:
                                                                                       
Government sponsored agencies
  $ 64,067       1.22 %   $ 45,942       1.18 %   $ 5,583       1.83 %   $ 1,929       0.91 %   $ 117,521       1.23 %   $ 117,521  
State and political subdivisions
    1,053       5.21       8,819       4.17       33,408       5.71       2,766       5.92       46,046       5.42       46,046  
Residential mortgage-backed securities
    50,713       2.29       56,799       2.97       9,352       4.40       20,071       4.46       136,935       3.03       136,935  
Collateralized mortgage obligations***
    81,020       0.91       112,337       0.88       22,481       1.75       18,083       1.62       233,921       1.03       233,921  
Corporate bonds
    6,994       0.88       35,753       2.58                               42,747       2.31       42,747  
Preferred stock
                                        1,440       5.59       1,440       5.59       1,440  
                                                                                         
Total Investment Securities Available-for-Sale
    203,847       1.37       259,650       1.74       70,824       3.98       44,289       3.28       578,610       2.00       578,610  
                                                                                         
Held-to-Maturity:
                                                                                       
State and political subdivisions
    18,259       4.10       65,394       4.23       50,290       4.75       20,957       6.55       154,900       4.70       155,248  
Trust preferred securities
                                        10,500       3.88       10,500       3.88       3,940  
                                                                                         
Total Investment Securities Held-to-Maturity
    18,259       4.10       65,394       4.23       50,290       4.75       31,457       5.66       165,400       4.64       159,188  
                                                                                         
Total Investment Securities
  $ 222,106       1.59 %   $ 325,044       2.24 %   $ 121,114       4.30 %   $ 75,746       4.27 %   $ 744,010       2.59 %   $ 737,798  
                                                                                         
 
* Yields are weighted by amount and time to contractual maturity, are on a taxable equivalent basis using a 35% federal income tax rate and are based on carrying value.
 
** Residential mortgage-backed securities and collateralized mortgage obligations (CMOs) are based on scheduled principal maturity. All other investment securities are based on final contractual maturity.
 
*** Yields disclosed are actual yields at December 31, 2010. The majority of the CMOs are variable rate financial instruments.
 
The following table summarizes the carrying value of investment securities at December 31, 2010, 2009 and 2008:
 
TABLE 2. SUMMARY OF INVESTMENT SECURITIES
 
                         
    December 31,  
    2010     2009     2008  
    (In thousands)  
 
Available-for-Sale:
                       
U.S. Treasury
  $     $     $ 21,494  
Government sponsored agencies
    117,521       191,985       172,234  
State and political subdivisions
    46,046       3,562       4,552  
Residential mortgage-backed securities
    136,935       154,205       169,214  
Collateralized mortgage obligations
    233,921       223,758       37,285  
Corporate bonds
    42,747       19,011       45,168  
Preferred stock
    1,440              
                         
Total Investment Securities Available-for-Sale
    578,610       592,521       449,947  
                         
Held-to-Maturity:
                       
Government sponsored agencies
                1,007  
State and political subdivisions
    154,900       120,447       85,495  
Residential mortgage-backed securities
          350       509  
Trust preferred securities
    10,500       10,500       10,500  
                         
Total Investment Securities Held-to-Maturity
    165,400       131,297       97,511  
                         
Total Investment Securities
  $ 744,010     $ 723,818     $ 547,458  
                         
 


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The carrying value of investment securities at December 31, 2010 totaled $744.0 million, an increase of $20.2 million, or 2.8%, from investment securities at December 31, 2009 of $723.8 million. The increase in investment securities was attributable to the acquisition of OAK’s investment securities portfolio, which was partially offset by the Corporation not reinvesting all of its maturing investment securities. At December 31, 2010, the Corporation’s investment securities portfolio consisted of $117.5 million in government sponsored agency debt obligations comprised primarily of senior bonds that were issued by the twelve regional Federal Home Loan Banks that make up the Federal Home Loan Bank System (FHLBanks); $201.0 million in state and political subdivisions debt obligations comprised primarily of general debt obligations of issuers primarily located in the State of Michigan; $136.9 million in residential mortgage-backed securities comprised primarily of fixed rate instruments backed by a U.S. government agency (Government National Mortgage Association) or government sponsored enterprises (Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannie Mae)); $233.9 million of collateralized mortgage obligations comprised primarily of variable rate instruments with average maturities of less than three years backed by the same U.S. government agency and government sponsored enterprises as the residential mortgage-backed securities; $42.8 million in corporate bonds comprised primarily of debt obligations of large national financial organizations; preferred stock securities of $1.4 million comprised of preferred stock securities of two large banks; and $10.5 million of trust preferred securities (TRUPs) comprised primarily of a 100% interest in a TRUP of a small non-public bank holding company in Michigan.
 
The acquisition of OAK increased the Corporation’s investment securities portfolio by $69.6 million at the acquisition date and slightly changed the mix of the investment securities portfolio by increasing the amount of state and political subdivisions investment securities by $46.3 million, of which $46.0 million remained at December 31, 2010 in the available-for-sale portfolio. In addition, the preferred stock securities of $1.4 million at December 31, 2010 were acquired in the OAK acquisition. The Corporation has re-invested a portion of funds from maturing government sponsored agencies and residential mortgage-backed securities in 2010 into state and political subdivisions investment securities, as opportunities in local municipal markets remained available due to a reduction in demand nationally for local municipal securities. State and political subdivisions investment securities, which consist primarily of issuers located in the State of Michigan and are general obligations of the issuers, totaled $201.0 million, or 27.0%, of investment securities at December 31, 2010, compared to $124.0 million, or 17.1%, of investment securities at December 31, 2009. The Corporation also invested maturing funds from its investment securities portfolio into corporate bonds during 2010 due to an improvement in that market related to credit risk. The corporate bond portfolio totaled $42.7 million, or 5.7% of investment securities, at December 31, 2010, compared to $19.0 million, or 2.6% of investment securities, at December 31, 2009. The remaining investment securities that matured in 2010 were primarily held in interest bearing deposits at the Federal Reserve Bank of Chicago (FRB) due to the lack of investment options that meet the Corporation’s investment strategy, which is primarily centered on investing in relatively short-term investment securities with average maturities of two years or less or variable rate investment securities with limited exposure to credit risk.
 
The Corporation records all investment securities in accordance with FASB ASC Topic 320, Investments-Debt and Equity Securities (ASC 320), under which the Corporation is required to assess equity and debt securities that have fair values below their amortized cost basis to determine whether the decline (impairment) is other-than-temporary. An assessment is performed quarterly by the Corporation to determine whether unrealized losses in its investment securities portfolio are temporary or other-than-temporary by carefully considering all available information. The Corporation reviews factors such as financial statements, credit ratings, news releases and other pertinent information of the underlying issuer or company to make its determination.
 
Effective April 1, 2009, in accordance with FASB Staff Position FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (later codified in ASC 320), if the Corporation intends to sell a security or it is more-likely- than-not that the Corporation will be required to sell the security prior to the recovery of its amortized cost, an other-than-temporary impairment (OTTI) write down is recognized in earnings equal to the entire difference between the security’s amortized cost basis and its fair value. If the Corporation does not intend to sell a security and it is not more-likely-than-not that the Corporation would be required to sell a security before the recovery of its amortized cost basis, then the recognition of the impairment is bifurcated. For a security where the impairment is bifurcated, the impairment is separated into an amount representing credit loss, which is recognized in earnings, and an amount related to all other factors, which is recognized in other comprehensive income. Prior to April 1, 2009, all declines in fair value deemed to be other-than-temporary were reflected in earnings as realized losses. In assessing whether OTTI exists, management considers, among other things, (i) the length of time and the extent to which the fair value has been less than amortized cost, (ii) the financial condition and near-term prospects of the issuer, (iii) the potential for impairments in an entire industry or sub-sector and (iv) the potential for impairments in certain economically depressed geographical locations.
 
The Corporation’s investment securities portfolio with a carrying value of $744.0 million at December 31, 2010, had gross impairment of $9.4 million at that date. Management believed that the unrealized losses on investment securities were temporary in nature and due primarily to changes in interest rates on the investment securities and market illiquidity and not as a result of credit-related issues. Accordingly, at December 31, 2010, the Corporation believed the impairment in its investment securities portfolio was temporary in nature and, therefore, no impairment loss was realized in the Corporation’s consolidated statement of income for 2010.


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However, due to market and economic conditions, OTTI may occur as a result of material declines in the fair value of investment securities in the future. A further discussion of the assessment of potential impairment and the Corporation’s process that resulted in the conclusion that the impairment was temporary in nature follows.
 
At December 31, 2010, the Corporation’s investment securities portfolio included government sponsored agencies securities with gross impairment of $0.04 million, state and political subdivisions securities with gross impairment of $1.99 million, residential mortgage-backed securities and collateralized mortgage obligations, combined, with gross impairment of $0.38 million, corporate bonds with gross impairment of $0.47 million and trust preferred securities with gross impairment of $6.56 million. The amortized costs and fair values of investment securities are disclosed in Note 3 to the consolidated financial statements.
 
The government sponsored agencies securities, included in the available-for-sale investment securities portfolio, had an amortized cost totaling $117.2 million, with gross impairment of $0.04 million, at December 31, 2010. This gross impairment was attributable to impaired government sponsored agencies securities with an amortized cost of $20.2 million. All of the impaired investment securities are backed by the full faith and credit of the U.S. government. The Corporation determined that the impairment on these investment securities was attributable to the recent increase in interest rates for these investments and was temporary in nature at December 31, 2010. At December 31, 2010, the Corporation’s government sponsored agencies securities included $48.9 million of senior bonds at fair value that were issued by the twelve FHLBanks. There was no impairment in these FHLBanks’ investment securities at December 31, 2010. FHLBanks are government-sponsored enterprises created by Congress to ensure access to low-cost funding for their member financial institutions. FHLBanks overall experienced declines in profitability during the fourth quarter of 2008 and first quarter of 2009, primarily due to a number of the FHLBanks incurring significant OTTI losses on their portfolios of private-label residential mortgage-backed securities and home equity loans due to the dramatic decline in interest rates that occurred in 2008. However, the capital of FHLBanks improved throughout 2009 and by September 30, 2009, the FHLBanks were categorized as well-capitalized under applicable regulatory requirements and continued to be well-capitalized in 2010.
 
The state and political subdivisions securities, included in the available-for-sale and the held-to-maturity investment securities portfolios, had an amortized cost totaling $200.9 million, with gross impairment of $1.99 million, at December 31, 2010. The majority of these investment securities are from issuers primarily located in the State of Michigan and are general obligations of the issuer, meaning that the Corporation has the first claim on taxes collected for the repayment of the investment securities. The gross impairment of $1.99 million at December 31, 2010 was attributable to $77.7 million of investment securities at amortized cost, with two-thirds of these investment securities maturing beyond 2013. The Corporation determined that the impairment of $1.99 million at December 31, 2010 was attributable to the recent change in market interest rates for these investment securities and the market’s perception of the Michigan economy causing illiquidity in the market for these investment securities. The Corporation determined that the impairment on these investment securities at December 31, 2010 was temporary in nature.
 
The residential mortgage-backed securities and collateralized mortgage obligations, included in the available-for-sale investment securities portfolio, had a combined amortized cost of $365.9 million, with gross impairment of $0.38 million, at December 31, 2010. Virtually all of the impaired investment securities in these two categories are backed by a guarantee of a U.S. government agency or government sponsored enterprise and are AAA rated. The Corporation assessed the impairment on these investment securities and determined that the impairment was attributable to the low level of market interest rates and the volatility of prepayment speeds and that the impairment on these investment securities at December 31, 2010 was temporary in nature.
 
At December 31, 2010, the Corporation’s corporate bond portfolio, included in the available-for-sale investment securities portfolio, had an amortized cost of $43.1 million, with gross impairment of $0.47 million. All of the corporate bonds held at December 31, 2010 were of an investment grade, except a single issue investment security of Lehman Brothers Holdings Inc. (Lehman) and a corporate bond of American General Finance Corporation (AGFC). During the third quarter of 2008, the Corporation recognized an OTTI loss of $0.4 million related to the write-down of the Lehman bond to fair value as the impairment was deemed to be other-than-temporary and entirely credit related. The Corporation’s remaining amortized cost of the Lehman bond was less than $0.1 million at December 31, 2010. AGFC was a wholly-owned subsidiary of Fortress Investment Group, LLC, which was rated BBB by Fitch at December 31, 2010. AGFC had previously been owned by American General Finance Inc. (AGFI), which was wholly-owned indirectly by American International Group (AIG). At December 31, 2010, the AGFC corporate bond had an amortized cost of $2.5 million with gross impairment of $0.15 million and a maturity date of December 15, 2011. At December 31, 2010, the Corporation’s assessment was that it was probable that it would collect all of the contractual amounts due on the AGFC corporate bond. The impairment at December 31, 2010 on the AGFC corporate bond of $0.15 million improved from $0.46 million of impairment at December 31, 2009. Ratings from Moody’s, Standard & Poor’s and Fitch were B2, BB+ and BB, respectively, at December 31, 2010. The investment grade ratings obtained for the balance of the corporate bond portfolio, with a gross impairment of $0.32 million at December 31, 2010, indicated that the obligors’ capacities to meet their financial commitments was “strong.” The Corporation assessed the gross impairment of $0.47 million on the corporate bond portfolio at December 31, 2010 and determined that the impairment was attributable to the low level of market interest rates, and not due to credit-related issues, and that the impairment on the corporate bond portfolio at December 31, 2010 was temporary in nature.


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At December 31, 2010, the Corporation held two TRUPs in the held-to-maturity investment securities portfolio, with a combined amortized cost of $10.5 million that had gross impairment of $6.56 million. One TRUP, with an amortized cost of $10.0 million, represented a 100% interest in a TRUP of a small non-public bank holding company in Michigan that was purchased in the second quarter of 2008. At December 31, 2010, the Corporation determined that the fair value of this TRUP was $3.80 million. The second TRUP, with an amortized cost of $0.5 million, represented a 10% interest in the TRUP of another small non-public bank holding company in Michigan. At December 31, 2010, the Corporation determined the fair value of this TRUP was $0.14 million. The fair value measurements of the two TRUP investments were developed based upon market pricing observations of much larger banking institutions in an illiquid market adjusted by risk measurements. The fair values of the TRUPs were based on calculations of discounted cash flows, and further based upon both observable inputs and appropriate risk adjustments that market participants would make for performance, liquidity and issuer specifics. See the additional discussion of the development of the fair values of the TRUPs in Note 3 to the consolidated financial statements.
 
Management reviewed financial information of the issuers of the TRUPs at December 31, 2010. Based on this review, the Corporation concluded that the significant decline in fair values of the TRUPs, compared to their amortized cost, was not attributable to materially adverse conditions specifically related to the issuers. The issuer of the $10.0 million TRUP reported net income in each of the three years ended December 31, 2010. At December 31, 2010, the issuer was categorized as well-capitalized under applicable regulatory requirements and had a liquidity position which included over $100 million in investment securities held as available-for-sale. Based on the Corporation’s analysis at December 31, 2010, it was the Corporation’s opinion that this issuer appeared to be a financially sound financial institution with sufficient liquidity to meet its financial obligations in 2011. This TRUP is not independently rated. Bank industry ratings as of September 30, 2010, obtained from Bauer Financial at www.bauerfinancial.com (Bauer) for subsidiaries of this issuer were rated good and excellent. Common stock cash dividends were paid throughout 2010 and 2009 by the issuer and the Corporation understands that the issuer’s management anticipates cash dividends to continue to be paid in the future. All scheduled interest payments on this TRUP were made on a timely basis in 2009 and 2010. The principal of $10.0 million of this TRUP matures in 2038, with interest payments due quarterly.
 
Based on the information provided by the issuer of the $10.0 million TRUP, it was the Corporation’s opinion that, as of December 31, 2010, there had been no material adverse changes in the issuer’s financial performance since the TRUP was issued and purchased by the Corporation and no indication that any material adverse trends were developing that would suggest that the issuer would be unable to make all future principal and interest payments under the TRUP. Further, based on the information provided by the issuer, the issuer appeared to be a financially viable financial institution with both the credit quality and liquidity necessary to meet its financial obligations in 2011. At December 31, 2010, the Corporation was not aware of any regulatory issues, memorandums of understanding or cease and desist orders that had been issued to the issuer or its subsidiaries. In reviewing all available information regarding the issuer, including past performance and its financial and liquidity position, it was the Corporation’s opinion that the future cash flows of the issuer supported the carrying value of the TRUP at its original cost of $10.0 million at December 31, 2010. While the total fair value of the TRUP was $6.2 million below the Corporation’s amortized cost at December 31, 2010, it was the Corporation’s assessment that, based on the overall financial condition of the issuer, the impairment was temporary in nature at December 31, 2010.
 
