SOUTHERN MICHIGAN BANCORP INC - FORM 10-Q

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2011

¨	Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from to

Commission File Number: 000-49772

SOUTHERN MICHIGAN BANCORP, INC.

(Exact Name of Registrant as Specified in its Charter)


Michigan		38-2407501
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

51 West Pearl Street Coldwater, Michigan		49036
(Address of Principal Executive Offices)		(Zip Code)

(517) 279-5500

(Registrant’s Telephone Number, Including Area Code)

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

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

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

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

The number of shares outstanding of the Registrant’s Common Stock, $2.50 par value, as of November 12, 2011, was 2,358,599 shares.

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 Southern Michigan Bancorp, Inc. Forward-looking statements may be identified by words or phrases such as “outlook”, “plan”, or “strategy”; that an event or trend “may”, “should”, “will”, “is likely”, or is “probable” to occur or “continue”, has “begun” or “is scheduled” or “on track” or that the Company or its management “anticipates”, “believes”, “estimates”, “plans”, “forecasts”, “intends”, “predicts”, “projects”, or “expects” a particular result, or is “committed”, “confident”, “optimistic” or has an “opinion” that an event will occur, or other words or phrases such as “ongoing”, “future”, “judgment”, “signs”, “efforts”, “tend”, “exploring”, “appearing”, “until”, “near term”, “going forward”, “starting” and variations of such words and similar expressions. 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 non-performing loans, dividends, future growth and funding sources, future liquidity levels, the availability of sources of liquidity, future profitability levels, the effects on earnings of changes in interest rates and other revenue sources, the effects of new or changed accounting standards and the effects of existing or new laws or regulations (or interpretations thereof). All statements with references to future time periods are forward-looking. Management’s determination of the provision and allowance for loan losses, the appropriate carrying value of intangible assets (including goodwill and mortgage servicing rights), deferred tax assets and other real estate owned, and 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) involves judgments that are inherently forward-looking. All of the information concerning interest rate sensitivity is forward-looking. Management’s assumptions regarding pension and other post retirement plans involve judgments that are inherently forward-looking. Our ability to sell other real estate at carrying value or at all, successfully implement new programs and initiatives, increase efficiencies, respond to declines in collateral values and credit quality, maintain our current level of deposits and other sources of funding, and improve profitability is not entirely within our control and is not assured. The future effect of changes in the real estate, financial and credit markets and the national and regional economy on the banking industry, generally, and Southern Michigan Bancorp, Inc., 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. Actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. We undertake no obligation to update or revise our forward-looking statements to reflect developments that occur or information obtained after the date of this report.

Risk factors include, but are not limited to, the risk factors described in “Item 1A - Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2010. 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.

Part I. Financial Information

Item 1.

Financial Statements

SOUTHERN MICHIGAN BANCORP, INC.

UNAUDITED INTERIM FINANCIAL STATEMENTS

Consolidated Balance Sheets CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(In thousands, except share data)


	September 30, 2011			December 31, 2010
ASSETS
Cash and cash equivalents	$	72,224		$	78,833
Federal funds sold		265			275
Securities available for sale		85,890			59,228
Loans held for sale		930			2,637
Loans, net of allowance for loan losses of $5,398 - 2011 ($5,694 - 2010)		308,228			303,830
Premises and equipment, net		12,498			12,599
Accrued interest receivable		2,416			2,107
Net cash surrender value of life insurance		10,216			9,965
Goodwill		13,422			13,422
Other intangible assets, net		1,751			2,005
Other assets		7,521			8,979

TOTAL ASSETS	$	515,361		$	493,880

LIABILITIES
Deposits:
Non-interest bearing	$	61,468		$	59,942
Interest bearing		367,793			349,959

Total deposits		429,261			409,901
Securities sold under agreements to repurchase and overnight borrowings		16,166			15,027
Accrued expenses and other liabilities		3,956			4,476
Other borrowings		8,495			10,079
Subordinated debentures		5,155			5,155
Common stock subject to repurchase obligation in Employee Stock Ownership Plan, shares outstanding – 112,002 in 2011 (107,627 shares in 2010)		1,344			1,399

Total liabilities		464,377			446,037

SHAREHOLDERS’ EQUITY
Preferred stock, 100,000 shares authorized; none issued or outstanding		—			—
Common stock, $2.50 par value:
Authorized - 4,000,000 shares
Issued – 2,358,599 shares in 2011 (2,340,717 shares in 2010) Outstanding (other than ESOP shares) – 2,246,597 shares in 2011 (2,233,090 shares in 2010)		5,616			5,583
Additional paid-in capital		18,173			18,033
Retained earnings		26,736			24,692
Accumulated other comprehensive income (loss), net		661			(168	)
Unearned Employee Stock Ownership Plan shares		(202	)		(297	)

Total shareholders’ equity		50,984			47,843

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	515,361		$	493,880

See accompanying notes to interim consolidated financial statements.

SOUTHERN MICHIGAN BANCORP, INC.

Consolidated Statements of Income CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(In thousands, except per share data)


	Three Months Ended September 30,				Nine Months Ended September 30,
	2011		2010		2011		2010
Interest income:
Loans, including fees	$	4,512	$	4,878	$	13,359	$	14,427
Securities:
Taxable		164		151		473		474
Tax-exempt		237		178		671		580
Other		31		42		129		99

Total interest income		4,944		5,249		14,632		15,580

Interest expense:
Deposits		771		928		2,418		2,863
Other		146		172		453		515

Total interest expense		917		1,100		2,871		3,378

Net interest income		4,027		4,149		11,761		12,202
Provision for loan losses		375		425		875		775

Net interest income after provision for loan losses		3,652		3,724		10,886		11,427

Non-interest income:
Service charges on deposit accounts		489		652		1,568		1,834
Trust fees		284		244		852		740
Net gains on security calls and sales		2		—		4		207
Net gains on loan sales		309		403		831		684
Earnings on life insurance assets		87		93		251		243
Gain on life insurance proceeds		—		—		—		156
Income from loan servicing		98		79		323		242
Brokerage income		76		49		170		168
ATM and debit card fee income		263		235		755		660
Other		113		83		276		242

Total non-interest income		1,721		1,838		5,030		5,176

Non-interest expense:
Salaries and employee benefits		2,378		2,529		7,262		7,467
Occupancy, net		230		324		939		1,068
Equipment		158		229		565		683
Printing, postage and supplies		139		146		382		437
Telecommunication expenses		74		107		271		281
Professional and outside services		253		160		673		685
FDIC assessments		101		157		376		473
Software maintenance		110		94		325		302
Amortization of other intangibles		85		87		254		262
Expenses relating to OREO property		72		32		203		384
ATM expenses		93		81		267		246
Other		545		482		1,365		1,387

Total non-interest expense		4,238		4,428		12,882		13,675

INCOME BEFORE INCOME TAXES		1,135		1,134		3,034		2,928
Federal income tax provision		248		264		637		553

NET INCOME	$	887	$	870	$	2,397	$	2,375

Basic Earnings Per Common Share	$	0.38	$	0.38	$	1.03	$	1.03

Diluted Earnings Per Common Share		0.38		0.38		1.03		1.03

Dividends Declared Per Common Share		0.05		0.05		0.15		0.15

See accompanying notes to interim consolidated financial statements.

SOUTHERN MICHIGAN BANCORP, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(In thousands, except number of shares and per share data)

For the Nine Months Ended September 30, 2011 and 2010


	Common Stock			Additional Paid-In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss), Net			Unearned ESOP Shares			Total
Balance at January 1, 2010	$	5,553		$	18,363		$	22,062		$	193		$	(437	)	$	45,734
Comprehensive income:
Net income								2,375									2,375
Net change in other comprehensive income items											50						50

Total comprehensive income																	2,425
Cash dividends declared - $.15 per share								(351	)								(351	)
Issuance of restricted stock (18,325 shares of common stock at $10.10 per share)		46			(46	)											—
Vesting of restricted stock					58												58
Forfeiture of restricted stock (1,018 shares)		(2	)		2												—
Change in common stock subject to repurchase		(6	)		(282	)											(288	)
Reduction of ESOP obligation														110			110
Stock option expense					57												57

Balance at September 30, 2010	$	5,591		$	18,152		$	24,086		$	243		$	(327	)	$	47,745

Balance at January 1, 2011	$	5,583		$	18,033		$	24,692		$	(168	)	$	(297	)	$	47,843
Comprehensive income:
Net income								2,397									2,397
Net change in other comprehensive income items											829						829

Total comprehensive income																	3,226
Cash dividends declared - $.15 per share								(353	)								(353	)
Vesting of restricted stock					72												72
Forfeiture of restricted stock (643 shares)		(2	)		2												—
Change in common stock subject to repurchase		(11	)		66												55
Issuance of restricted stock (18,525 shares of common stock at $12.70)		46			(46	)											—
Reduction of ESOP obligation														95			95
Stock option expense					46												46

Balance at September 30, 2011	$	5,616		$	18,173		$	26,736		$	661		$	(202	)	$	50,984

See accompanying notes to interim consolidated financial statements.

SOUTHERN MICHIGAN BANCORP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(Dollars in thousands)


	Nine Months Ended September 30,
	2011			2010
Operating Activities
Net income	$	2,397		$	2,375
Adjustments to reconcile net income to net cash from operating activities:
Provision for loan losses		875			775
Depreciation		654			746
Net amortization of investment securities		335			402
Loans originated for sale		(27,706	)		(29,955	)
Proceeds on loans sold		30,244			30,129
Net gains on loan sales		(831	)		(684	)
Gain on life insurance proceeds		—			(156	)
Stock option and restricted stock grant compensation expense		118			115
Net gains on security calls and sales		(4	)		(207	)
Net loss from sale or write down of other real estate owned and repossessed assets		136			241
Amortization of other intangible assets		254			262
Net loss on disposal of premises and equipment		8			(3	)
Net change in obligation under ESOP		95			110
Net change in:
Accrued interest receivable		(309	)		(312	)
Cash surrender value		(251	)		(243	)
Other assets		988			935
Accrued expenses and other liabilities		(521	)		144