The issuer of the $0.5 million TRUP reported a net loss in 2010 that was significantly greater than a small net loss reported in 2009. At December 31, 2010, the issuer was categorized as well-capitalized under applicable regulatory requirements and its subsidiary bank was rated adequate by Bauer based on September 30, 2010 financial data. All scheduled interest payments on this TRUP were made on a timely basis in 2010 and 2009. The principal of $0.5 million of this TRUP matures in 2033, with interest payments due quarterly. At December 31, 2010, the Corporation was not aware of any regulatory issues, memorandums of understanding or cease and desist orders that had been issued to the issuer of this TRUP or any subsidiary. In reviewing all financial information regarding the $0.5 million TRUP, it was the Corporation’s opinion that the carrying value of this TRUP at its original cost of $0.5 million was supported by the issuer’s financial position at December 31, 2010, even though the fair value of the TRUP was $0.3 million below the Corporation’s amortized cost at December 31, 2010. It was the Corporation’s assessment that the impairment was temporary in nature at December 31, 2010.
 
At December 31, 2010, the Corporation expected to fully recover the entire amortized cost basis of each impaired investment security in its investment securities portfolio at that date. Furthermore, at December 31, 2010, the Corporation did not have the intent to sell any of its impaired investment securities and believed that it was more likely-than-not that the Corporation would not have to sell any of its impaired investment securities before a full recovery of amortized cost. However, there can be no assurance that OTTI losses will not be recognized on the TRUPs or on any other investment security in the future.
 
The Corporation did not realize any investment securities impairment losses in 2010 or 2009. In 2008, the Corporation recorded a $0.4 million loss related to the write-down of a specific investment debt security to fair value as the impairment was deemed to be other-than-temporary in nature and entirely credit related.


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LOANS
 
Chemical Bank is a full-service commercial bank and, therefore, the acceptance and management of credit risk is an integral part of the Corporation’s business. At December 31, 2010, the Corporation’s loan portfolio was $3.68 billion and consisted of loans to commercial borrowers (commercial, real estate commercial and real estate construction and land development) totaling $2.04 billion, or 55.4% of total loans, loans to borrowers for the purpose of acquiring residential real estate totaling $798 million, or 21.7% of total loans, and loans to consumer borrowers secured by various types of collateral totaling $845 million, or 22.9% of total loans, at that date. Loans at fixed interest rates comprised approximately 72% of the Corporation’s total loan portfolio at December 31, 2010, compared to 80% at December 31, 2009.
 
The Corporation maintains loan policies and credit underwriting standards as part of the process of managing credit risk. These standards include making loans generally only within the Corporation’s market areas. The Corporation’s lending markets generally consist of communities across the middle to southern and western sections of the lower peninsula of Michigan. The Corporation’s lending market areas do not include the southeastern portion of Michigan. The Corporation has no foreign loans or any loans to finance highly leveraged transactions. The Corporation’s lending philosophy is implemented through strong administrative and reporting controls. The Corporation maintains a centralized independent loan review function that monitors the approval process and ongoing asset quality of the loan portfolio.
 
Table 3 includes the composition of the Corporation’s loan portfolio, by major loan category, as of December 31, 2010, 2009, 2008, 2007 and 2006.
 
TABLE 3. SUMMARY OF LOANS
 
                                             
    December 31,
    2010     2009     2008     2007     2006      
    (In thousands)
 
Distribution of Loans:
                                           
Commercial
  $ 818,997     $ 584,286     $ 587,554     $ 515,319     $ 545,591      
Real estate commercial
    1,076,971       785,675       786,404       760,399       726,554      
Real estate construction and land development
    142,620       121,305       119,001       134,828       145,933      
Real estate residential
    798,046       739,380       839,555       838,545       835,263      
Consumer installment and home equity
    845,028       762,514       649,163       550,343       554,319      
                                             
Total loans
  $ 3,681,662     $ 2,993,160     $ 2,981,677     $ 2,799,434     $ 2,807,660      
                                             
 
Table 4 presents the maturity distribution of commercial, real estate commercial and real estate construction and land development loans. These loans totaled $2.04 billion and represented 55% of total loans at December 31, 2010. The percentage of these loans maturing within one year was 41% at December 31, 2010, while the percentage of these loans maturing beyond five years remained low at 6% at December 31, 2010. At December 31, 2010, commercial, real estate commercial and real estate construction and land development loans with maturities beyond one year totaled $1.21 billion and were comprised of 73% of fixed interest rate loans.
 
TABLE 4. COMPARISON OF LOAN MATURITIES AND INTEREST SENSITIVITY (Dollars in thousands)
 
                                 
    December 31, 2010  
    Due In  
    1 Year
    1 to 5
    Over 5
       
    or Less     Years     Years     Total  
 
Loan Maturities:
                               
Commercial
  $ 489,153     $ 268,481     $ 61,363     $ 818,997  
Real estate commercial
    252,301       766,320       58,350       1,076,971  
Real estate construction and land development
    90,892       47,333       4,395       142,620  
                                 
Total
  $ 832,346     $ 1,082,134     $ 124,108     $ 2,038,588  
                                 
Percent of Total
    41 %     53 %     6 %     100 %
                                 
 


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    December 31, 2010  
    Amount     Percent  
 
Interest Sensitivity:
               
Above loans maturing after one year which have:
               
Fixed interest rates
  $ 878,696       73 %
Variable interest rates
    327,546       27  
                 
Total
  $ 1,206,242       100 %
                 
 
Total loans were $3.68 billion at December 31, 2010, an increase of $689 million, or 23%, from total loans of $2.99 billion at December 31, 2009. Total loans increased $11.5 million, or 0.4%, during 2009, from total loans of $2.98 billion at December 31, 2008. The increase in total loans during 2010 was due primarily to the loans acquired in the acquisition of OAK. In addition, during 2010, the Corporation originated $71 million of fifteen-year fixed-rate residential mortgage loans that it held in its portfolio, as opposed to selling them in the secondary market as has been its general practice. At April 30, 2010, OAK’s loan portfolio was recorded by the Corporation at its fair value of $627 million and was comprised of commercial loans totaling $191 million, real estate commercial loans totaling $294 million, real estate construction and land development loans totaling $39 million, real estate residential loans totaling $34 million and consumer installment and home equity loans totaling $69 million. A summary of the Corporation’s loan portfolio by category follows.
 
Commercial loans consist of loans to varying types of businesses, including municipalities, school districts and nonprofit organizations, for the purpose of supporting working capital and operational needs and term financing of equipment. Repayment of such loans is generally provided through operating cash flows of the customer. Commercial loans are generally secured with inventory, accounts receivable, equipment, personal guarantees of the owner or other sources of repayment, although the Corporation may also obtain real estate as collateral.
 
Commercial loans were $819.0 million at December 31, 2010, an increase of $234.7 million, or 40.2%, from commercial loans at December 31, 2009 of $584.3 million, with the increase due primarily to the acquisition of OAK. Commercial loans decreased $3.2 million, or 0.6%, during 2009 from commercial loans at December 31, 2008 of $587.5 million. Commercial loans represented 22.2% of the Corporation’s loan portfolio at December 31, 2010, compared to 19.5% and 19.7% at December 31, 2009 and 2008, respectively.
 
Real estate commercial loans include loans that are secured by real estate occupied by the borrower for ongoing operations, non-owner occupied real estate leased to one or more tenants and vacant land that has been acquired for investment or future land development. Real estate commercial loans were $1.08 billion at December 31, 2010, an increase of $291.3 million, or 37.1%, from real estate commercial loans at December 31, 2009 of $785.7 million, with the increase due primarily to the acquisition of OAK. Loans secured by owner occupied properties, non-owner occupied properties and vacant land comprised 63%, 34% and 3%, respectively, of the Corporation’s real estate commercial loans outstanding at December 31, 2010. Real estate commercial loans decreased $0.7 million, or 0.1%, during 2009 from real estate commercial loans at December 31, 2008 of $786.4 million. Real estate commercial loans represented 29.3% of the Corporation’s loan portfolio at December 31, 2010, compared to 26.2% and 26.4% at December 31, 2009 and 2008, respectively.
 
Real estate commercial lending is generally considered to involve a higher degree of risk than real estate residential lending and typically involves larger loan balances concentrated in a single borrower. In addition, the payment experience on loans secured by income-producing properties and vacant land loans are typically dependent on the success of the operation of the related project and are typically affected by adverse conditions in the real estate market and in the economy.
 
The Corporation generally attempts to mitigate the risks associated with commercial and real estate commercial lending by, among other things, lending primarily in its market areas, lending across industry lines, not developing a concentration in any one line of business and using prudent loan-to-value ratios in the underwriting process. The weakened economy in Michigan has resulted in higher loan delinquencies, customer bankruptcies and real estate foreclosures. Based on current economic conditions in Michigan, management expects real estate foreclosures to remain higher than historical averages. It is also management’s belief that the loan portfolio is generally well-secured, despite declining market values for all types of real estate in the State of Michigan and nationwide.
 
Real estate construction and land development loans are primarily originated for land development and construction of commercial properties. Land development loans include loans made to developers for the purpose of infrastructure improvements to vacant land to create finished marketable residential and commercial lots/land. Real estate construction loans often convert to a real estate commercial loan at the completion of the construction period; however, most land development loans are originated with the intention that the loans will be re-paid through the sale of finished properties by the developers within twelve months of the completion date. Real estate construction and land development loans were $142.6 million at December 31, 2010, an increase of

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$21.3 million, or 17.6%, from real estate construction and land development loans at December 31, 2009 of $121.3 million, with the increase primarily due to the acquisition of OAK. Real estate construction and land development loans increased $2.3 million, or 1.9%, during 2009 from real estate construction and land development loans of $119.0 million at December 31, 2008. The Corporation’s land development loans totaled $53.4 million and $46.6 million at December 31, 2010 and 2009, respectively, and consisted primarily of loans to develop residential real estate. Real estate construction and land development loans represented 3.9% of the Corporation’s loan portfolio at December 31, 2010, compared to 4.1% and 4.0% at December 31, 2009 and 2008, respectively.
 
Real estate construction lending involves a higher degree of risk than real estate commercial lending and real estate residential lending because of the uncertainties of construction, including the possibility of costs exceeding the initial estimates, the need to obtain a tenant or purchaser of the property if it will not be owner-occupied or the need to sell developed properties. The Corporation generally attempts to mitigate the risks associated with construction lending by, among other things, lending primarily in its market areas, using prudent underwriting guidelines and closely monitoring the construction process. The Corporation’s risk in this area has increased since early 2008 due to the recessionary economic environment within the State of Michigan. The sale of lots and units in both residential and commercial development projects remains weak, as customer demand also remains low, resulting in the inventory of unsold lots and housing units remaining high across the State of Michigan. The unfavorable economic environment in Michigan has resulted in the inability of most developers to sell their finished developed lots and units within their original expected time frames. Accordingly, few of the Corporation’s land development borrowers have sold developed lots or units since early 2008 due to the unfavorable economic environment.
 
The Corporation’s commercial loan portfolio, comprised of commercial, real estate commercial and real estate construction and land development loans, is well diversified across business lines and has no concentration in any one industry. The commercial loan portfolio totaling $2.04 billion at December 31, 2010 included 142 loan relationships of $2.5 million or greater. These 142 borrowing relationships totaled $747 million and represented 37% of the commercial loan portfolio at December 31, 2010. At December 31, 2010, 12 of these borrowing relationships had outstanding balances of $10 million or higher, totaling $166 million, or 8%, of the commercial loan portfolio at that date. Further, the Corporation had four loan relationships at December 31, 2010 with loan balances greater than $2.5 million and less than $10 million, totaling $32.2 million, that had unfunded credit amounts that, if advanced, could result in a loan relationship of $10 million or more.
 
Real estate residential loans consist primarily of one- to four-family residential loans with fixed interest rates of fifteen years or less. The Corporation generally sells fixed interest rate real estate residential loans originated with maturities of over fifteen years in the secondary market. The loan-to-value ratio at the time of origination is generally 80% or less. Loans with more than an 80% loan-to-value ratio generally require private mortgage insurance. Real estate residential loans were $798.0 million at December 31, 2010, an increase of $58.7 million, or 7.9%, from real estate residential loans at December 31, 2009 of $739.4 million. The increase in real estate residential loans in 2010 was partially due to the acquisition of OAK and partially due to the Corporation electing to hold in its portfolio $71 million of fifteen-year term fixed interest rate real estate residential loans during 2010 that historically have been sold in the secondary market. Real estate residential loans decreased $100.2 million, or 11.9%, during 2009 from real estate residential loans of $839.6 million at December 31, 2008. The decrease in real estate residential loans in 2009 was attributable to both a significant decline in Michigan’s housing market due to the overall economic environment and customers refinancing adjustable rate and balloon mortgages to long-term fixed interest rate loans that the Corporation sold in the secondary market. While real estate residential loans have historically involved the least amount of credit risk in the Corporation’s loan portfolio, the risk on these loans has increased as the unemployment rate has increased and real estate property values have decreased in the State of Michigan. Real estate residential loans also include loans to consumers for the construction of single family residences that are secured by these properties. Real estate residential construction loans to consumers were $15.3 million at December 31, 2010, compared to $22.9 million at December 31, 2009 and $29.2 million at December 31, 2008. Real estate residential loans represented 21.7% of the Corporation’s loan portfolio at December 31, 2010, compared to 24.7% and 28.1% at December 31, 2009 and 2008, respectively.
 
The Corporation’s consumer loans consist of relatively small loan amounts to consumers to finance personal items; primarily automobiles, recreational vehicles and boats. These loans are spread across many individual borrowers, which minimizes the risk per loan transaction. Collateral values, particularly those of automobiles, recreational vehicles and boats, are negatively impacted by many factors, such as new car promotions, the physical condition of the collateral and even more significantly, overall economic conditions. Consumer loans also include home equity loans, whereby consumers utilize equity in their personal residence, generally through a second mortgage, as collateral to secure the loan.
 
Consumer installment and home equity loans (consumer loans) were $845.0 million at December 31, 2010, an increase of $82.5 million, or 10.8%, from consumer loans at December 31, 2009 of $762.5 million, with the increase due primarily to the acquisition of OAK. Consumer loans increased $113.4 million, or 17.5%, during 2009 from consumer loans of $649.2 million at December 31, 2008. The increase in consumer loans during 2009 was primarily attributable to an increase in indirect consumer loans, due to a combination of an increased sales effort, new technology to support indirect loan application processing and a


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reduction in the number of competing lenders. Indirect consumer loans include automobile, recreational vehicle and boat financing purchased from dealerships. At December 31, 2010, approximately 45% of consumer loans were secured by the borrowers’ personal residences (primarily second mortgages), 25% by automobiles, 19% by recreational vehicles, 8% by marine vehicles and the remaining 3% was mostly unsecured. Consumer loans represented 22.9% of the Corporation’s loan portfolio at December 31, 2010, compared to 25.5% and 21.8% at December 31, 2009 and 2008, respectively.
 
Consumer loans generally have shorter terms than residential mortgage loans, but generally involve more credit risk than real estate residential lending because of the type and nature of the collateral. The Corporation originates consumer loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. Consumer lending collections are dependent on the borrowers’ continuing financial stability and are more likely to be affected by adverse personal situations. Overall, credit risk on these loans has increased as the unemployment rate has increased. The unemployment rate in the State of Michigan was 11.7% at December 31, 2010, down from 14.6% at December 31, 2009, although higher than 10.2% at December 31, 2008 and the national average of 9.4% at December 31, 2010. The Corporation has experienced significant increases in losses on consumer loans, with net loan losses totaling 116 basis points of average consumer loans during 2010, compared to 77 basis points of average consumer loans in 2009 and 71 basis points of average consumer loans in 2008. The credit risk on home equity loans has historically been low as property values of residential real estate have historically increased year over year. However, credit risk has increased since the beginning of 2008 as property values have declined throughout the State of Michigan, thus increasing the risk of insufficient collateral, and in many instances no collateral, as the majority of these loans are secured by a second mortgage on the borrowers’ residences.
 
ASSET QUALITY
 
Nonperforming Assets
 
Nonperforming assets consist of originated loans for which the accrual of interest has been discontinued, originated loans that are past due as to principal or interest by 90 days or more and are still accruing interest, originated loans which have been modified due to a decline in the credit quality of the borrower (collectively referred to as nonperforming loans or nonperforming loans of the originated portfolio) and assets obtained through foreclosures and repossessions, including foreclosed and repossessed assets acquired as a result of the OAK transaction. The Corporation transfers an originated loan that is 90 days or more past due to nonaccrual status (except for real estate residential loans that are transferred at 120 days past due), unless it believes the loan is both well-secured and in the process of collection. Accordingly, the Corporation has determined that the collection of accrued and unpaid interest on any originated loan that is 90 days or more past due (120 days or more past due on real estate residential loans) and still accruing interest is probable.
 