Net cash from operating activities		6,482			4,674

Investing Activities
Activity in available for sale securities:
Proceeds on securities sold		—			7,445
Proceeds from maturities and calls		28,503			32,163
Purchases		(54,240	)		(40,836	)
Net change in federal funds sold		10			2,319
Loan originations and payments, net		(5,925	)		10,940
Proceeds from life insurance		—			421
Proceeds from sale of other real estate owned and repossessed assets		559			717
Proceeds from sale of equipment		57			15
Additions to premises and equipment		(618	)		(556	)

Net cash from investing activities		(31,654	)		12,628

Financing Activities
Net change in deposits		19,360			21,083
Net change in securities sold under agreements to repurchase and overnight borrowings		1,139			2,077
Proceeds from other borrowings		—			5,000
Repayments of other borrowings		(1,584	)		(5,514	)
Cash dividends paid		(352	)		(351	)

Net cash from financing activities		18,563			22,295

Net change in cash and cash equivalents		(6,609	)		39,597
Beginning cash and cash equivalents		78,833			24,814

Ending cash and cash equivalents	$	72,224		$	64,411

Cash paid for interest	$	2,913		$	3,415
Cash paid for income taxes		350			250
Transfers from loans to other real estate owned		652			747

See accompanying notes to interim consolidated financial statements.

SOUTHERN MICHIGAN BANCORP, INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE A – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation: The consolidated financial statements include the accounts of Southern Michigan Bancorp, Inc. (the Company) and its wholly-owned subsidiary, Southern Michigan Bank & Trust (SMB&T), after elimination of significant inter-company balances and transactions. SMB&T owns FNB Financial Services, which conducts a brokerage business and is consolidated into SMB&T’s financial statements. During 2004, the Company formed a special purpose trust, Southern Michigan Bancorp Capital Trust I, for the sole purpose of issuing trust preferred securities. Under accounting principles generally accepted in the United States of America, the trust is not consolidated into the financial statements of the Company.

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions for Form 10-Q and Rule 8-03 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments considered necessary in order to make the financial statements not misleading have been included. Operating results for the nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.

The accompanying consolidated financial statements should be read in conjunction with the consolidated financial statements and related footnotes of the Company for December 31, 2010 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, filed with the Securities and Exchange Commission on March 28, 2011.

Loans: Loans are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and an allowance for loan losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt, typically when payments are past due over 90 days, unless the loan is both well secured and in the process of collection. Past due status is based on the contractual terms of the loan. All interest accrued but not received for these loans is reversed against interest income. Payments received on such loans are reported as principal reductions until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest contractually due are brought current and future payments are reasonably assured.

Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. Estimating the risk of loss and the amount of loss on any loan is necessarily subjective. Accordingly, management estimates the allowance balance based on past loan loss experience, nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, information in regulatory examination reports, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired.

Consumer loans are typically charged-off no later than 120 days past due. Real estate mortgage loans in the process of collection are charged-off on or before they become 365 days past due. Commercial loans are charged-off promptly upon the determination that all or a portion of any loan balance is uncollectible. In all cases, loans are placed on nonaccrual status or charged-off at an earlier date if collection of principal or interest is considered doubtful.

Impaired Loans: Loan impairment is reported when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage and consumer loans and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s effective interest rate or at the fair value of collateral if repayment is expected solely from the collateral. Loans are evaluated for impairment when payments are delayed, typically 90 days or more, or when it is probable that all principal and interest amounts will not be collected according to the original terms of the loan. Loans for which the terms have been modified and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and are classified as impaired. All nonaccrual loans have also been determined by the Company to meet the definition of an impaired loan.

Reclassifications

Some items in the prior period consolidated financial statements have been reclassified to conform to the current year presentation.

NOTE B – NEW ACCOUNTING PRONOUNCEMENTS

Adoption of New Accounting Standards: In July 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses which increases disclosures made about the credit quality of loans and the allowance for credit losses. The disclosures provide additional information about the nature of credit risk inherent in the Company’s loans, how credit risk is analyzed and assessed, and the reasons for the change in the allowance for loan losses. The expanded disclosure requirements of ASU 2010-20 were disclosed in the Company’s December 31, 2010 consolidated financial statements. Other required disclosures about activity that occurs during an interim reporting period are effective for periods beginning on or after December 15, 2010, and are disclosed for the period ended September 30, 2011 in Note D.

In December 2010, the FASB issued ASU No. 2010-29 “Business Combinations (Topic 805) - Disclosure of Supplementary Pro Forma Information for Business Combinations.” If a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. ASU 2010-29 also expands the supplementary pro forma disclosures. ASU 2010-29 is effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. ASU 2010-29 will only affect the Company if there are future business combinations.