Nonperforming assets do not include acquired loans that were not performing in accordance with the loans’ contractual terms. These loans were recorded at their estimated fair value, which included estimated credit losses, at the acquisition date and are considered performing due to the application of ASC 310-30 as discussed in Note 1 to the consolidated financial statements under the subheading, Loans Acquired in a Business Combination. Accordingly, these acquired loans have been excluded from Table 5 — Nonperforming Assets.
 
Nonperforming assets were $175.2 million at December 31, 2010, compared to $153.3 million at December 31, 2009 and $113.3 million at December 31, 2008, and represented 3.3%, 3.6% and 2.9%, respectively, of total assets. The decrease in this ratio at December 31, 2010 compared to December 31, 2009 was attributable to the acquisition of OAK, which increased total assets $820 million at the acquisition date, with no increase in nonperforming loans, as the acquired loans were recorded at their fair value, which included a discount attributable, in part, to credit quality. It is management’s belief that the elevated levels of nonperforming assets are primarily attributable to the unfavorable economic climate within the State of Michigan, which has resulted in cash flow difficulties being encountered by many business and consumer loan customers. The unemployment rate in Michigan was 11.7% at December 31, 2010, compared to 9.4% nationwide. The Corporation’s nonperforming assets are not concentrated in any one industry or any one geographical area within Michigan, other than $10.2 million in nonperforming land development loans. At December 31, 2010, there were seven commercial loan relationships exceeding $2.5 million, totaling $24.3 million, that were in nonperforming status. Based on declines in both residential and commercial real estate appraised values due to the weakness in the Michigan economy over the past several years, management continues to evaluate and, when appropriate, discount appraised values and obtain new appraisals to compute estimated fair market values of impaired real estate secured loans and other real estate properties. Due to the economic climate within Michigan, it is management’s belief that nonperforming assets will remain at elevated levels throughout 2011.


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Table 5 provides a five-year history of nonperforming assets, including the composition of nonperforming loans of the originated portfolio, by major loan category.
 
TABLE 5. NONPERFORMING ASSETS
 
                                         
    December 31,  
    2010     2009     2008     2007     2006  
    (Dollars in thousands)  
 
Nonaccrual loans(1):
                                       
Commercial
  $ 16,668     $ 19,309     $ 16,324     $ 10,961     $ 4,203  
Real estate commercial
    60,558       49,419       27,344       19,672       9,612  
Real estate construction and land development
    8,967       15,184       15,310       12,979       2,552  
Real estate residential
    12,083       15,508       12,175       8,516       2,887  
Consumer installment and home equity
    4,686       7,169       5,313       3,468       985  
                                         
Total nonaccrual loans
    102,962       106,589       76,466       55,596       20,239  
Accruing loans contractually past due 90 days or more
as to interest or principal payments:
                                       
Commercial
    530       1,371       1,652       1,958       1,693  
Real estate commercial
    1,350       3,971       9,995       4,170       2,232  
Real estate construction and land development
    1,220       1,990       759             174  
Real estate residential
    3,253       3,614       3,369       1,470       1,158  
Consumer installment and home equity
    1,055       787       1,087       166       1,414  
                                         
Total accruing loans contractually past due 90 days or more as to interest or principal payments
    7,408       11,733       16,862       7,764       6,671  
Loans modified under troubled debt restructurings(2):
                                       
Commercial and real estate commercial
    15,057                          
Real estate residential
    22,302       17,433                    
                                         
Total loans modified under troubled debt restructurings
    37,359       17,433                    
                                         
Total nonperforming loans of the originated portfolio
    147,729       135,755       93,328       63,360       26,910  
Other real estate and repossessed assets(3)
    27,510       17,540       19,923       11,132       8,852  
                                         
Total nonperforming assets
  $ 175,239     $ 153,295     $ 113,251     $ 74,492     $ 35,762  
                                         
Nonperforming loans as a percent of total originated loans
    4.72 %     4.54 %     3.13 %     2.26 %     0.96 %
                                         
Nonperforming assets as a percent of total assets
    3.34 %     3.61 %     2.92 %     1.98 %     0.94 %
                                         
 
(1) There was no interest income recognized on nonaccrual loans in 2010 while they were in nonaccrual status. During 2010, the Corporation recognized $1.1 million of interest income on these loans while they were in an accruing status. Additional interest income of $5.9 million would have been recorded during 2010 on nonaccrual loans had they been current in accordance with their original terms.
 
(2) Interest income of $1.8 million was recorded in 2010 on loans modified under troubled debt restructurings.
 
(3) Includes property acquired through foreclosure and by acceptance of a deed in lieu of foreclosure and other property held for sale, including properties acquired as a result of the OAK transaction.
 
The following schedule provides the composition of nonperforming loans of the originated portfolio, by major loan category, as of December 31, 2010 and 2009.
 
                                 
    December 31,  
    2010     2009  
          Percent
          Percent
 
    Amount     of Total     Amount     of Total  
    (Dollars in thousands)  
 
Commercial
  $ 22,511       15 %   $ 20,680       15 %
Real estate commercial
    71,652       49       53,390       39  
Real estate construction and land development
    10,187       7       17,174       13  
                                 
Subtotal
    104,350       71       91,244       67  
Real estate residential
    37,638       25       36,555       27  
Consumer installment and home equity
    5,741       4       7,956       6  
                                 
Total nonperforming loans of originated portfolio
  $ 147,729       100 %   $ 135,755       100 %
                                 


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Total nonperforming loans of the originated portfolio at December 31, 2010 were $147.7 million, an increase of $11.9 million, or 8.8%, compared to $135.8 million at December 31, 2009. The Corporation’s nonperforming loans to commercial borrowers (commercial, real estate commercial and real estate construction and land development) of the originated portfolio, including loans modified under troubled debt restructurings, were $104.4 million at December 31, 2010, an increase of $13.2 million, or 14%, from $91.2 million at December 31, 2009. The net increase in nonperforming loans to commercial borrowers of the originated portfolio during 2010 was largely due to an increase in loans modified under troubled debt restructurings. Nonperforming loans to commercial borrowers comprised 71% of total nonperforming loans at December 31, 2010, compared to 67% at December 31, 2009. Likewise, as disclosed in Table 6, the majority of the Corporation’s net loan charge-offs during 2010 occurred within these three commercial loan categories, with 55% of net loan charge-offs during 2010 attributable to commercial borrowers, although down from 75% in 2009. Nonperforming real estate residential loans of the originated portfolio, including loans modified under troubled debt restructurings, were $37.6 million at December 31, 2010, an increase of $1.0 million, or 3.0%, from $36.6 million at December 31, 2009. Nonperforming consumer loans of the originated portfolio were $5.7 million at December 31, 2010, a decrease of $2.3 million, or 28%, from $8.0 million at December 31, 2009.
 
The following schedule summarizes changes in nonaccrual loans of the originated portfolio during 2010 and 2009:
                 
    Years Ended December 31,  
    2010     2009  
    (In thousands)  
 
Balance at beginning of year
  $ 106,589     $ 76,466  
Additions during period
    85,882       124,403  
Principal balances charged off
    (35,845 )     (36,146 )
Transfers to other real estate/repossessed assets
    (21,534 )     (18,320 )
Return to accrual status
    (9,576 )     (18,174 )
Payments received
    (22,554 )     (21,640 )
                 
Balance at end of year
  $ 102,962     $ 106,589  
                 
 
The following schedule presents data related to nonperforming commercial, real estate commercial and real estate construction and land development loans of the originated portfolio by dollar amount as of December 31, 2010 and 2009.
 
                                 
    December 31,  
    2010     2009  
    Number of
          Number of
       
    Borrowers     Amount     Borrowers     Amount  
    (Dollars in thousands)  
 
$5,000,000 or more
    1     $ 7,227       1     $ 7,532  
$2,500,000 - $4,999,999
    6       17,071       4       11,926  
$1,000,000 - $2,499,999
    18       29,246       17       28,989  
$500,000 - $999,999
    22       14,483       21       14,640  
$250,000 - $499,999
    50       18,188       40       14,042  
Under $250,000
    202       18,135       175       14,115  
                                 
Total
    299     $ 104,350       258     $ 91,244  
                                 
 
Nonperforming commercial loans of the originated portfolio were $22.5 million at December 31, 2010, an increase of $1.8 million, or 8.9%, from $20.7 million at December 31, 2009. The nonperforming commercial loans of the originated portfolio at December 31, 2010 were not concentrated in any single industry and it is management’s belief that the increase from December 31, 2009 was primarily reflective of the unfavorable economic conditions in Michigan.
 
Nonperforming real estate commercial loans of the originated portfolio were $71.7 million at December 31, 2010, an increase of $18.3 million, or 34%, from $53.4 million at December 31, 2009. At December 31, 2010, the Corporation’s nonperforming real estate commercial loans of the originated portfolio were comprised of $34.6 million of loans secured by owner occupied real estate, $29.4 million of loans secured by non-owner occupied real estate and $7.7 million of loans secured by vacant land, resulting in approximately 6% of owner occupied real estate commercial loans of the originated portfolio, 12% of non-owner occupied real estate commercial loans of the originated portfolio and 29% of vacant land loans of the originated portfolio in a nonperforming status at December 31, 2010. At December 31, 2010, the Corporation’s nonperforming real estate commercial loans of the originated portfolio were comprised of a diverse mix of commercial lines of business and were also geographically disbursed throughout the Corporation’s market areas. The largest concentration of the $71.7 million in nonperforming real estate commercial loans of the


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originated portfolio at December 31, 2010 was one customer relationship totaling $6.8 million that was secured by a combination of vacant land and non-owner occupied commercial real estate. This same customer relationship had another $0.4 million included in nonperforming real estate construction and land development loans of the originated portfolio. At December 31, 2010, $11.4 million of the nonperforming real estate commercial loans of the originated portfolio were in various stages of foreclosure with 38 borrowers. Challenges remain in the Michigan economy, thus creating a difficult business environment for many lines of business across the state.
 
Nonperforming real estate construction and land development loans of the originated portfolio were $10.2 million at December 31, 2010, a decrease of $7.0 million, or 41%, from $17.2 million at December 31, 2009. At December 31, 2010, all of the nonperforming real estate construction and land development loans were land development loans secured primarily by residential real estate improved lots and housing units. The $10.2 million of nonperforming loans secured by land development projects represented 29% of total land development loans of the originated portfolio outstanding of $34.7 million at December 31, 2010. The economy in Michigan has adversely impacted housing demand throughout the state and, accordingly, a significant percentage of the Corporation’s residential real estate development borrowers have experienced cash flow difficulties associated with a significant decline in sales of both lots and residential real estate.
 
Nonperforming real estate residential loans of the originated portfolio, including loans modified under troubled debt restructurings, were $37.6 million at December 31, 2010, an increase of $1.0 million, or 3.0%, from $36.6 million at December 31, 2009. At December 31, 2010, a total of $9.7 million of nonperforming real estate residential loans of the originated portfolio were in various stages of foreclosure.
 
Nonperforming consumer loans of the originated portfolio were $5.7 million at December 31, 2010, a decrease of $2.3 million, or 28%, from $8.0 million at December 31, 2009. The decrease in nonperforming consumer loans during 2010 was primarily attributable to elevated levels of net loan charge-offs of consumer loans of the originated portfolio, which were $9.0 million during 2010, compared to $5.6 million during 2009.
 
The unfavorable economic climate in Michigan has resulted in an increasing number of both business and consumer customers with cash flow difficulties and thus the inability to maintain their loan balances in a performing status. The Corporation determined that it was probable that certain customers who were past due on their loans, if provided a reduction in their monthly payment for a limited time period, would be able to bring their loan relationship to a performing status and was believed by the Corporation to potentially result in a lower level of loan losses and loan collection costs than if the Corporation currently proceeded through the foreclosure process with these borrowers.
 
The Corporation’s loans modified under troubled debt restructurings-commercial and real estate commercial generally consist of allowing borrowers to defer scheduled principal payments and make interest only payments for a short period of time at the stated interest rate of the original loan agreement or lower payments due to a modification of the loan’s contractual terms. The outstanding balance of these loans was $15.1 million at December 31, 2010. The Corporation does not expect to incur a loss on these loans based on its assessment of the borrowers’ expected cash flows, and accordingly, no additional provision for loan losses has been recognized related to these loans. Additionally, these loans are individually evaluated for impairment and transferred to nonaccrual status when it is probable that any remaining principal and interest payments due on the loan will not be collected in accordance with the contractual terms of the loan.
 
The Corporation’s loans modified under troubled debt restructurings-real estate residential generally consist of reducing a borrower’s monthly payments by decreasing the interest rate charged on the loan to 3% for a specified period of time (generally 24 months). The outstanding loan balance of these loans was $22.3 million at December 31, 2010, compared to $17.4 million at December 31, 2009. All loans reported as loans modified under troubled debt restructurings-real estate residential will remain in nonperforming status until a sustained payment history has been observed. The Corporation recognized $0.6 million and $0.8 million of additional provision for loan losses during 2010 and 2009, respectively, related to impairment on these loans based on the present value of expected future cash flows discounted at the loan’s original effective interest rate. These loans are moved to nonaccrual status when the loan becomes ninety days past due as to principal or interest and sooner if conditions warrant.
 
Other real estate and repossessed assets is a component of nonperforming assets that includes residential and commercial real estate and development properties acquired through foreclosure or by acceptance of a deed in lieu of foreclosure, and also other personal and commercial assets. Other real estate and repossessed assets were $27.5 million at December 31, 2010, an increase of $10.0 million, or 57%, from $17.5 million at December 31, 2009. The increase from December 31, 2009 was partially attributable to $2.7 million of other real estate and $0.2 million of repossessed assets acquired in the OAK acquisition at the acquisition date. The increase was also attributable to the foreclosure and transfer into other real estate of one real estate commercial loan acquired in the OAK acquisition with a carrying value of $4.3 million.


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The following schedule provides the composition of other real estate and repossessed assets at December 31, 2010 and 2009:
 
                 
    December 31,  
    2010     2009  
    (In thousands)  
 
Other real estate:
               
Vacant land
  $ 9,149     $ 3,427  
Commercial properties
    8,604       4,160  
Residential real estate properties
    6,189       7,384  
Residential development properties
    3,035       2,277  
                 
Total other real estate
    26,977       17,248  
Repossessed assets
    533       292  
                 
Total other real estate and repossessed assets
  $ 27,510     $ 17,540  
                 
 
The following schedule summarizes other real estate and repossessed asset activity during 2010 and 2009:
                 
    Years Ended December 31,  
    2010     2009  
    (In thousands)  
 
Balance at beginning of year
  $ 17,540     $ 19,923  
Additions attributable to OAK acquisition
    2,907        
Other additions
    26,429       18,320  
Write-downs to fair value
    (2,694 )     (4,722 )
Dispositions
    (16,672 )     (15,981 )
                 
Balance at end of year
  $ 27,510     $ 17,540  
                 
 
The historically large inventory of real estate properties for sale across the State of Michigan has resulted in an increase in the Corporation’s carrying time and cost of holding other real estate. Consequently, the Corporation had $8.9 million in real estate properties at December 31, 2010 that had been held in excess of one year as of that date, of which $2.9 million was vacant land, $2.1 million were commercial properties, $2.6 million were residential real estate properties and $1.3 million were residential development properties. Due to the redemption period on foreclosures being relatively long in Michigan (six months to one year) and the Corporation having a significant number of nonperforming loans that were in the process of foreclosure at December 31, 2010, it is anticipated that the level of other real estate will remain at elevated levels throughout 2011. Other real estate properties are carried at the lower of cost or fair value less estimated cost to sell.
 
At December 31, 2010, all of the other real estate properties had been written down to fair value through a charge-off at the transfer of the loan to other real estate, a write-down recorded as an operating expense to recognize a further market value decline of the property after the initial transfer date or a recording at fair value in conjunction with the OAK acquisition. Accordingly, at December 31, 2010, the carrying value of other real estate of $27.0 million, was reflective of $35.7 million in charge-offs, write-downs or fair value adjustments, and represented 43% of the contractual loan balance remaining at the time the property was transferred to other real estate.
 
During 2010, the Corporation sold 185 pieces of other real estate properties for net proceeds of $14.5 million. On an average basis, the net proceeds from these sales represented 110% of the carrying value of the property at the time of sale, although the net proceeds represented 56% of the remaining loan balance at the time the Corporation received title to the properties.
 