In December 2010, the FASB issued ASU No. 2010-28 “Intangibles - Goodwill and Other (Topic 350) - When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” ASU 2010-28 affects all entities that have recognized goodwill and have one or more reporting units whose carrying amount for purposes of performing Step 1 of the goodwill impairment test is zero or negative. ASU 2010-28 is effective for fiscal years and interim periods within those years, beginning after December 15, 2010. ASU 2010-28 did not have an impact on the Company’s financial condition, results of operations, or disclosures for the period ended September 30, 2011 because the most recent Step 1 goodwill impairment test was performed as of November 30, 2010 and did not result in a negative carrying amount.

In April 2011, FASB issued ASU No. 2011-02 “Receivables (Topic 310) - A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.” ASU 2011-02 clarifies whether loan modifications constitute troubled debt restructuring. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. ASU 2011-02 was effective July 1, 2011, retrospectively to January 1, 2011, and did not have any impact on the Company’s financial condition or results of operations.

In May 2011, FASB issued ASU No. 2011-04 “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. The amendments in ASU 2011-04 generally represent clarifications of Topic 820, but also include some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. ASU 2011-04 results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRSs. The amendments in ASU 2011-04 are to be applied

prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011 and early application is not permitted. The Company will adopt the methodologies prescribed by ASU 2011-04 by the date required, and does not anticipate the ASU will have a material effect on its financial position or results of operations.

In June 2011, FASB issued ASU No. 2011-05 “Amendments to Topic 220, Comprehensive Income”. Under the amendments in ASU 2011-05, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Either option requires the entity to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments in ASU 2011-05 do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income.

The amendments in ASU 2011-05 should be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted and the amendments do not require any transition disclosures. The Company does not anticipate early adoption of ASU 2011-05.

In September 2011, FASB issued ASU 2011-08, “Intangibles – Goodwill and Other (Topic 350) Testing Goodwill for Impairment”. The amendments in ASU 2011-08 gives the entity the option of first assessing qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after the assessment, the entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. The amendments in ASU 2011-08 are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, however the Company does not anticipate early adoption of ASU 2011-08.

NOTE C – EARNINGS PER SHARE

Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. ESOP shares are considered outstanding for this calculation unless unearned. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends per common share are restated for all stock splits and stock dividends through the date of issue of the financial statements.

A reconciliation of the numerators and denominators of basic and diluted earnings per share for the three and nine month periods ended September 30, 2011 and 2010 is as follows (dollars in thousands, except per share data):


	Three Months Ended September 30, 2011		Three Months Ended September 30, 2010		Nine Months Ended September 30, 2011		Nine Months Ended September 30, 2010
Basic earnings per share:
Net income	$	887	$	870	$	2,397	$	2,375

Weighted average common shares outstanding		2,358,599		2,340,717		2,347,655		2,339,121
Less unallocated ESOP shares		19,692		28,799		21,911		28,604

Weighted average common shares outstanding for basic earnings per share		2,338,907		2,311,918		2,325,744		2,310,517
Basic earnings per share	$	0.38	$	0.38	$	1.03	$	1.03


Diluted earnings per share:
Net income	$	887	$	870	$	2,397	$	2,375

Weighted average common shares outstanding for basic earnings per share		2,338,907		2,311,918		2,325,744		2,310,517
Add: Dilutive effect of assumed exercise of stock options		4,427		3,986		4,519		3,312

Weighted average common and dilutive potential common shares outstanding		2,343,334		2,315,904		2,330,263		2,313,829

Diluted earnings per share	$	0.38	$	0.38	$	1.03	$	1.03

Stock option awards that were anti-dilutive, and therefore not included in the computation of diluted earnings per share, were as follows: 199,961 and 197,702 as of September 30, 2011 and 2010, respectively.

NOTE D – ALLOWANCE FOR LOAN LOSSES

In evaluating the allowance for loan losses, loans are analyzed based on the department originating the loan (commercial, mortgage or consumer), which in some instances may be different than how the loans are categorized for regulatory reporting purposes. Required disclosures about activity in the allowance for loan losses for reporting periods subsequent to December 15, 2010 are provided below for the nine months ended September 30, 2011.

The following is an analysis of the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of and for the nine month period ended September 30, 2011 and as of December 31, 2010 (in thousands):


	2011
September 30, 2011	Commercial including CRE			*Consumer*			Real Estate Mortgage *1^st Lien*			*Real* Estate Mortgage Junior Lien			*Total*			*2010*
*Allowance for Loan Losses:*
Balance at January 1	$	4,239		$	87		$	1,211		$	157		$	5,694		$	6,075
Provision for loan losses		379			29			368			99			875			775
Loans charged off		(699	)		(58	)		(457	)		(105	)		(1,319	)		(1,261	)
Recoveries		118			17			9			4			148			139

Balance at September 30	$	4,037		$	75		$	1,131		$	155		$	5,398		$	5,728

Ending balance individually evaluated for impairment	$	749			—		$	190			—		$	939

Ending balance collectively evaluated for impairment	$	3,288		$	75		$	941		$	155		$	4,459

Total Loans:
Ending balance	$	224,665		$	8,158		$	67,488		$	13,315		$	313,626

Ending balance individually evaluated for impairment	$	6,964		$	39		$	3,107		$	56		$	10,166

Ending balance collectively evaluated for impairment	$	217,701		$	8,119		$	64,381		$	13,259		$	303,460

Commercial loans also include demand deposit loan account charge-offs and recoveries amounting to $130,000 and $55,000, respectively, for the nine months ended September 30, 2011.


December 31, 2010	Commercial including CRE		Consumer		Real Estate Mortgage 1^st Lien		Real Estate Mortgage Junior Lien		Total
Allowance for Loan Losses:
Ending balance individually evaluated for impairment	$	867		—	$	300	$	4	$	1,171
Ending balance collectively evaluated for impairment	$	3,372	$	87	$	911	$	153	$	4,523

Total	$	4,239	$	87	$	1,211	$	157	$	5,694

Total Loans:
Ending balance	$	216,401	$	9,849	$	69,437	$	13,837	$	309,524

Ending balance individually evaluated for impairment	$	7,676	$	87	$	2,881	$	122	$	10,766

Ending balance collectively evaluated for impairment	$	208,725	$	9,762	$	66,556	$	13,715	$	298,758

The following tables present loans individually evaluated for impairment by class of loans as of September 30, 2011 and December 31, 2010 (in thousands):


September 30, 2011	Unpaid Principal Balance		Allowance for Loan Losses Allocated
With no related allowance recorded:
Commercial	$	614	$	—
Real estate - commercial		3,003		—
Real estate - construction		300		—
Consumer		39		—
Real estate mortgage		2,525		—
With an allowance recorded:
Commercial		368		70
Real estate - commercial		1,285		434
Real estate - construction		77		2
Consumer		—		—
Real estate mortgage		1,955		433

Total	$	10,166	$	939


December 31, 2010	Unpaid Principal Balance		Allowance for Loan Losses Allocated
With no related allowance recorded:
Commercial	$	608	$	—
Real estate - commercial		2,685		—
Real estate - construction		—		—
Consumer		87		—
Real estate mortgage		2,495		—
With an allowance recorded:
Commercial		588		99
Real estate - commercial		1,823		413
Real estate - construction		583		173
Consumer		—		—
Real estate mortgage		1,897		486

Total	$	10,766	$	1,171

The following table presents the aging of the recorded investment in past due and nonaccrual loans as of September 30, 2011 and December 31, 2010 by class of loans (in thousands):


September 30, 2011	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due & Non Accrual		Total Past Due & Non Accrual		Loans Not Past Due or Non Accrual		Total
Commercial	$	191	$	—	$	447	$	638	$	57,732	$	58,370
Real estate - commercial		43		—		3,217		3,260		140,536		143,796
Real estate - construction		—		—		377		377		12,742		13,119
Consumer		34		58		45		137		8,345		8,482
Real estate mortgage		552		1		2,144		2,697		87,162		89,859

Total	$	820	$	59	$	6,230	$	7,109	$	306,517	$	313,626


December 31, 2010	30-59 Days Past Due		60-89 Days Past Due		Greater than 90 Days Past Due & Non Accrual		Total Past Due & Non Accrual		Loans Not Past Due or Non Accrual		Total
Commercial	$	277	$	20	$	217	$	514	$	58,249	$	58,763
Real estate - commercial		184		—		2,295		2,479		133,892		136,371
Real estate - construction		—		—		583		583		10,552		11,135
Consumer		62		—		87		149		10,004		10,153
Real estate mortgage		737		28		2,112		2,877		90,225		93,102

Total	$	1,260	$	48	$	5,294	$	6,602	$	302,922	$	309,524

Modifications:

The Company’s loan portfolio also includes certain loans that have been modified in a Troubled Debt Restructuring (TDR), where economic concessions have been granted to borrowers who have experienced or are expected to experience financial difficulties. These concessions typically result from the Company’s loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance or other actions. Certain TDRs are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months.

When the Company modifies a loan, management evaluates any possible concession based on the present value of expected future cash flows, discounted at the contractual interest rate of the original loan agreement, except when the sole source of repayment for the loan is the liquidation of the collateral. In these cases, management uses the current fair value of the collateral, less selling costs. If management determines that the value of the modified loan is less than the recorded investment in the loan (net of previous charge-offs and deferred loan fees or costs), impairment is recognized through an allowance estimate or a charge-off to the allowance.

The following table summarizes the number and volume of TDRs the Company has recorded in its loan portfolio as of September 30, 2011 as well as the amount of specific reserves in the allowance for loan losses relating to the TDRs (in thousands):


September 30, 2011	Number of Loans		Amount		Specific Reserves Allocated
Commercial		2	$	751	$	50
Real estate - commercial		5		1,752		34
Real estate - construction		1		157		—
Real estate - mortgage		18		1,545		122
Consumer		—		—		—

Total		26	$	4,205	$	206

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt, such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes all loans from the commercial loan department. This analysis is performed at least annually. The Company uses the following definitions for risk ratings:

Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date.

Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.