As previously discussed, due to the application of ASC 310-30, nonperforming assets at December 31, 2010 did not include acquired loans totaling $21.4 million that were not performing in accordance with the loan’s original contractual terms due to a market interest yield recognized on these loans in interest income during 2010. Additionally, the risk of credit loss at the acquisition date was recognized as part of the fair value adjustment. These loans are included in the Corporation’s impaired loan schedule in Note 4 to the consolidated financial statements.


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Impaired Loans
 
A loan is considered impaired when management determines it is probable that all of the principal and interest due will not be collected according to the original contractual terms of the loan agreement. The Corporation has determined that all of its nonaccrual loans and loans modified under troubled debt restructurings meet the definition of an impaired loan. Acquired loans that meet the definition of an impaired loan are included even though the amortization of the accretable yield results in interest income recognition on these loans. In most instances, impairment is measured based on the fair market value of the underlying collateral. It is the Corporation’s general policy to, at least annually, obtain new appraisals on impaired commercial and real estate commercial loans that are secured by real estate. At December 31, 2010, the Corporation had a current appraisal on approximately 90% of impaired loans, with 50% of these appraisals being performed during the second half of 2010. Impairment may also be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate. A portion of the allowance for loan losses may be specifically allocated to impaired loans.
 
Impaired loans totaled $161.7 million at December 31, 2010, an increase of $37.7 million, or 30%, compared to $124.0 million at December 31, 2009. Impaired loans increased $47.5 million, or 62%, during 2009 from $76.5 million at December 31, 2008. The increase in impaired loans during 2010 was due to increases in the amount of loans modified under troubled debt restructurings and loans acquired in the acquisition of OAK that were not performing in accordance with the loans’ contractual terms. Impaired loans at December 31, 2010 included $21.4 million of loans acquired in the OAK acquisition that were recorded at fair value at the acquisition date. After analyzing the various components of the customer relationships and evaluating the underlying collateral of impaired loans, it was determined that impaired commercial, real estate commercial and real estate construction and land development loans totaling $44.9 million at December 31, 2010 required a specific allocation of the allowance for loan losses (valuation allowance), compared to $38.2 million of impaired loans at December 31, 2009 and $30.3 million of impaired loans at December 31, 2008. The valuation allowance on these impaired loans was $15.0 million at December 31, 2010, compared to $10.5 million at December 31, 2009 and $9.2 million at December 31, 2008. At December 31, 2010 and 2009, loans modified under troubled debt restructurings-real estate residential of $22.3 million and $17.4 million, respectively, also required a valuation allowance of $0.8 million and $0.7 million, respectively. Loans modified under troubled debt restructurings-commercial and real estate commercial of $15.1 million at December 31, 2010 did not require a valuation allowance as the Corporation expects to collect the full principal and interest owed on each loan. At December 31, 2010, there was no valuation allowance required on impaired loans acquired in the OAK acquisition. The process of measuring impaired loans and the allocation of the allowance for loan losses requires judgment and estimation. The eventual outcome may differ from the estimates used on these loans. A discussion of the allowance for loan losses is included under the subheading, “Allowance for Loan Losses,” below.


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ALLOWANCE FOR LOAN LOSSES
 
The allowance for loan losses (allowance) provides for probable losses in the originated loan portfolio that have been identified with specific customer relationships and for probable losses believed to be inherent in the remainder of the originated loan portfolio but that have not been specifically identified. The allowance is comprised of specific allowances (assessed for originated loans that have known credit weaknesses), pooled allowances based on assigned risk ratings and historical loan loss experience for each loan type, and an unallocated allowance for imprecision in the subjective nature of the specific and pooled allowance methodology. Management evaluates the allowance on a quarterly basis in an effort to ensure the level is adequate to absorb probable losses inherent in the loan portfolio. This evaluation process is inherently subjective as it requires estimates that may be susceptible to significant change and has the potential to affect net income materially. The Corporation’s methodology for measuring the adequacy of the allowance includes several key elements, which includes a review of the loan portfolio, both individually and by category, and includes consideration of changes in the mix and volume of the loan portfolio, actual loan loss experience, review of collateral values, the financial condition of the borrowers, industry and geographical exposures within the portfolio, economic conditions and employment levels of the Corporation’s local markets and other factors affecting business sectors. Management believes that the allowance is currently maintained at an appropriate level, considering the inherent risk in the loan portfolio. Future significant adjustments to the allowance may be necessary due to changes in economic conditions, delinquencies or the level of loan losses incurred. Further discussion of the Corporation’s methodology used to determine the allowance is included in Notes 1 and 4 to the consolidated financial statements.
 
The Corporation’s allowance at December 31, 2010 did not include losses inherent in the acquired loan portfolio, as an allowance was not carried over on the date of acquisition. The acquired loans were recorded at their estimated fair value at the date of acquisition, with the estimated fair value including a component for expected credit losses. A portion of the allowance, however, may be set aside in the future, related to the acquired loans, if an acquired loan pool experiences a decrease in expected cash flows as compared to those expected at the acquisition date. An allowance for loan losses related to acquired loans was not required at December 31, 2010 due to no material changes in expected cash flows since the date of acquisition.
 
A summary of the activity in the allowance for loan losses for the last five years is included in Table 6.
 
TABLE 6. ANALYSIS OF ALLOWANCE FOR LOAN LOSSES
 
                                         
    Years Ended December 31,  
    2010     2009     2008     2007     2006  
    (Dollars in thousands)  
 
Balance at beginning of year
  $ 80,841     $ 57,056     $ 39,422     $ 34,098     $ 34,148  
Provision for loan losses
    45,600       59,000       49,200       11,500       5,200  
Loan charge-offs:
                                       
Commercial
    (8,430 )     (12,001 )     (16,787 )     (1,622 )     (1,389 )
Real estate commercial
    (10,811 )     (9,231 )     (6,995 )     (1,675 )     (1,564 )
Real estate construction and land development
    (2,544 )     (6,969 )     (2,963 )     (1,272 )     (1,201 )
Real estate residential
    (8,036 )     (3,694 )     (2,458 )     (484 )     (515 )
Consumer installment and home equity
    (10,665 )     (6,791 )     (4,739 )     (1,935 )     (1,976 )
                                         
Total loan charge-offs
    (40,486 )     (38,686 )     (33,942 )     (6,988 )     (6,645 )
Recoveries of loans previously charged off:
                                       
Commercial
    921       904       1,473       249       370  
Real estate commercial
    426       495       131       21       6  
Real estate construction and land development
    20       307       29       30        
Real estate residential
    543       614       160       18       98  
Consumer installment and home equity
    1,665       1,151       583       494       521  
                                         
Total loan recoveries
    3,575       3,471       2,376       812       995  
                                         
Net loan charge-offs
    (36,911 )     (35,215 )     (31,566 )     (6,176 )     (5,650 )
Allowance of branches acquired
                            400  
                                         
Allowance for loan losses at end of year
  $ 89,530     $ 80,841     $ 57,056     $ 39,422     $ 34,098  
                                         
Net loan charge-offs during the year as a percentage of average loans outstanding during the year
    1.07 %     1.18 %     1.10 %     0.22 %     0.20 %
                                         
Allowance for loan losses as a percentage of total originated loans outstanding at end of year
    2.86 %     2.70 %     1.91 %     1.41 %     1.21 %
                                         
Allowance for loan losses as a percentage of nonperforming originated loans outstanding at end of year
    61 %     60 %     61 %     62 %     127 %
                                         


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The Corporation’s allowance was $89.5 million at December 31, 2010, compared to $80.8 million at December 31, 2009 and $57.1 million at December 31, 2008. The allowance as a percentage of originated loans was 2.86% at December 31, 2010, compared to 2.70% at December 31, 2009 and 1.91% at December 31, 2008. The allowance as a percentage of nonperforming originated loans was 61% at December 31, 2010, compared to 60% at December 31, 2009 and 61% at December 31, 2008.
 
The allocation of the allowance in Table 7 is based upon ranges of estimates and is not intended to imply either limitations on the usage of the allowance or exactness of the specific amounts. The entire allowance is available to absorb future loan losses without regard to the categories in which the loan losses are classified. The allocation of the allowance is based upon a combination of factors, including historical loss factors, credit-risk grading, past-due experiences, and the trends in these, as well as other factors, as discussed above.
 
TABLE 7. ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
 
                                                                                 
    December 31,  
    2010     2009     2008     2007     2006  
          Percent of
                                                 
          Originated
                                                 
          Loans
          Percent
          Percent
          Percent
          Percent
 
          in Each
          of Loans
          of Loans
          of Loans
          of Loans
 
          Category
          in Each
          in Each
          in Each
          in Each
 
          to Total
          Category
          Category
          Category
          Category
 
    Allowance
    Originated
    Allowance
    to Total
    Allowance
    to Total
    Allowance
    to Total
    Allowance
    to Total
 
Loan Type
  Amount     Loans     Amount     Loans     Amount     Loans     Amount     Loans     Amount     Loans  
    (Dollars in millions)  
 
Commercial
  $ 22.2       22 %   $ 19.1       20 %   $ 12.3       20 %   $ 9.7       19 %   $ 8.9       19 %
Real estate commercial
    32.6       25       23.9       26       20.3       26       12.8       27       11.4       26  
Real estate construction and land development
    4.6       3       5.7       4       3.8       4       3.0       5       1.8       5  
Real estate residential
    10.8       25       13.1       25       8.0       28       5.5       30       3.6       30  
Consumer installment and home equity
    16.6       25       17.3       25       10.9       22       6.6       19       6.8       20  
Unallocated
    2.7             1.7             1.8             1.8             1.6        
                                                                                 
Total
  $ 89.5       100 %   $ 80.8       100 %   $ 57.1       100 %   $ 39.4       100 %   $ 34.1       100 %
                                                                                 
 
The following schedule summarizes impaired loans to commercial borrowers and the related valuation allowance at December 31, 2010 and 2009 and partial loan charge-offs taken on these impaired loans (confirmed losses):
 
                                 
          Valuation
    Confirmed
    Cumulative
 
    Amount     Allowance     Losses     Loss Percentage  
    (Dollars in thousands)  
 
December 31, 2010
                               
Originated portfolio:
                               
Impaired loans with valuation allowance and no charge-offs
  $ 33,056     $ 12,015     $       36 %
Impaired loans with valuation allowance and charge-offs
    11,795       2,951       1,551       34  
Impaired loans with charge-offs and no valuation allowance
    20,033             18,277       48  
Impaired loans without valuation allowance or charge-offs
    36,366                   0  
                                 
Total impaired loans to commercial borrowers-originated portfolio
    101,250     $ 14,966     $ 19,828       29 %
                                 
Impaired acquired loans
    21,385                          
                                 
Total impaired loans to commercial borrowers
  $ 122,635                          
                                 
December 31, 2009
                               
Impaired loans with valuation allowance and no charge-offs
  $ 33,052     $ 10,036     $       30 %
Impaired loans with valuation allowance and charge-offs
    5,165       471       908       23  
Impaired loans with charge-offs and no valuation allowance
    20,800             17,084       45  
Impaired loans without valuation allowance or charge-offs
    24,895                   0  
                                 
Total impaired loans to commercial borrowers
  $ 83,912     $ 10,507     $ 17,992       28 %
                                 
 
Confirmed losses represent partial loan charge-offs on impaired loans due to the receipt of a recent third-party property appraisal indicating the value of the collateral securing the loan is below the loan balance and management believes the full collection of the loan balance is not likely.
 
The Corporation’s valuation allowance for impaired commercial, real estate commercial and real estate construction and land development loans was $15.0 million at December 31, 2010, an increase of $4.5 million from $10.5 million at December 31, 2009. The increase in the valuation allowance is reflective of continued declines in collateral values during 2010. Additionally, at December 31, 2010 and 2009, the Corporation had a valuation allowance attributable to loans modified under troubled debt restructurings-real estate residential of $0.8 million and $0.7 million, respectively.


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The following schedule summarizes the allowance as a percentage of nonperforming originated loans at December 31, 2010 and 2009:
 
                 
    December 31,  
    2010     2009  
    (Dollars in thousands)  
 
Allowance for loan losses
  $ 89,530     $ 80,841  
Nonperforming originated loans
    147,729       135,755  
Allowance as a percent of nonperforming originated loans
    61 %     60 %
Allowance as a percent of nonperforming originated loans, net of impaired originated loans for which the full loss has been charged-off
    79 %     70 %
 
Economic conditions in the Corporation’s markets, all within Michigan, were generally less favorable than those nationwide during 2010. Economic challenges remain in Michigan and are expected to continue in 2011. Accordingly, management believes net loan losses, delinquencies and nonperforming loans will remain at elevated levels during 2011.
 
DEPOSITS
 
Total deposits at December 31, 2010 were $4.33 billion, an increase of $914 million, or 27%, from total deposits at December 31, 2009 of $3.42 billion. Total deposits increased $439 million, or 15%, during 2009. The increase in total deposits in 2010 was primarily attributable to $693 million of deposits acquired in the OAK transaction at the acquisition date. In addition to the increase in deposits related to the OAK acquisition, the Corporation experienced an increase in customer deposits of $221 million.
 
The Corporation’s average deposit balances and average rates paid on deposits for the past three years are included in Table 9. Average total deposits in 2010 were $4.02 billion, an increase of $821.8 million, or 25.7%, over average deposits in 2009. Average total deposits in 2009 were $3.20 billion, an increase of $271.1 million, or 9.3%, over average deposits in 2008. There was no significant change in the mix of average deposits during 2010 or 2009. At December 31, 2010, the Corporation had $163.3 million in brokered deposits that were acquired in the OAK acquisition. The Corporation intends to use its excess liquidity to pay off brokered deposits as they mature with $85.5 million, $36.3 million, $34.3 million and $7.2 million of brokered deposits maturing in 2011, 2012, 2013 and 2014 and thereafter, respectively. The Corporation did not have any brokered deposits at December 31, 2009 or 2008.
 
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, the Corporation’s financial strength and a general trend in customers holding more liquid assets, resulted in the Corporation experiencing a significant increase in deposits during 2010.
 
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 Chemical Financial Advisor program, offers a wide array of mutual funds, annuity products and marketable securities through an alliance with an independent, registered broker/dealer. During 2010 and 2009, customers purchased $88.8 million and $110.0 million, respectively, of annuity products, mutual fund and other investments through the Chemical Financial Advisor program.


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Table 8 presents the maturity distribution of time deposits of $100,000 or more at December 31, 2010. Time deposits of $100,000 or more totaled $508.2 million and represented 11.7% of total deposits at December 31, 2010.
 
TABLE 8. MATURITY DISTRIBUTION OF TIME DEPOSITS OF $100,000 OR MORE
 
                 
    December 31, 2010  
    Amount     Percent  
    (Dollars in thousands)  
 
Maturity:
               
Within 3 months
  $ 129,989       26 %
After 3 but within 6 months
    67,330       13  
After 6 but within 12 months
    111,903       22  
After 12 months
    198,974       39  
                 
Total
  $ 508,196       100 %
                 
 
BORROWED FUNDS
 
Borrowed funds include short-term borrowings and long-term FHLB advances. Short-term borrowings are comprised of securities sold under agreements to repurchase with customers and short-term FHLB advances that have original maturities of one year or less. Securities sold under agreements to repurchase are funds deposited by customers that were exchanged for investment securities that are owned by Chemical Bank, as these deposits are not covered by FDIC insurance. These funds have been a stable source of liquidity for Chemical Bank, much like its core deposit base. Short-term FHLB advances are generally used to fund short-term liquidity needs. FHLB advances, both short-term and long-term, are secured under a blanket security agreement of real estate residential first lien loans with an aggregate book value equal to at least 155% of the advances and FHLB stock owned by the Corporation. Short-term borrowings are highly interest rate sensitive. Total short-term borrowings were $242.7 million at December 31, 2010, $240.6 million at December 31, 2009 and $233.7 million at December 31, 2008 and were comprised solely of securities sold under agreements to repurchase at these dates. A summary of short-term borrowings for 2010, 2009 and 2008 is included in Note 10 to the consolidated financial statements.
 
Long-term borrowings, comprised solely of FHLB advances, were $74.1 million at December 31, 2010 and $90.0 million at December 31, 2009. Long-term FHLB advances are borrowings that are generally used to fund loans and a portion of the investment securities portfolio. At December 31, 2010, long-term FHLB advances that will mature in 2011 totaled $31.1 million. A summary of FHLB advances outstanding at December 31, 2010 and 2009 is included in Note 11 to the consolidated financial statements.