As of September 30, 2011 and December 31, 2010, based on the most recent analysis performed, the risk category of loans by class of loans was as follows (in thousands):


September 30, 2011	Pass		Special Mention		Substandard		Doubtful		Not Risk Rated		Total
Commercial	$	46,118	$	7,374	$	4,878	$	—	$	—	$	58,370
Real estate - commercial		121,311		14,496		7,412		—		577		143,796
Real estate - construction		7,195		1,043		682		—		4,199		13,119
Real estate - mortgage		9,070		1,144		3,121		—		76,524		89,859
Consumer		—		—		—		—		8,482		8,482

Total	$	183,694	$	24,057	$	16,093	$	—	$	89,782	$	313,626


December 31, 2010	Pass		Special Mention		Substandard		Doubtful		Not Risk Rated		Total
Commercial	$	44,819	$	12,821	$	1,123	$	—	$	—	$	58,763
Real estate - commercial		110,384		19,054		6,311		370		252		136,371
Real estate - construction		2,371		1,047		4,630		—		3,087		11,135
Real estate - mortgage		7,096		2,892		2,700		—		80,414		93,102
Consumer		—		—		—		—		10,153		10,153

Total	$	164,670	$	35,814	$	14,764	$	370	$	93,906	$	309,524

NOTE E – STOCK OPTIONS

Shareholders of the Company approved a stock option plan in April 2000 and a stock incentive plan in June 2005. The plans authorized the Company to issue up to 115,500 and 157,500 shares, respectively. In May 2008, shareholders of the Company ratified amendments to the Stock Incentive Plan of 2005, which among other things increased the authorized shares for issuance from 157,500 to 300,000. On March 20, 2010, the April 2000 stock option plan terminated. As of September 30, 2011, there were 99,007 shares available for future issuance under the 2005 plan.

A summary of stock option activity is as follows for the nine months ended September 30, 2011:


	Shares		Weighted Average Price
Outstanding at beginning of year		218,977	$	21.29
Granted		8,075		12.70
Exercised		—		—
Forfeited		6,026		18.23

Outstanding at September 30, 2011		221,026	$	21.06

Options exercisable at September 30, 2011		141,276	$	20.85

The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model that uses the weighted average assumptions noted in the following table. The expected volatility and life assumptions are based on historical experience. The interest rate is based on the U.S. Treasury yield curve and the dividend assumption is based on the Company’s history and expected dividend payouts. Following are the assumptions used in calculating the fair value of the options issued during the nine months ended September 30, 2011:


Dividend yield		2.99	%
Expected life		8 years
Expected volatility		23.40	%
Risk-free interest rate		0.33	%
Weighted average fair value of options granted during 2011	$	1.86

The Company recorded compensation expense of $46,000 and $57,000, respectively, related to stock options during the nine month periods ended September 30, 2011 and 2010.

Restricted Stock – Shares of restricted stock may also be granted under the Stock Incentive Plan of 2005. Compensation expense is recognized over the vesting period of the shares based on the market value of the shares on the grant date. All shares of restricted stock issued and outstanding vest 20% per year over five years. Compensation expense related to the award of shares of restricted stock was $72,000 and $58,000, respectively, during the nine months ended September 30, 2011 and 2010. As of September 30, 2011, there was $408,000 of total unrecognized compensation expense related to non-vested shares of restricted stock granted under the plan, which is expected to be recognized over a weighted average period of 3.7 years.

A summary of restricted stock activity is as follows for the nine months ended September 30, 2011:


	Shares			Weighted Average Grant Date Fair Value
Nonvested at January 1, 2011		30,593		$	10.46
Granted		18,525			12.70
Vested		(7,166	)		11.24
Forfeited		(643	)		10.17

Nonvested at September 30, 2011		41,309		$	11.33

NOTE F – FAIR VALUE INFORMATION

The following methods and assumptions were used by the Company in estimating fair values for financial instruments:

Cash and cash equivalents and federal funds sold: The carrying amount reported in the balance sheet approximates fair value.

Securities available for sale: Fair values for securities available for sale are based on quoted market prices, where available. For all other securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the securities’ terms and conditions, among other things.

Loans and loans held for sale, net: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans are estimated using discounted cash flows analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The allowance for loan losses is considered to be a reasonable estimate of discount for credit quality concerns.

Accrued interest receivable: The carrying amount reported in the balance sheet approximates fair value.

Off-balance-sheet financial instruments: The estimated fair value of off-balance-sheet financial instruments is based on current fees or costs that would be charged to enter or terminate the arrangements. The estimated fair value is not considered to be significant for this presentation.

Deposits: The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of expected monthly maturities on time deposits.

Securities sold under agreements to repurchase and overnight borrowings: The carrying amount reported in the balance sheet approximates fair value.

Other borrowings: The fair value of other borrowings is estimated using discounted cash flows analysis based on the current incremental borrowing rate for similar types of borrowing arrangements.

Subordinated debentures: The carrying amount reported in the balance sheet approximates fair value of the variable-rate subordinated debentures.

Accrued interest payable: The carrying amount reported in the balance sheet approximates fair value.

While these estimates of fair value are based on management’s judgment of appropriate factors, there is no assurance that if the Company had disposed of such items at September 30, 2011 or December 31, 2010, the estimated fair values would have been realized. Market values may differ depending on various circumstances not taken into consideration in this methodology. The estimated fair values at September 30, 2011 and December 31, 2010, should not be considered to apply at subsequent dates.