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CONTRACTUAL OBLIGATIONS AND CREDIT RELATED COMMITMENTS
 
The Corporation has various financial obligations, including contractual obligations and commitments, which may require future cash payments. The following schedule summarizes the Corporation’s noncancelable contractual obligations and future required minimum payments at December 31, 2010. Refer to Notes 9, 10, 11 and 19 to the consolidated financial statements for a further discussion of these contractual obligations.
 
Contractual Obligations
 
                                         
    December 31, 2010  
    Minimum Payments Due by Period  
    Less than
                More than
       
    1 year     1-3 years     3-5 years     5 years     Total  
    (In thousands)  
 
Deposits with no stated maturity*
  $ 2,738,719     $     $     $     $ 2,738,719  
Certificates of deposit with a stated maturity*
    909,078       491,721       102,610       89,637       1,593,046  
Short-term borrowings*
    242,703                         242,703  
FHLB advances — long-term*
    31,073       36,792       6,265             74,130  
Commitment to fund low income housing partnerships
    3,323       599       69       81       4,072  
Commitment to fund a private equity capital investment
    880                         880  
Operating leases and noncancelable contracts
    7,884       9,646       540             18,070  
                                         
Total contractual obligations
  $ 3,933,660     $ 538,758     $ 109,484     $ 89,718     $ 4,671,620  
                                         
 
* Deposits and borrowings exclude accrued interest.
 
The Corporation also has credit related commitments that may impact liquidity. The following schedule summarizes the Corporation’s credit related commitments and expiration dates by period at December 31, 2010. Since many of these commitments historically have expired without being drawn upon, the total amount of these commitments does not necessarily represent future cash requirements of the Corporation. Refer to Note 19 to the consolidated financial statements for a further discussion of these obligations.
 
Credit Related Commitments
 
                                         
    December 31, 2010  
    Expiration Dates by Period  
    Less than
                More than
       
    1 year     1-3 years     3-5 years     5 years     Total  
    (In thousands)  
 
Unused commitments to extend credit
  $ 407,881     $ 72,259     $ 72,956     $ 71,164     $ 624,260  
Loan commitments
    159,040                         159,040  
Standby letters of credit
    39,364       1,693       3,784       10       44,851  
                                         
Total credit related commitments
  $ 606,285     $ 73,952     $ 76,740     $ 71,174     $ 828,151  
                                         
 
CASH DIVIDENDS
 
The Corporation’s annual cash dividends paid per common share over the past five years were as follows:
 
                                         
    2010   2009   2008   2007   2006
 
Annual Cash Dividend (per common share)
  $ 0.80     $ 1.18     $ 1.18     $ 1.14     $ 1.10  
 
The Corporation has paid regular cash dividends every quarter since it began operating as a bank holding company in 1973. The earnings of Chemical Bank have been the principal source of funds to pay cash dividends to shareholders. Over the long-term, cash dividends to shareholders are dependent upon earnings, as well as capital requirements, regulatory restraints and other factors affecting Chemical Bank.


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CAPITAL
 
Capital supports current operations and provides the foundation for future growth and expansion. Total shareholders’ equity was $560.1 million at December 31, 2010, an increase of $85.8 million, or 18.1%, from total shareholders’ equity of $474.3 million at December 31, 2009. The significant increase in shareholders’ equity during 2010 was attributable to the issuance of approximately 3.5 million shares of common stock related to the OAK acquisition on April 30, 2010, which increased shareholders’ equity by $83.7 million. Book value per common share at December 31, 2010 and 2009 was $20.41 and $19.85, respectively.
 
Shareholders’ equity decreased $17.2 million in 2009, with $18.2 million of the decrease attributable to cash dividends paid to shareholders exceeding net income of the Corporation.
 
The ratio of shareholders’ equity to total assets was 10.7% at December 31, 2010, compared to 11.2% at December 31, 2009 and 12.7% at December 31, 2008. The Corporation’s tangible equity to assets ratio was 8.6%, 9.6% and 11.0% at December 31, 2010, 2009 and 2008, respectively.
 
Under the regulatory “risk-based” capital guidelines in effect for both banks and bank holding companies, minimum capital levels are based upon perceived risk in the Corporation’s various asset categories. These guidelines assign risk weights to on- and off-balance sheet items in arriving at total risk-adjusted assets. Regulatory capital is divided by the computed total of risk-adjusted assets to arrive at the risk-based capital ratios.
 
The Corporation continues to maintain a strong capital position which significantly exceeded the minimum levels prescribed by the Federal Reserve at December 31, 2010, as shown in the following schedule:
 
                         
    December 31, 2010
        Risk-Based
    Leverage
  Capital Ratios
    Ratio   Tier 1   Total
 
Chemical Financial Corporation’s capital ratios
    8.4 %     11.6 %     12.9 %
Chemical Bank’s capital ratios
    8.2       11.4       12.7  
Regulatory capital ratios — minimum requirements
    4.0       4.0       8.0  
 
As of December 31, 2010, Chemical Bank’s capital ratios exceeded the minimum required for an institution to be categorized as well-capitalized, as defined by applicable regulatory requirements. See Note 20 to the consolidated financial statements for more information regarding the Corporation’s and Chemical Bank’s regulatory capital ratios.
 
From time to time, the board of directors of the Corporation approves common stock repurchase programs allowing management to repurchase shares of the Corporation’s common stock in the open market. The repurchased shares are available for later reissuance in connection with potential future stock dividends, the Corporation’s dividend reinvestment plan, employee benefit plans and other general corporate purposes. Under these programs, the timing and actual number of shares subject to repurchase are at the discretion of management and are contingent on a number of factors, including the projected parent company cash flow requirements and the Corporation’s share price.
 
In January 2008, the board of directors of the Corporation authorized management to repurchase up to 500,000 shares of the Corporation’s common stock under a stock repurchase program. Since the January 2008 authorization, no shares have been repurchased. At December 31, 2010, there were 500,000 remaining shares available for repurchase under the Corporation’s stock repurchase programs.
 
During 2008, 38,416 shares of the Corporation’s common stock were delivered or attested in satisfaction of the exercise price and/or tax withholding obligations by holders of employee stock options. The Corporation’s stock compensation plans permit employees to use stock to satisfy such obligations based on the market value of the stock on the date of exercise. There was no such activity during 2010 or 2009.


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NET INTEREST INCOME
 
Interest income is the total amount earned on funds invested in loans, investment and other securities, federal funds sold and other interest-bearing deposits with unaffiliated banks and others. Interest expense is the amount of interest paid on interest-bearing checking and savings accounts, time deposits, short-term borrowings and FHLB advances. Net interest income, on a fully taxable equivalent (FTE) basis, is the difference between interest income and interest expense adjusted for the tax benefit received on tax-exempt commercial loans and investment securities. Net interest margin is calculated by dividing net interest income (FTE) by average interest-earning assets. Net interest spread is the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Because noninterest-bearing sources of funds, or free funds (principally demand deposits and shareholders’ equity), also support earning assets, the net interest margin exceeds the net interest spread.
 
Net interest income (FTE) in 2010, 2009 and 2008 was $175.5 million, $150.3 million and $147.6 million, respectively. The presentation of net interest income on a FTE basis is not in accordance with GAAP but is customary in the banking industry. This non-GAAP measure ensures comparability of net interest income arising from both taxable and tax-exempt loans and investment securities. The adjustments to determine tax equivalent net interest income were $4.35 million, $2.90 million and $2.37 million for 2010, 2009 and 2008, respectively. These adjustments were computed using a 35% federal income tax rate. The increase in 2010 was attributable to higher interest income on tax-exempt loans and securities.
 
Net interest income is the most important source of the Corporation’s earnings and thus is critical in evaluating the results of operations. Changes in the Corporation’s net interest income are influenced by a variety of factors, including changes in the level and mix of interest-earning assets and interest-bearing liabilities, the level and direction of interest rates, the difference between short-term and long-term interest rates (the steepness of the yield curve) and the general strength of the economies in the Corporation’s markets. Risk management plays an important role in the Corporation’s level of net interest income. The ineffective management of credit risk, and more significantly interest rate risk, can adversely impact the Corporation’s net interest income. Management monitors the Corporation’s consolidated statement of financial position to reduce the potential adverse impact on net interest income caused by significant changes in interest rates. The Corporation’s policies in this regard are further discussed under the subheading “Market Risk.”
 
The Federal Reserve influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. The prime interest rate, which is the rate offered on loans to borrowers with strong credit, began 2008 at 7.25% and decreased 200 basis points in the first quarter of 2008, 25 basis points in the second quarter of 2008 and 175 basis points in the fourth quarter of 2008 to end the year at 3.25%. During 2009 and 2010, the prime interest rate remained at 3.25%.
 
Net interest income (FTE) in 2010 of $175.5 million was $25.2 million, or 16.7%, higher than net interest income (FTE) in 2009 of $150.3 million. The increase in net interest income (FTE) in 2010 primarily resulted from an increase in the average volume of interest-earning assets, which was largely attributable to the acquisition of OAK on April 30, 2010. The average volume of interest-earning assets in 2010 increased $771.0 million, or 20.0%, compared to 2009. Over the same time frame, net interest margin decreased 11 basis points from 3.91% in 2009 to 3.80% in 2010. The average yield on interest-earning assets decreased 44 basis points to 4.65% in 2010, from 5.09% in 2009. The declines in net interest margin and the yield on interest-earning assets during 2010, compared to 2009, was partially attributable to the Corporation’s decision to maintain a higher level of liquidity during the twelve months ended December 31, 2010. The Corporation’s average cash deposits held at the Federal Reserve Bank of Chicago (FRB) during 2010 were $375.4 million, compared to $195.7 million during 2009. These cash deposits earned approximately 25 basis points throughout 2010 and 2009. The decrease in the average yield on interest-earning assets was also partially attributable to a reduction in the yield on taxable investment securities to 1.84% in 2010, compared to 2.89% in 2009. The decrease in yield on taxable investment securities was primarily attributable to the Corporation increasing its holdings of variable rate investment securities to lessen the impact on net interest income and the net interest margin of rising interest rates. At December 31, 2010, the Corporation held $325 million in variable rate investment securities, compared to $297 million at December 31, 2009. The average cost of interest-bearing liabilities decreased 44 basis points to 1.07% in 2010, from 1.51% in 2009. The decrease in the cost of interest-bearing liabilities was attributable to the lag effect of declines in market interest rates beginning in 2008 in addition to the Corporation utilizing its excess liquidity to pay-off maturing higher-rate FHLB advances.
 
Net interest income (FTE) in 2009 of $150.3 million was $2.7 million, or 1.8%, higher than net interest income (FTE) in 2008 of $147.6 million. The increase in net interest income (FTE) in 2009 primarily resulted from an increase in the average volume of interest-earning assets, particularly in investments and loans, that was partially offset by a decrease in net interest margin. The average volume of interest-earning assets in 2009 increased $296.4 million, or 8.3%, compared to 2008. Over the same time frame, net interest margin decreased 25 basis points from 4.16% in 2008 to 3.91% in 2009, with the decline during 2009, compared to 2008, partially attributable to the Corporation’s decision to maintain a higher level of liquidity coupled with a significant increase in nonaccrual loans during 2009. The average yield on interest-earning assets decreased 84 basis points to 5.09% in 2009, from 5.93% in 2008. The average cost of interest-bearing liabilities decreased 82 basis points to 1.51% in 2009 from 2.33% in 2008. The


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decreases in the yield on interest-earning assets and the cost of interest-bearing liabilities were primarily attributable to the lag effect of the decline in market interest rates during 2008. The yield on the loan portfolio and net interest margin were also slightly adversely impacted in 2009 by an increase in nonaccrual loans of $30.1 million, or 39.4%, during the year to $106.6 million at December 31, 2009.
 
The Corporation’s balance sheet has historically been liability sensitive, meaning that interest-bearing liabilities have generally repriced more quickly than interest-earning assets. Therefore, the Corporation’s net interest margin has historically increased in sustained periods of declining interest rates and decreased in sustained periods of increasing interest rates. However, during 2009 and 2010, the Corporation became more asset sensitive as it increased its holdings of variable rate investment securities and cash deposits at the FRB to lessen the impact on net interest income and net interest margin of rising interest rates. At December 31, 2010, approximately 44% of the Corporation’s investment securities were variable rate compared to 41% at December 31, 2009 and 28% at December 31, 2008. In addition, the percentage of variable rate loans in the Corporation’s loan portfolio increased in 2010 due primarily to the acquisition of OAK. At December 31, 2010 and 2009, approximately 28% and 20%, respectively, of the Corporation’s loans were at variable interest rates.
 
The Corporation is primarily funded by core deposits and this lower-cost funding base has historically had a positive impact on the Corporation’s net interest income and net interest margin in a declining interest rate environment. However, based on the historically low level of market interest rates and the Corporation’s current low levels of interest rates on its core deposit transaction accounts, further market interest rate reductions would likely not result in a significant decrease in interest expense.
 
The Corporation’s competitive position within many of its market areas has historically limited its ability to materially increase core deposits without adversely impacting the weighted average cost of the deposit portfolio. While competition for core deposits remained strong throughout the Corporation’s markets during 2010 and 2009, the Corporation experienced increases in deposits during 2010 and 2009 due to the acquisition of OAK in 2010, the Corporation’s increased efforts to expand its deposit relationships with existing customers, the Corporation’s financial strength and a general trend in customers holding more liquid assets in 2009 and 2010. Total deposits increased $913.6 million, or 26.7%, during the twelve months ended December 31, 2010, and $439.3 million, or 14.7%, during the twelve months ended December 31, 2009.
 
Table 9 presents for 2010, 2009 and 2008 average daily balances of the Corporation’s major categories of assets and liabilities, interest income and expense on a FTE basis, average interest rates earned and paid on the assets and liabilities, net interest income (FTE), net interest spread and net interest margin.
 
Table 10 allocates the dollar change in net interest income (FTE) between the portion attributable to changes in the average volume of interest-earning assets and interest-bearing liabilities, including changes in the mix of assets and liabilities and changes in average interest rates earned and paid.


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TABLE 9. AVERAGE BALANCES, TAX EQUIVALENT INTEREST AND EFFECTIVE YIELDS AND RATES* (Dollars in thousands)
 
                                                                         
    Years Ended December 31,  
    2010     2009     2008  
          Tax
    Effective
          Tax
    Effective
          Tax
    Effective
 
    Average
    Equivalent
    Yield/
    Average
    Equivalent
    Yield/
    Average
    Equivalent
    Yield/
 
    Balance     Interest     Rate     Balance     Interest     Rate     Balance     Interest     Rate  
 
ASSETS
                                                                       
Interest-Earning Assets:
                                                                       
Loans**
  $ 3,449,562     $ 194,035       5.62 %   $ 2,997,277     $ 173,456       5.79 %   $ 2,873,151     $ 181,568       6.32 %
Taxable investment securities
    618,847       11,363       1.84       532,844       15,385       2.89       511,109       21,793       4.26  
Tax-exempt investment securities
    139,377       7,563       5.43       93,350       5,425       5.81       69,076       4,309       6.24  
Other securities
    25,463       766       3.01       22,128       821       3.71       22,141       1,167       5.27  
Federal funds sold and interest-bearing deposits with unaffiliated banks and others
    384,763       1,055       0.27       201,407       541       0.27       75,134       1,865       2.48  
                                                                         
Total interest-earning assets
    4,618,012       214,782       4.65       3,847,006       195,628       5.09       3,550,611       210,702       5.93  
Less: Allowance for loan losses
    88,757                       70,028                       42,185                  
Other Assets:
                                                                       
Cash and cash due from banks
    111,388                       91,829                       96,094                  
Premises and equipment
    63,329                       53,054                       50,222                  
Interest receivable and other assets
    209,338                       144,368                       129,875                  
                                                                         
Total Assets
  $ 4,913,310                     $ 4,066,229                     $ 3,784,617                  
                                                                         
                                                                         
LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                        
Interest-Bearing Liabilities:
                                                                       
Interest-bearing demand deposits
  $ 780,889     $ 1,792       0.23 %   $ 559,026     $ 2,538       0.45 %   $ 509,256     $ 5,226       1.03 %
Savings deposits
    1,085,793       4,244       0.39       925,588       6,230       0.67       792,449       10,804       1.36  
Time deposits
    1,481,722       29,859       2.02       1,169,201       30,732       2.63       1,084,531       38,733       3.57  
Securities sold under agreements to repurchase
    249,731       650       0.26       232,185       906       0.39       196,413       2,144       1.09  
FHLB advances — short-term
                                        8,593       79       0.92  
FHLB advances — long-term
    87,051       2,765       3.18       116,050       4,881       4.21       120,171       6,097       5.07  
                                                                         
Total interest-bearing liabilities
    3,685,186       39,310       1.07       3,002,050       45,287       1.51       2,711,413       63,083       2.33  
Noninterest-bearing deposits
    668,826                       541,596                       538,125                  
                                                                         
Total deposits and borrowed funds
    4,354,012                       3,543,646                       3,249,538                  
Interest payable and other liabilities
    28,479                       39,549                       25,979                  
Shareholders’ equity
    530,819                       483,034                       509,100                  
                                                                         
Total Liabilities and Shareholders’ Equity
  $ 4,913,310                     $ 4,066,229                     $ 3,784,617                  
                                                                         
Net Interest Spread (Average yield earned minus average rate paid)
                    3.58 %                     3.58 %                     3.60 %
                                                                         
Net Interest Income (FTE)
          $ 175,472                     $ 150,341                     $ 147,619          
                                                                         
Net Interest Margin
                                                                       
(Net interest income (FTE)/total average interest-earning assets)
                    3.80 %                     3.91 %                     4.16 %
                                                                         
 
* Taxable equivalent basis using a federal income tax rate of 35%.
 
** Nonaccrual loans and loans held-for-sale are included in average balances reported and are included in the calculation of yields. Also, tax equivalent interest includes net loan fees.


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TABLE 10. VOLUME AND RATE VARIANCE ANALYSIS* (In thousands)
 
                                                 
    2010 Compared to 2009     2009 Compared to 2008  
    Increase (Decrease)
          Increase (Decrease)
       
    Due to Changes in     Combined
    Due to Changes in     Combined
 
    Average
    Average
    Increase
    Average
    Average
    Increase
 
    Volume**     Yield/Rate**     (Decrease)     Volume**     Yield/Rate**     (Decrease)  
 
Changes in Interest Income on Interest-Earning Assets:
                                               
Loans
  $ 25,386     $ (4,807 )   $ 20,579     $ 7,814     $ (15,926 )   $ (8,112 )
Taxable investment/other securities
    2,327       (6,404 )     (4,077 )     766       (7,520 )     (6,754 )
Tax-exempt investment securities
    2,526       (388 )     2,138       1,436       (320 )     1,116  
Federal funds sold and interest-bearing deposits with unaffiliated banks and others
    506       8       514       1,307       (2,631 )     (1,324 )
                                                 
Total change in interest income on interest-earning assets
    30,745       (11,591 )     19,154       11,323       (26,397 )     (15,074 )
                                                 
Changes in Interest Expense on Interest-Bearing Liabilities:
                                               
Interest-bearing demand deposits
    799       (1,545 )     (746 )     615       (3,303 )     (2,688 )
Savings deposits
    783       (2,769 )     (1,986 )     1,365       (5,939 )     (4,574 )
Time deposits
    7,148       (8,021 )     (873 )     4,177       (12,178 )     (8,001 )
Short-term borrowings
    64       (320 )     (256 )     255       (1,572 )     (1,317 )
FHLB advances
    (1,067 )     (1,049 )     (2,116 )     (204 )     (1,012 )     (1,216 )
                                                 
Total change in interest expense on interest-bearing liabilities
    7,727       (13,704 )     (5,977 )     6,208       (24,004 )     (17,796 )
                                                 
Total Increase (Decrease) in Net Interest Income (FTE)
  $ 23,018     $ 2,113     $ 25,131     $ 5,115     $ (2,393 )   $ 2,722  
                                                 
 
* Taxable equivalent basis using a federal income tax rate of 35%.
 
** The change in interest income and interest expense due to both volume and rate has been allocated to the volume and rate change in proportion to the relationship of the absolute dollar amount of the change in each.
 
PROVISION FOR LOAN LOSSES
 
The provision for loan losses (provision) is an increase to the allowance to provide for probable losses inherent in the originated loan portfolio and for impairment of pools of acquired loans that results from the Corporation experiencing a decrease in cash flows of acquired loans compared to expected cash flows estimated at the acquisition date. The level of the provision reflects management’s assessment of the adequacy of the allowance. The Corporation did not recognize any provision related to the acquired portfolio during 2010 as there have been no significant changes in expected cash flows compared to cash flows estimated at the date of acquisition.
 
The provision was $45.6 million in 2010, $59.0 million in 2009 and $49.2 million in 2008. The Corporation experienced net loan charge-offs of originated loans of $36.9 million in 2010, $35.2 million in 2009 and $31.6 million in 2008. 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, $0.3 million in 2009 and $0.2 million in 2010 through the sale of collateral securing the loan. Net loan charge-offs of originated loans as a percentage of average loans were 1.07% in 2010, 1.18% in 2009 and 1.10% in 2008. The level of net loan charge-offs reflects the general deterioration in credit quality across the loan portfolio. Net loan charge-offs of commercial, real estate commercial and real estate construction and land development loans totaled $20.4 million in 2010, compared to $26.5 million in 2009 and $25.1 million in 2008 and represented 55% of total net loan charge-offs during 2010, compared to 75% in 2009 and 80% in 2008. The commercial loan portfolio’s net loan charge-offs in 2010 were not concentrated in any one industry or borrower. Net loan charge-offs of residential real estate and consumer loans totaled $16.5 million in 2010, compared to $8.7 million in 2009 and $6.5 million in 2008.
 
The Corporation’s provision of $45.6 million in 2010 was $8.7 million higher than 2010 net loan charge-offs of $36.9 million, although $13.4 million lower than the provision for loan losses in 2009 of $59.0 million. The level of the provision in 2010 was reflective of the credit quality of the originated portfolio that included slightly higher net loan charge-offs, modest decreases in nonaccrual loans and loans past due 90 days or more and no significant changes in risk grade categories of the commercial loan portfolio. The slight increase in net loan charge-offs in 2010, compared to 2009, was partially attributable to a continued decline in


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real estate values within the State of Michigan during 2010, as evidenced by lower appraised values of real estate and lower sales prices of real estate. It is management’s belief that the overall credit quality of the Corporation’s loan portfolio during the three years ended December 31, 2010 was adversely impacted by the economic environment in the State of Michigan, with the state unemployment rate at 11.7%, compared to 9.4% nationwide, at December 31, 2010. The Corporation’s originated loan portfolio has 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 2010 and 2009.
 
NONINTEREST INCOME
 
Noninterest income totaled $42.5 million in 2010, $41.1 million in 2009 and $41.2 million in 2008. Noninterest income increased $1.4 million, or 3.3%, in 2010 compared to 2009 and was consistent in 2009 compared to 2008. Noninterest income as a percentage of net revenue (net interest income plus noninterest income) was 19.9% in 2010, 21.8% in 2009 and 22.1% in 2008.
 
The following schedule includes the major components of noninterest income during the past three years:
                         
    Years Ended December 31,  
    2010     2009     2008  
    (In thousands)  
 
Service charges on deposit accounts
  $ 18,562     $ 19,116     $ 20,048  
Wealth management revenue
    10,106       9,273       10,625  
Electronic banking fees
    5,389       4,023       3,341  
Mortgage banking revenue
    3,925       4,412       1,836  
Other fees for customer services
    2,837       2,454       2,511  
Insurance commissions
    1,373       1,259       1,042  
Investment securities gains
          95       1,722  
Other-than-temporary impairment loss on investment security
                (444 )
Other
    280       487       516  
                         
Total Noninterest Income
  $ 42,472     $ 41,119     $ 41,197  
                         
 
Service charges on deposit accounts were $18.6 million in 2010, $19.1 million in 2009 and $20.0 million in 2008. The decline of $0.5 million, or 2.9%, in 2010, compared to 2009, was primarily attributable to new federal banking regulations that took effect on August 15, 2010, which require customers to provide authorization (opt in) to Chemical Bank to pay overdrafts on ATM and debit card transactions, that was partially offset by increased service charges attributable to the acquisition of OAK. The decline of $0.9 million, or 4.6%, in 2009, compared to 2008, was primarily attributable to a lower level of customer activity in areas where fees and service charges are applicable and customers choosing alternative non-fee based accounts.
 
Wealth management revenue was $10.1 million in 2010, $9.3 million in 2009 and $10.6 million in 2008. The increase of $0.8 million, or 9.0%, in 2010, compared to 2009, resulted primarily from improving equity market performance, as well as growth in new assets, both of which led to increased assets under management. Average assets under management in the Wealth Management department of $2.01 billion in 2010 represented an increase of approximately $200 million in average assets under management, compared to 2009. Wealth management revenue also includes fees from sales of investment products offered through the Chemical Financial Advisors program. Fees from this program totaled $2.3 million in both 2010 and 2009 and $2.8 million in 2008. The declines in revenue in both 2010 and 2009, compared to 2008, resulted primarily from lower program sales of fixed annuity products, as those investments became less attractive to investors due to declining interest rates for these products over the past two years.
 
Electronic banking fees were $5.4 million in 2010, $4.0 million in 2009 and $3.3 million in 2008. Electronic banking fees increased $1.4 million, or 34.0%, in 2010, compared to 2009, due primarily to increased customer debit card activity that was mostly attributable to the acquisition of OAK. Electronic banking fees increased $0.7 million, or 20.4%, in 2009, compared to 2008, due primarily to an increase in the ATM user fee for non-customers.
 
Mortgage banking revenue (MBR) includes revenue from originating, selling and servicing real estate residential loans for the secondary market. MBR was $3.9 million in 2010, $4.4 million in 2009 and $1.8 million in 2008. The decrease in mortgage banking revenue in 2010, compared to 2009, was primarily due to a decrease in the volume of loans sold in the secondary market compared to 2009 that was only partially offset by an increase in the average net gain per loan associated with the sale of these loans. The Corporation originated $453 million of real estate residential loans during 2010, of which $276 million, or 61%, were sold in the secondary market, compared to the origination of $467 million of real estate residential loans during 2009, of which $361 million, or 77%, were sold in the secondary market. The reduction in the volume of loans sold in the secondary market in 2010, compared to


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2009, was primarily attributable to the Corporation originating $71 million of fifteen year fixed-interest rate loans that it held in its portfolio as opposed to selling them in the secondary market as has been its general practice. In 2008, the Corporation originated $341 million of real estate residential loans, of which $145 million, or 43%, were sold in the secondary market. At December 31, 2010, the Corporation was servicing $892 million of real estate residential loans that had been originated by the Corporation in its market areas and subsequently sold in the secondary mortgage market, up from $755 million at December 31, 2009. The increase in the Corporation’s servicing portfolio in 2010 was primarily due to the acquisition of OAK and the continued strong volume of loans sold in the secondary market with servicing retained.
 
The Corporation sells loans in the secondary market on both a servicing retained and servicing released basis. The sale of real estate residential loans in the secondary market includes the Corporation entering into residential mortgage loan sale agreements with buyers in the normal course of business. The agreements contain provisions that include various representations and warranties regarding the origination and characteristics of the mortgage loans that indemnify the buyer against losses arising from inadequate underwriting. Inadequate underwriting examples include, but are not limited to, insufficient or lack of verification of the borrowers’ income or financial status, validity of the lien securing the loan, absence of delinquent taxes, liens against the property securing the loan, substandard appraisals and validity of customer information. The recourse of the buyer may result in either indemnification of the loss incurred by the buyer or a requirement for the Corporation to repurchase the loan which the buyer believes does not comply with the representations included in the loan sale agreement. If the buyer believes that a representation has been breached, it notifies the Corporation. Upon receipt of this notification, the Corporation has an opportunity to provide information that may resolve the buyer’s claim. The Corporation primarily sells residential mortgage loans to Freddie Mac and Fannie Mae (GSEs) who include the residential mortgage loans in GSE-guaranteed mortgage securitizations. Repurchase demands and loss indemnifications received by the Corporation are reviewed by a senior officer on an individual loan by loan basis to validate the claim made by the buyer. During 2010, the Corporation was required to repurchase $0.6 million of loans sold in the secondary market and incurred $0.2 million of expense related to the indemnification of losses incurred by the buyers on three residential mortgage loans. During 2008 and 2009, the Corporation was required to repurchase $2.7 million of loans that had been sold in the secondary market and incurred loan losses of $0.6 million on these loans and incurred an additional $0.2 million of expense related to the indemnification of buyer losses. The majority of the loans required to be repurchased in 2008 and 2009 were attributable to borrower misrepresentations obtained at origination. The Corporation established a $0.25 million estimated liability at December 31, 2010 for probable losses expected to be incurred from loans previously sold in the secondary market. This estimate was based on trends in repurchase and indemnification requests, actual loss experience, known and inherent risks in the sale of loans in the secondary market and current economic conditions. At December 31, 2010, the Corporation had eleven unresolved repurchase demands/buyer indemnification loss requests.
 
Other fees for customer services were $2.8 million in 2010 and approximately $2.5 million in both 2009 and 2008. Other fees for customer services increased $0.3 million, or 15.6%, in 2010, compared to 2009, due primarily to increases in letter of credit fees and annual home equity line of credit fees. In general, these fees rose, primarily due to the acquisition of OAK. While 2009 was unchanged from 2008, an increase in safe deposit box revenue, resulting primarily from an increase in 2009 rental rates, was offset by a decrease in the amount of fees earned on outstanding bank money orders. During 2009, the Corporation began processing its bank money orders internally. Prior to 2009, the Corporation outsourced the processing of bank money orders to a third-party vendor, which paid the Corporation fees based on the level of outstanding bank money orders.
 
Insurance commissions were $1.4 million in 2010, $1.2 million in 2009 and $1.0 million in 2008. Insurance commissions increased $0.2 million, or 9.1%, in 2010, compared to 2009, and $0.2 million, or 20.8%, in 2009 from 2008, due to higher closing fees and title insurance premium income from increases in mortgage loan closing activity. The increases in mortgage loan closing activity occurred due to lower market interest rates on residential real estate loans.
 
In 2009, the Corporation realized a $0.1 million gain related to the sale of the remaining balance of its MasterCard Class B shares, which had no cost basis. During 2008, the Corporation realized a $1.7 million gain related to the sale of 92% of the its MasterCard Class B shares, which had no cost basis. The Corporation had no investment securities gains in 2010.
 
In 2008, the Corporation recognized a $0.4 million OTTI loss on a Lehman corporate bond in the Corporation’s available-for-sale investment securities portfolio. The Corporation had no OTTI losses during 2010 or 2009.
 
Noninterest income, excluding revenue from investment securities net gains and losses, was $42.5 million in 2010, $41.0 million in 2009 and $39.9 million in 2008. Noninterest income, excluding these items, increased $1.5 million, or 3.5%, in 2010, compared to 2009, and $1.1 million, or 2.8%, in 2009, compared to 2008. The increase in 2010, compared to 2009, was primarily attributable to increases in electronic banking fees and wealth management revenue that were partially offset by decreases in service charges on deposit accounts and mortgage banking revenue. The increase in 2009, compared to 2008, was primarily attributable to increases in electronic banking fees, insurance commissions and mortgage banking revenue that were partially offset by decreases in service charges on deposit accounts and wealth management revenue.


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OPERATING EXPENSES
 
Total operating expenses were $136.8 million in 2010, $117.6 million in 2009 and $109.1 million in 2008. Total operating expenses as a percentage of total average assets were 2.78% in 2010, 2.89% in 2009 and 2.88% in 2008.
 
The following schedule includes the major categories of operating expenses during the past three years:
                             
    Years Ended December 31,      
    2010     2009     2008      
    (Dollars in thousands)      
 
Salaries and wages
  $ 56,750     $ 49,227     $ 48,713      
Employee benefits
    11,666       10,991       10,514      
Equipment and software
    13,446       9,723       9,230      
Occupancy
    11,491       10,359       10,221      
FDIC insurance premiums
    7,388       7,013       899      
Professional fees
    5,589       4,165       3,554      
Loan and collection costs
    4,537       3,056       1,592      
Outside processing/service fees
    4,534       3,231       3,219      
Other real estate and repossessed asset expenses
    3,660       6,031       4,680      
Postage and courier
    3,115       2,951       3,169      
Advertising and marketing
    3,054       2,396       2,492      
Telephone
    1,768       1,840       2,186      
Supplies
    1,740       1,526       1,482      
Intangible asset amortization
    1,705       719       1,543      
Non-loan losses
    540       291       1,473      
Other
    5,819       4,091       4,141      
                             
Total Operating Expenses
  $ 136,802     $ 117,610     $ 109,108      
                             
Full-time equivalent staff (at December 31)
    1,608       1,427       1,416      
Efficiency ratio
    62.8 %     61.4 %     57.8 %    
                             
 
Operating expenses were $136.8 million in 2010, an increase of $19.2 million, or 16.3%, compared to 2009. The increase in 2010, compared to 2009, was primarily due to the acquisition of OAK, which resulted in increases in personnel costs, equipment and software expense, occupancy expense, professional fees, outside processing/service fees, advertising and marketing expenses, intangible asset amortization and other expenses. The increase in operating expenses attributable to the OAK acquisition was partially offset by a significant decrease in other real estate and repossessed asset expenses. Operating expenses were $117.6 million in 2009, an increase of $8.5 million, or 7.8%, compared to 2008. The increase in operating expenses in 2009, compared to 2008, was primarily due to increases in personnel costs, FDIC insurance premiums, loan and collection costs and other real estate and repossessed asset expenses that were partially offset by decreases in intangible asset amortization and non-loan losses.
 