In addition, other assets and liabilities that are not defined as financial instruments are not included in the following disclosures, such as property and equipment. Also, non-financial instruments typically not recognized in financial statements may have value but are not included in the following disclosures. These include, among other items, the estimated earnings power of core deposit accounts, trained work force, customer goodwill and similar items.

The estimated fair values of the Company’s financial instruments are as follows (in thousands):


	September 30, 2011						December 31, 2010
	Carrying Amount			Fair Value			Carrying Amount			Fair Value
Financial assets:
Cash and cash equivalents	$	72,224		$	72,224		$	78,833		$	78,833
Federal funds sold		265			265			275			275
Securities available for sale		85,890			85,890			59,228			59,228
Loans held for sale		930			930			2,637			2,637
Loans, net of allowance for loan losses		308,228			312,527			303,830			307,946
Accrued interest receivable		2,416			2,416			2,107			2,107
Financial liabilities:
Deposits	$	(429,261	)	$	(431,560	)	$	(409,901	)	$	(406,143	)
Securities sold under agreements to repurchase and overnight borrowings		(16,166	)		(16,166	)		(15,027	)		(15,027	)
Other borrowings		(8,495	)		(8,635	)		(10,079	)		(9,835	)
Subordinated debentures		(5,155	)		(5,155	)		(5,155	)		(5,155	)
Accrued interest payable		(129	)		(129	)		(171	)		(171	)

The preceding table does not include net cash surrender value of life insurance and dividends payable, which are also considered financial instruments. The estimated fair value of such items is considered to be their carrying amount.

The Company also has unrecognized financial instruments, which include commitments to extend credit and standby letters of credit. The estimated fair value of such instruments is considered to be their contract amount.

NOTE G – FAIR VALUE MEASUREMENTS

The Fair Value Measurements Topic of ASC 820-10 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. ASC 820-10-20 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability is not adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact, and (iv) willing to transact.

ASC 820-10 requires the use of valuation techniques that are consistent with the market approach, the income approach, or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. In that regard, ASC Topic 820-10-55 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

Level 1 Inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 Inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.), or inputs that are derived principally from or corroborated by market data by correlation or other means.

Level 3 Inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, follows. These valuation methodologies were applied to all of the Company’s financial and nonfinancial assets and liabilities carried at fair value.

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

Securities Available for Sale. Securities classified as available for sale are reported at fair value utilizing Level 1, Level 2 and Level 3 inputs. Unadjusted quoted prices in active markets for identical assets are utilized to determine fair value at the measurement date for Level 1 securities. For all other securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the bond’s terms and conditions, among other things. When there are unobservable inputs, such securities are classified as Level 3.

Securities available for sale classified as Level 3 inputs represent non-publicly traded municipal issues with limited trading activity from entities within the Company’s market area. The fair value of these investments is determined using Level 3 valuation techniques, as there is no market available to price these investments. The method used for determining the fair value for these investments includes a comparison to the fair value of other investment securities valued with Level 2 inputs with similar characteristics (credit, time to maturity, call structure, etc.) and the interest yield curve for comparable debt investments.

Impaired Loans. The Company does not record impaired loans at fair value on a recurring basis. However, periodically, a loan is considered impaired and is reported at the fair value of the underlying collateral, less estimated costs to sell, if repayment is expected solely from the collateral. Impaired loans measured at fair value typically consist of loans on nonaccrual status and loans with a portion of the allowance for loan losses allocated specific to the loan. Some loans may be included in both categories whereas other loans may only be included in one category. Collateral values are estimated using level 2 inputs, including recent appraisals, and Level 3 inputs based on customized discounting criteria. Due to the significance of the level 3 inputs, impaired loans have been classified as level 3.

Other Real Estate Owned (OREO). The Company values OREO at the fair value of the underlying collateral less expected selling costs. Collateral values are estimated primarily using appraisals and reflect a market value approach.

The following table summarizes financial and nonfinancial assets (there were no financial or nonfinancial liabilities) measured at fair value as of September 30, 2011 and December 31, 2010, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value (in thousands):


September 30, 2011	Level 1 Inputs		Level 2 Inputs		Level 3 Inputs		Total Fair Value
Available for Sale Securities:
U.S. Treasury and Federal agencies	$	34,574	$	—	$	—	$	34,574
U.S. Government sponsored entities		16,486		—		—		16,486
State and political subdivisions		—		31,604		2,705		34,309
Mortgage backed securities		—		521		—		521

Total available-for-sale securities	$	51,060	$	32,125	$	2,705	$	85,890
Nonrecurring:
Impaired loans	$	—	$	—	$	9,227	$	9,227
Other real estate owned	$	—	$	—	$	1,233	$	1,233

Impaired loans are reported net of a $939,000 allowance for loan losses.