Salaries and wages were $56.7 million in 2010, $49.2 million in 2009 and $48.7 million in 2008. Salaries and wages expense in 2010 was $7.5 million, or 15.3%, higher than in 2009, due primarily to additional employees related to the acquisition of OAK and an increase in performance based awards and incentives. Salaries and wages expense in 2009 was $0.5 million higher than 2008 due to higher costs attributable to merit salary increases and new positions, which were partially offset by a decrease in mortgage loan originator commissions. Mortgage loan originator commissions decreased as a component of salary expense due to a decrease in the volume of mortgage loans originated for the bank’s loan portfolio in 2009, compared to 2008.
 
Employee benefits expense was $11.7 million in 2010, $11.0 million in 2009 and $10.5 million in 2008. Employee benefits expense increased $0.7 million, or 6.1% in 2010, compared to 2009, due to higher payroll taxes attributable to both higher salaries and wages attributable to the acquisition of OAK and an increase in performance based awards and incentives, as well as other benefit costs attributable to the acquisition of OAK. Employee benefits expense increased $0.5 million, or 4.5%, in 2009, compared to 2008, due to higher retirement and group health insurance plan costs.
 
Compensation expenses, which include salaries and wages and employee benefits, as a percentage of total operating expenses were 50.0% in 2010, 51.2% in 2009 and 54.3% in 2008.
 
Equipment and software expense was $13.4 million in 2010, $9.7 million in 2009 and $9.2 million in 2008. Equipment and software expense increased $3.7 million, or 38.3%, in 2010, compared to 2009, primarily due to the acquisition of OAK, including information technology conversion costs of $1.4 million. The increase in equipment and software expense in 2010 compared to 2009, was also due to higher equipment depreciation expense and software maintenance expense related to information technology initiatives. Equipment and software expense increased $0.5 million, or 5.3%, in 2009, compared to 2008, primarily due to higher


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depreciation expense associated with equipment upgrades completed in 2008. Equipment and software depreciation expense included in equipment expense was $5.0 million, $4.0 million and $3.5 million in 2010, 2009 and 2008, respectively.
 
Occupancy expense was $11.5 million in 2010, $10.4 million in 2009 and $10.2 million in 2008. Occupancy expense increased $1.1 million, or 10.9%, in 2010, compared to 2009, primarily due to the OAK acquisition, which increased the Corporation’s branch network by thirteen branches at the acquisition date. Occupancy expense increased $0.2 million, or 1.4%, in 2009, compared to 2008, due to slight increases in building depreciation expense and property taxes on real estate used for bank operations. Depreciation expense on buildings included in occupancy expense was $2.8 million, $2.4 million and $2.3 million in 2010, 2009 and 2008, respectively.
 
FDIC insurance premiums were $7.4 million in 2010, $7.0 million in 2009 and $0.9 million in 2008. The $0.4 million increase in FDIC premiums in 2010, compared to 2009, was due to an increase in deposits as a result of the OAK acquisition and growth in customer core deposits insured by the FDIC. These increases were partially offset by the lack of a FDIC special assessment in 2010. In 2009, the Corporation’s FDIC premiums increased $6.1 million, compared to 2008, due to an industry-wide FDIC special assessment which resulted in the Corporation recognizing $1.8 million of additional premium expense, an increase in FDIC assessment rates, a 10 basis point assessment paid on covered transaction accounts exceeding $0.25 million under the TAGP during 2009, the loss of FDIC premium assessment credits which were fully utilized as of December 31, 2008 and growth in customer core deposits insured by the FDIC.
 
Professional fees were $5.6 million in 2010, $4.2 million in 2009 and $3.6 million in 2008. Professional fees were $1.4 million, or 34.2%, higher in 2010 than in 2009 due primarily to an increase in consulting expenses attributable to the acquisition of OAK. Professional fees were $0.6 million, or 17.2%, higher in 2009 than in 2008 due to an increase in consulting expenses attributable to the pending acquisition of OAK, which were partially offset by a decrease in external auditing fees.
 
Loan and collection expenses were $4.5 million in 2010, $3.1 million in 2009 and $1.6 million in 2008. These costs included legal fees, appraisal fees and other costs recognized in the collection of problem loans. The significant increases in these expenses in both 2010 and 2009 were attributable to deterioration in the credit quality of the loan portfolio and corresponding increased costs associated with foreclosing on properties and obtaining title to properties securing loans from customers that defaulted on payments.
 
Outside processing and service fees were $4.5 million in 2010 and $3.2 million in both 2009 and 2008. Outside processing and service fees increased $1.3 million, or 40.3% in 2010, compared to 2009, due primarily to additional outside services expense incurred as a result of transferring the processing of customer statement printing and mailing from an in-house process to a third-party vendor. In addition, internet banking costs increased in 2010 due to growth in the customer user base.
 
Other real estate and repossessed asset (ORE) expenses were $3.7 million in 2010, $6.0 million in 2009 and $4.7 million in 2008. ORE expenses include costs to carry ORE such as property taxes, insurance and maintenance costs, as well as fair value write-downs after the property is transferred to ORE and net gains/losses from the disposition of ORE. As property values in Michigan declined in 2008 and 2009, the Corporation recorded significant write-downs to the carrying value of ORE to fair value, which were recognized as operating costs in both of those years. Write-downs and net gains/losses from dispositions of ORE generated net expense of $1.3 million in 2010, compared to $3.7 million in 2009 and $2.9 million in 2008. Property taxes on ORE were $1.0 million in 2010, $1.1 million in 2009 and $0.6 million in 2008. Other operating costs on ORE were $1.4 million in 2010 and $1.2 million in both 2009 and 2008.
 
Advertising and marketing expenses were $3.1 million in 2010, $2.4 million in 2009 and $2.5 million in 2008. Advertising and marketing expenses increased $0.7 million, or 27.5%, in 2010, compared to 2009, due primarily to the acquisition of OAK. The decrease in advertising and marketing expenses in 2009, compared to 2008, was due to the Corporation increasing its expenditures for targeted direct mail campaigns in 2009, which was offset by a reduction in expenditures for more traditional advertising expenses such as newspaper, radio and television.
 
Intangible asset amortization was $1.7 million in 2010, $0.7 million in 2009 and $1.5 million in 2008. Intangible asset amortization increased $1.0 million, or 138% in 2010, compared to 2009, due to additional amortization expense on core deposit intangible assets and non-compete agreements as a result of the OAK acquisition. Intangible asset amortization declined $0.8 million, or 53.5%, in 2009, compared to 2008, due to a number of core deposit intangible assets becoming fully amortized during the latter half of 2008 and early 2009.
 
Non-loan losses were $0.5 million in 2010, $0.3 million in 2009 and $1.5 million in 2008. Non-loan losses in 2008 included a branch office loss of $0.8 million.
 
All other categories of operating expenses were $12.4 million in 2010, $10.4 million in 2009 and $11.0 million in 2008. The increase of $2.0 million, or 19.5%, in all other categories of operating expenses in 2010, compared to 2009, was primarily attributable to the


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acquisition of OAK. The decrease of $0.6 million, or 5.2%, in all other categories of operating expenses in 2009, as compared to 2008, was largely attributable to decreases in postage and courier and telephone expenses.
 
The Corporation’s efficiency ratio, which measures total operating expenses divided by the sum of net interest income (FTE) and noninterest income, was 62.8% in 2010, 61.4% in 2009 and 57.8% in 2008. The increase in 2010, compared to 2009, was attributable to higher operating expenses due, in part, to transaction related costs attributable to the acquisition of OAK. The increase in 2009, compared to 2008, was attributable to higher operating expenses.
 
INCOME TAXES
 
The Corporation’s effective federal income tax rate was 26.0% in 2010, 16.3% in 2009 and 29.5% in 2008. The fluctuations in the Corporation’s effective federal income tax rate reflect changes each year in the proportion of interest income exempt from federal taxation, nondeductible interest expense and other nondeductible expenses relative to pretax income and tax credits. Based on the Corporation’s assessment of uncertain tax positions during 2010, 2009 and 2008, no adjustments to the federal income tax provision were required. The Corporation had no uncertain tax positions during the three years ended December 31, 2010. The significant increase in the Corporation’s effective federal income tax rate in 2010, compared to 2009, was due to an increase in the Corporation’s pre-tax income and nondeductible acquisition expenses attributable to the OAK transaction, that were partially offset by an increase in tax credits and tax exempt income, also largely due to the OAK transaction.
 
Tax-exempt income (FTE), net of related nondeductible interest expense, totaled $10.9 million in 2010, $8.0 million in 2009 and $6.5 million in 2008. Tax-exempt income (FTE) as a percentage of total interest income (FTE) was 5.1% in 2010, 4.1% in 2009 and 3.1% in 2008.
 
Income before income taxes (FTE) was $35.5 million in 2010, $14.9 million in 2009 and $30.5 million in 2008.
 
LIQUIDITY RISK
 
Liquidity risk is the possibility of the Corporation being unable to meet current and future financial obligations in a timely manner and the adverse impact on net interest income if the Corporation was unable to meet its funding requirements at a reasonable cost.
 
Liquidity is managed to ensure stable, reliable and cost-effective sources of funds are available to satisfy deposit withdrawals and lending and investment opportunities. The Corporation’s largest sources of liquidity on a consolidated basis are the deposit base that comes from consumer, business and municipal customers within the Corporation’s local markets, principal payments on loans, cash held at the FRB, unpledged investment securities available-for-sale and federal funds sold. During 2010, total deposits increased $913.6 million, or 26.7%, compared to an increase of $439.3 million, or 14.7%, during 2009. The significant increase in deposits in 2010 was largely attributable to $693 million of deposits acquired in the OAK transaction. The Corporation’s loan-to-deposit ratio decreased to 85.0% at December 31, 2010 from 87.6% at December 31, 2009. At December 31, 2010 and 2009, the Corporation had $440 million and $223 million, respectively, of cash deposits held at the FRB that were not invested in federal funds sold due to the low interest rate environment. In addition, at December 31, 2010, the Corporation had $135 million of unpledged investment securities available-for-sale. The Corporation also has available unused wholesale sources of liquidity, including FHLB advances and borrowings from the discount window of the FRB.
 
Chemical Bank is a member of the FHLB and as such has access to short-term and long-term advances from the FHLB that are generally secured by real estate residential first lien loans. The Corporation considers advances from the FHLB as its primary wholesale source of liquidity. FHLB advances decreased $15.9 million during 2010 to $74.1 million at December 31, 2010. At December 31, 2010, the Corporation’s additional borrowing availability from the FHLB, based on its FHLB capital stock and subject to certain requirements, was $298 million. At December 31, 2010, if the Corporation acquired an additional $2.1 million of FHLB capital stock, its borrowing availability from the FHLB would increase by another $118 million, resulting in additional borrowing availability from the FHLB of $416 million. See the Borrowed Funds section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 11 to the consolidated financial statements for more information on advances from the FHLB. Chemical Bank can also borrow from the FRB’s discount window to meet short-term liquidity requirements. These borrowings are required to be secured by investment securities and/or certain loan types, with each category of assets carrying various borrowing capacity percentages. At December 31, 2010, Chemical Bank maintained an unused borrowing capacity of $30 million with the FRB’s discount window based upon pledged collateral as of that date, although it is management’s opinion that this borrowing capacity could be expanded, if deemed necessary, as Chemical Bank has a significant amount of additional assets that could be used as collateral at the FRB’s discount window.
 
The Corporation manages its liquidity primarily through dividends from Chemical Bank. The Corporation manages its liquidity position to provide the cash necessary to pay dividends to shareholders, invest in new subsidiaries, enter new banking markets, pursue


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investment opportunities and satisfy other operating requirements. The long-term ability of the Corporation to pay cash dividends to shareholders is dependent on the adequacy of capital and earnings of Chemical Bank.
 
Federal and state banking laws place certain restrictions on the amount of dividends that a bank may pay to its parent company. During 2010, Chemical Bank paid $21.3 million in dividends to the Corporation. The Corporation paid cash dividends to shareholders of $21.2 million in 2010. The Corporation’s cash decreased $2.3 million during 2010 to $5.5 million at December 31, 2010, which it held in a deposit account at Chemical Bank as of that date. During 2009, Chemical Bank did not pay any dividends to the Corporation. The Corporation paid cash dividends to shareholders of $28.2 million in 2009. The Corporation’s cash decreased $28.5 million during 2009 to $7.8 million at December 31, 2009. At December 31, 2010, Chemical Bank could pay dividends totaling $17.5 million to the Corporation without Federal Reserve approval. The earnings of Chemical Bank have been the principal source of funds to pay cash dividends to the Corporation’s shareholders. Over the long term, cash dividends to shareholders are dependent upon earnings, as well as capital requirements, regulatory restraints and other factors affecting Chemical Bank.
 
The Corporation maintains a liquidity contingency plan that outlines the process for addressing a liquidity crisis. The plan provides for an evaluation of funding sources under various market conditions. It also assigns specific roles and responsibilities for effectively managing liquidity through a problem period.
 
MARKET RISK
 
Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due primarily to changes in interest rates. Interest rate risk is the Corporation’s primary market risk and results from timing differences in the repricing of interest rate sensitive assets and liabilities and changes in relationships between rate indices due to changes in interest rates. The Corporation’s net interest income is largely dependent upon the effective management of interest rate risk. The Corporation’s goal is to avoid a significant decrease in net interest income, and thus an adverse impact on the profitability of the Corporation, in periods of changing interest rates. Sensitivity of earnings to interest rate changes arises when yields on assets change differently from the interest costs on liabilities. Interest rate sensitivity is determined by the amount of interest-earning assets and interest-bearing liabilities repricing within a specific time period and the magnitude by which interest rates change on the various types of interest-earning assets and interest-bearing liabilities. The management of interest rate sensitivity includes monitoring the maturities and repricing opportunities of interest-earning assets and interest-bearing liabilities. The Corporation’s interest rate risk is managed through policies and risk limits approved by the boards of directors of the Corporation and Chemical Bank and an Asset and Liability Committee (ALCO). The ALCO, which is comprised of executive management from various areas of the Corporation and Chemical Bank, including finance, lending, investments and deposit gathering, meets regularly to execute asset and liability management strategies. The ALCO establishes guidelines and monitors the sensitivity of earnings to changes in interest rates. The goal of the ALCO process is to maximize net interest income and the net present value of future cash flows within authorized risk limits.
 
The primary technique utilized by the Corporation to measure its interest rate risk is simulation analysis. Simulation analysis forecasts the effects on the balance sheet structure and net interest income under a variety of scenarios that incorporate changes in interest rates, the shape of the Treasury yield curve, interest rate relationships and the mix of assets and liabilities and loan prepayments. These forecasts are compared against net interest income projected in a stable interest rate environment. While many assets and liabilities reprice either at maturity or in accordance with their contractual terms, several balance sheet components demonstrate characteristics that require an evaluation to more accurately reflect their repricing behavior. Key assumptions in the simulation analysis include prepayments on loans, probable calls of investment securities, changes in market conditions, loan volumes and loan pricing, deposit sensitivity and customer preferences. These assumptions are inherently uncertain as they are subject to fluctuation and revision in a dynamic environment. As a result, the simulation analysis cannot precisely forecast the impact of rising and falling interest rates on net interest income. Actual results will differ from simulated results due to many other factors, including changes in balance sheet components, interest rate changes, changes in market conditions and management strategies.
 
The Corporation’s interest rate sensitivity is estimated by first forecasting the next twelve months of net interest income under an assumed environment of constant market interest rates. The Corporation then compares the results of various simulation analyses to the constant interest rate forecast (base case). At December 31, 2010 and 2009, the Corporation projected the change in net interest income during the next twelve months assuming short-term market interest rates were to uniformly and gradually increase or decrease by up to 200 basis points in a parallel fashion over the entire yield curve during the same time period. These projections were based on the Corporation’s assets and liabilities remaining static over the next twelve months, while factoring in probable calls and prepayments of certain investment securities and real estate residential and consumer loans. The ALCO regularly monitors the Corporation’s forecasted net interest income sensitivity to ensure that it remains within established limits.


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A summary of the Corporation’s interest rate sensitivity at December 31, 2010 and 2009 is as follows:
 
                                                 
December 31, 2010
                                               
Twelve month interest rate change projection (in basis points)
    −200       −100       0       +100       +200          
     
     
Percent change in net interest income vs. constant rates
    (5.3 )%     (2.6 )%           1.6 %     2.6 %        
                                                 
December 31, 2009
                                               
Twelve month interest rate change projection (in basis points)
    −200       −100       0       +100       +200          
     
     
Percent change in net interest income vs. constant rates
    (3.0 )%     (1.6 )%           0.6 %     0.0 %        
 
At December 31, 2010, the Corporation’s model simulations projected that 100 and 200 basis point increases in interest rates would result in positive variances in net interest income of 1.6% and 2.6%, respectively, relative to the base case over the next 12 month period, while decreases in interest rates of 100 and 200 basis points would result in negative variances in net interest income of 2.6% and 5.3%, respectively, relative to the base case over the next 12 month period. At December 31, 2009, the model simulations projected that 100 and 200 basis point increases in interest rates would result in positive variances in net interest income of 0.6% and 0.0%, respectively, relative to the base case over the next 12 month period, while decreases in interest rates of 100 and 200 basis points would result in negative variances in net interest income of 1.6% and 3.0%, respectively, relative to the base case over the next 12 month period. The likelihood of a decrease in interest rates beyond 100 basis points at December 31, 2010 and 2009 was considered to be unlikely given prevailing interest rate levels.
 
The Corporation’s mix of interest-earning assets and interest-bearing liabilities has historically resulted in its interest rate position being liability sensitive. The Corporation modestly adjusted its liability sensitive position by significantly increasing the amount of variable rate investment securities in its investment securities portfolio. Variable rate investment securities at December 31, 2010 of $325 million comprised 44% of total investment securities at that date, compared to $297 million, or 41% of total investment securities, at December 31, 2009 and $155 million, or 28% of total investment securities, at December 31, 2008. In addition, the proportion of variable rate loans in the Corporation’s loan portfolio increased in 2010 due primarily to the acquisition of OAK. At December 31, 2010 and 2009, approximately 28% and 20%, respectively, of the Corporation’s loans were at variable interest rates.


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MANAGEMENT’S ASSESSMENT AS TO THE EFFECTIVENESS
OF INTERNAL CONTROL OVER FINANCIAL REPORTING
 
Management of the Corporation is responsible for establishing and maintaining effective internal control over financial reporting that is designed to provide reasonable assurance regarding reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. The system of internal control over financial reporting as it relates to the financial statements is evaluated for effectiveness by management and tested for reliability through a program of internal audits. Actions are taken to correct potential deficiencies as they are identified. Any system of internal control, no matter how well designed, has inherent limitations, including the possibility that a control can be circumvented or overridden and misstatements due to error or fraud may occur and not be detected. Also, because of changes in conditions, internal control effectiveness may vary over time. Accordingly, even an effective system of internal control will provide only reasonable assurance with respect to financial reporting and financial statement preparation.
 
Management assessed the Corporation’s system of internal control over financial reporting as of December 31, 2010, as required by Section 404 of the Sarbanes-Oxley Act of 2002. Management’s assessment is based on the criteria for effective internal control over financial reporting as described in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management has concluded that, as of December 31, 2010, its system of internal control over financial reporting was effective and meets the criteria of the “Internal Control — Integrated Framework.” The Corporation’s independent registered public accounting firm that audited the Corporation’s consolidated financial statements included in this annual report has issued an attestation report on the Corporation’s internal control over financial reporting as of December 31, 2010.
 
     
-s- David B. Ramaker   -s- Lori A. Gwizdala
David B. Ramaker
  Lori A. Gwizdala
Chairman, Chief Executive Officer
  Executive Vice President, Chief Financial Officer
and President
  and Treasurer
     
February 25, 2011
  February 25, 2011


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
The Board of Directors and Shareholders
Chemical Financial Corporation:
 
We have audited Chemical Financial Corporation’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Chemical Financial Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Assessment as to the Effectiveness of Internal Control over Financial Reporting. Our responsibility is to express an opinion on Chemical Financial Corporation’s internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
In our opinion, Chemical Financial Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial position of Chemical Financial Corporation and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2010, and our report dated February 25, 2011 expressed an unqualified opinion on those consolidated financial statements.
 
-s- KPMG LLp
 
 
Detroit, Michigan
February 25, 2011


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
The Board of Directors and Shareholders
Chemical Financial Corporation:
 
We have audited the accompanying consolidated statements of financial position of Chemical Financial Corporation and subsidiaries (the Corporation) as of December 31, 2010 and 2009, and the related consolidated statements of income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2010. These consolidated financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Chemical Financial Corporation and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Chemical Financial Corporation’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 25, 2011 expressed an unqualified opinion on the effectiveness of the Corporation’s internal control over financial reporting.
 
-s- KPMG LLp
 
 
Detroit, Michigan
February 25, 2011


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CONSOLIDATED FINANCIAL STATEMENTS
 
CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
 
                 
    December 31,  
    2010     2009  
    (In thousands, except share data)  
 
Assets
               
Cash and cash equivalents:
               
Cash and cash due from banks
  $ 91,403     $ 131,383  
Interest-bearing deposits with unaffiliated banks and others
    444,762       229,326  
                 
Total cash and cash equivalents
    536,165       360,709  
Investment securities:
               
Available-for-sale at fair value
    578,610       592,521  
Held-to-maturity (fair value — $159,188 at December 31, 2010 and $125,730 at December 31, 2009)
    165,400       131,297  
                 
Total investment securities
    744,010       723,818  
Other securities
    27,133       22,128  
Loans held for sale
    20,479       8,362  
Loans
    3,681,662       2,993,160  
Allowance for loan losses
    (89,530 )     (80,841 )
                 
Net loans
    3,592,132       2,912,319  
Premises and equipment
    65,961       53,934  
Goodwill
    113,414       69,908  
Other intangible assets
    13,521       5,408  
Interest receivable and other assets
    133,394       94,126  
                 
Total Assets
  $ 5,246,209     $ 4,250,712  
                 
Liabilities and Shareholders’ Equity
               
Deposits:
               
Noninterest-bearing
  $ 753,553     $ 573,159  
Interest-bearing
    3,578,212       2,844,966  
                 
Total deposits
    4,331,765       3,418,125  
Interest payable and other liabilities
    37,533       27,708  
Short-term borrowings
    242,703       240,568  
Federal Home Loan Bank (FHLB) advances
    74,130       90,000  
                 
Total liabilities
    4,686,131       3,776,401  
Shareholders’ equity:
               
Preferred stock, no par value:
               
Authorized — 200,000 shares, none issued
           
Common stock, $1 par value per share:
               
Authorized — 30,000,000 shares
               
Issued and outstanding — 27,440,006 shares at December 31, 2010 and 23,891,321 shares at December 31, 2009
    27,440       23,891  
Additional paid in capital
    429,511       347,676  
Retained earnings
    117,238       115,391  
Accumulated other comprehensive loss
    (14,111 )     (12,647 )
                 
Total shareholders’ equity
    560,078       474,311  
                 
Total Liabilities and Shareholders’ Equity
  $ 5,246,209     $ 4,250,712  
                 
 
See accompanying notes to consolidated financial statements.


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CONSOLIDATED STATEMENTS OF INCOME
 
                         
    Years Ended December 31,  
    2010     2009     2008  
    (In thousands, except per share data)  
 
Interest Income
                       
Interest and fees on loans
  $ 192,247     $ 172,388     $ 180,629  
Interest on investment securities:
                       
Taxable
    11,363       15,385       21,793  
Tax-exempt
    4,999       3,596       2,882  
Dividends on other securities
    766       821       1,167  
Interest on federal funds sold
                1,666  
Interest on deposits with unaffiliated banks and others
    1,055       541       199  
                         
Total Interest Income
    210,430       192,731       208,336  
Interest Expense
                       
Interest on deposits
    35,895       39,500       54,763  
Interest on short-term borrowings
    650       906       2,223  
Interest on FHLB advances
    2,765       4,881       6,097  
                         
Total Interest Expense
    39,310       45,287       63,083  
                         
Net Interest Income
    171,120       147,444       145,253  
Provision for loan losses
    45,600       59,000       49,200  
                         
Net Interest Income after Provision for Loan Losses
    125,520       88,444       96,053  
Noninterest Income
                       
Service charges on deposit accounts
    18,562       19,116       20,048  
Wealth management revenue
    10,106       9,273       10,625  
Other charges and fees for customer services
    9,599       7,736       6,894  
Mortgage banking revenue
    3,925       4,412       1,836  
Investment securities gains
          95       1,722  
Other-than-temporary impairment loss on investment security
                (444 )
Other
    280       487       516  
                         
Total Noninterest Income
    42,472       41,119       41,197  
Operating Expenses
                       
Salaries, wages and employee benefits
    68,416       60,218       59,227  
Occupancy
    11,491       10,359       10,221  
Equipment and software
    13,446       9,723       9,230  
Other
    43,449       37,310       30,430  
                         
Total Operating Expenses
    136,802       117,610       109,108  
                         
Income Before Income Taxes
    31,190       11,953       28,142  
Federal income tax expense
    8,100       1,950       8,300  
                         
Net Income
  $ 23,090     $ 10,003     $ 19,842  
                         
Net Income Per Common Share
                       
Basic
  $ 0.88     $ 0.42     $ 0.83  
Diluted
    0.88       0.42       0.83  
Cash Dividends Declared Per Common Share
    0.80       1.18       1.18  
 
See accompanying notes to consolidated financial statements.


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CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
 
                                         
    Years Ended December 31, 2010, 2009 and 2008  
                      Accumulated
       
          Additional
          Other
       
    Common
    Paid in
    Retained
    Comprehensive
       
(In thousands, except per share data)
  Stock     Capital     Earnings     Loss     Total  
 
Balances at January 1, 2008
  $ 23,815     $ 344,579     $ 141,867     $ (1,797 )   $ 508,464  
Comprehensive income:
                                       
Net income for 2008
                    19,842                  
Other:
                                       
Change in net unrealized gains on investment securities available-for-sale, net of tax expense of $606
                            1,125          
Reclassification adjustment for other-than-temporary impairment loss realized on investment security included in net income, net of tax benefit of $156
                            289          
Adjustment for pension and other postretirement benefits, net of tax benefit of $6,703
                            (12,448 )        
Comprehensive income
                                    8,808  
Cash dividends declared and paid of $1.18 per share
                    (28,131 )             (28,131 )
Shares issued — stock options
    58       1,450                       1,508  
Shares issued — directors’ stock purchase plan
    8       223                       231  
Share-based compensation
            664                       664  
                                         
Balances at December 31, 2008
    23,881       346,916       133,578       (12,831 )     491,544  
Comprehensive income:
                                       
Net income for 2009
                    10,003                  
Other:
                                       
Change in net unrealized gains on investment securities available-for-sale, net of tax expense of $42
                            79          
Reclassification adjustment for realized gain on call of investment security — available-for-sale included in net income, net of tax expense of $6
                            (11 )        
Adjustment for pension and other postretirement benefits, net of tax expense of $63
                            116          
Comprehensive income
                                    10,187  
Cash dividends declared and paid of $1.18 per share
                    (28,190 )             (28,190 )
Shares issued — stock options
    1       35                       36  
Shares issued — directors’ stock purchase plan
    9       235                       244  
Share-based compensation
            490                       490  
                                         
Balances at December 31, 2009
    23,891       347,676       115,391       (12,647 )     474,311  
Comprehensive income:
                                       
Net income for 2010
                    23,090                  
Other:
                                       
Change in net unrealized gains on investment securities available-for-sale, net of tax expense of $140
                            259          
Adjustment for pension and other postretirement benefits, net of tax benefit of $928
                            (1,723 )        
Comprehensive income
                                    21,626  
Cash dividends declared and paid of $0.80 per share
                    (21,243 )             (21,243 )
Shares issued — stock options
    1       41                       42  
Shares and stock options issued in the acquisition of O.A.K. Financial Corporation
    3,530       80,167                       83,697  
Shares issued — directors’ stock purchase plan
    12       238                       250  
Share-based compensation
    6       1,389                       1,395  
                                         
Balances at December 31, 2010
  $ 27,440     $ 429,511     $ 117,238     $ (14,111 )   $ 560,078  
                                         
 
See accompanying notes to consolidated financial statements.


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CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                                 
    Years Ended December 31,        
    2010     2009     2008        
    (In thousands)        
Operating Activities
                               
Net income
  $ 23,090     $ 10,003     $ 19,842          
Adjustments to reconcile net income to net cash provided by operating activities:
                               
Provision for loan losses
    45,600       59,000       49,200          
Gains on sales of loans
    (5,986 )     (6,431 )     (1,790 )        
Proceeds from sales of loans
    281,511       367,796       147,172          
Loans originated for sale
    (286,317 )     (361,264 )     (145,943 )        
Proceeds from sale of trading securities
    1,083                      
Investment securities net gains
          (95 )     (1,722 )        
Other-than-temporary impairment loss on investment security
                444          
Net gains on sales of other real estate and repossessed assets
    (1,394 )     (969 )     (283 )        
Net (gain) loss on disposal of premises and equipment, branch bank properties and insurance settlement
    865       (162 )     (242 )        
Depreciation of premises and equipment
    7,826       6,429       5,878          
Amortization of intangible assets
    3,609       2,569       2,613          
Net amortization of premiums and discounts on investment securities
    2,818       815       625          
Share-based compensation expense
    1,395       490       664          
Deferred income tax provision
    3,439       (6,977 )     (6,882 )        
Contributions to defined benefit pension plan
    (10,000 )     (7,500 )              
Net (increase) decrease in interest receivable and other assets
    35       (17,973 )     (12,284 )        
Net increase in interest payable and other liabilities
    9,325       306       12,378          
                                 
Net Cash Provided by Operating Activities
    76,899       46,037       69,670          
Investing Activities
                               
Investment securities — available-for-sale:
                               
Proceeds from maturities, calls and principal reductions
    333,878       264,998       161,375          
Proceeds from sales
          78       1,724          
Purchases
    (253,815 )     (408,344 )     (107,417 )        
Investment securities — held-to-maturity:
                               
Proceeds from maturities, calls and principal reductions
    47,150       41,511       67,560          
Purchases
    (81,346 )     (75,219 )     (73,356 )        
Other securities:
                               
Proceeds from redemption
    2,802             14          
Purchases
    (2,487 )           (7 )        
Net increase in loans
    (124,985 )     (64,754 )     (235,110 )        
Proceeds from sales of other real estate and repossessed assets
    18,066       16,950       9,802          
Proceeds from sales of branch bank properties and insurance settlement
    58       433       554          
Purchases of premises and equipment, net
    (7,791 )     (7,431 )     (9,262 )        
Cash acquired, net of cash paid, in business combination
    17,177                      
                                 
Net Cash Used in Investing Activities
    (51,293 )     (231,778 )     (184,123 )        
Financing Activities
                               
Net increase in noninterest-bearing and interest-bearing demand deposits and savings accounts
    200,829       222,222       111,554          
Net increase (decrease) in time deposits
    19,570       217,111       (8,351 )        
Net increase in securities sold under agreements to repurchase
    2,135       6,830       36,375          
Increase in short-term FHLB advances
                250,000          
Repayment of short-term FHLB advances
                (250,000 )        
Increase in long-term FHLB advances
                65,000          
Repayment of long-term FHLB advances
    (51,733 )     (45,025 )     (80,024 )        
Cash dividends paid
    (21,243 )     (28,190 )     (28,131 )        
Tax benefits from share-based awards
                140          
Proceeds from directors’ stock purchase plan and exercise of stock options
    292       280       1,599          
                                 
Net Cash Provided by Financing Activities
    149,850       373,228       98,162          
                                 
Net Increase (Decrease) in Cash and Cash Equivalents
    175,456       187,487       (16,291 )        
Cash and cash equivalents at beginning of year
    360,709       173,222       189,513          
                                 
Cash and Cash Equivalents at End of Year
  $ 536,165     $ 360,709     $ 173,222          
                                 
Supplemental Disclosures of Cash Flow Information
                               
Interest paid
  $ 40,206     $ 46,232     $ 64,629          
Federal income taxes paid
    9,800       9,725       16,881          
Loans transferred to other real estate and repossessed assets
    26,429       18,320       21,282          
Investment securities — available-for-sale transferred to Investment securities — held-to-maturity
                502          
Closed branch bank properties transferred to other assets
                225          
Business combination:
                               
Fair value of tangible assets acquired (noncash)
    749,916                      
Goodwill and identifiable intangible assets acquired
    53,310                      
Liabilities assumed
    736,706