December 31, 2010	Level 1 Inputs		Level 2 Inputs		Level 3 Inputs		Total Fair Value
Available for Sale Securities:
U.S. Treasury and Federal agencies	$	24,106	$	—	$	—	$	24,106
U.S. Government sponsored entities		6,678		—		—		6,678
State and political subdivisions		—		22,378		2,992		25,370
Asset-backed securities		2,476		—		—		2,476
Mortgage backed securities		—		598		—		598

Total available-for-sale securities	$	33,260	$	22,976	$	2,992	$	59,228
Nonrecurring:
Impaired loans	$	—	$	—	$	9,595	$	9,595
Other real estate owned	$	—	$	—	$	1,247	$	1,247

Impaired loans are reported net of a $1,171,000 allowance for loan losses.

The following is a reconciliation of the beginning and ending balances of securities available for sale which are measured at fair value on a recurring basis using significant unobservable (Level 3) inputs during the nine month period ended September 30, 2011 (in thousands):


Balance at January 1, 2011	$	2,992
Net maturities and calls		(802	)
Transfers into Level 3		—
Purchases		352
Unrealized net gains included in other comprehensive income		163

Balance at September 30, 2011	$	2,705

NOTE H – SUBSEQUENT EVENTS

Management evaluated subsequent events through the date the financial statements were issued. Events or transactions occurring after September 30, 2011, but prior to when the financial statements were issued, that provided additional evidence about conditions that existed at September 30, 2011, have been recognized in the financial statements for the nine month period ended September 30, 2011. Events or transactions that provided evidence about conditions that did not exist at September 30, 2011, but arose before the financial statements were issued, have not been recognized in the financial statements for the nine month period ended September 30, 2011.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion provides information about the consolidated financial condition and results of operations of the Company and its subsidiary, Southern Michigan Bank & Trust (SMB&T) for the three and nine month periods ended September 30, 2011 and 2010.

Executive Summary

Net income for the three and nine month periods ended September 30, 2011 was $887,000 and $2,397,000 respectively, compared to $870,000 and $2,375,000, respectively, for the same periods in 2010. Earnings per share were $0.38 and $1.03, respectively, for the three and nine month periods ended June 30, 2011 and 2010. Return on average assets was 0.64% for the first nine months of 2011 compared to 0.67% for the first nine months of 2010. Return on average shareholders’ equity was 6.46% for the first nine months of 2011 compared to 6.76% for the same period in 2010.

Total consolidated assets at September 30, 2011 were $515.4 million compared to $493.9 million at December 31, 2010. Total deposits at September 30, 2011 were $429.3 million compared to $409.9 million at December 31, 2010. Total shareholders’ equity was $51.0 million at September 30, 2011 compared to $47.8 million at December 31, 2010.

Results of Operations

Net Interest Income

The Company derives the greatest portion of its income from net interest income. Net interest margin for the nine month period ended September 30, 2011 was 3.63% compared to 4.02% for the same period of 2010, a decrease of 39 basis points. Average loan balances for the first nine months of 2011 decreased $16.6 million compared to the same period of 2010, while the average balance in the lower yielding categories federal funds sold and other and taxable securities increased $15.3 million and $24.2 million, respectively. This overall increase in lower yielding assets resulted in a 60 basis point reduction in total interest earning asset yield. This reduction was partially offset as the Company was able to lower its cost of funds by 23 basis points during the nine month period ended September 30, 2011 compared to the same period of 2010.

The following tables provide information regarding interest income and expense for the nine-month periods ended September 30, 2011 and 2010, respectively. Table 1 shows the year-to-date daily average balances for interest earning assets and interest bearing liabilities, interest earned or paid, and the annualized effective rate. Table 2 shows the effect on interest income and expense of changes in volume and interest rates on a tax equivalent basis.

Table 1 – Average Balances and Tax Equivalent Interest Rates

(Dollars in Thousands):


	September 30, 2011								September 30, 2010
	Average Balance			Interest		Yield/ Rate			Average Balance			Interest		Yield/ Rate
ASSETS
Interest earning assets:
Loans(1)(2)(3)	$	308,566		$	13,370		5.78	%	$	325,105		$	14,487		5.94	%
Federal funds sold and other(6)		54,401			129		.32			39,090			99		.34
Taxable securities(4)		55,708			473		1.13			31,523			474		2.00
Tax-exempt securities(1)		25,869			1,016		5.24			20,925			878		5.59

Total interest earning assets		444,544			14,988		4.50			416,643			15,938		5.10
Non-interest earning assets:
Cash and due from banks		11,271								11,257
Other assets(5)		48,199								49,877
Less allowance for loan losses		(5,464	)							(5,813	)

Total assets	$	498,550							$	471,964

Interest bearing liabilities:
Demand deposits	$	169,122			373		.29	%	$	145,878			386		.35	%
Savings deposits		50,652			34		.09			47,756			58		.16
Time deposits		130,316			2,011		2.06			135,417			2,419		2.38
Securities sold under agreements to repurchase and federal funds purchased		15,331			37		.32			16,051			35		.29
Other borrowings		9,092			302		4.43			12,770			362		3.78
Subordinated debentures		5,155			114		2.95			5,155			118		3.05

Total interest bearing liabilities		379,668			2,871		1.01			363,027			3,378		1.24
Non-interest bearing liabilities:
Demand deposits		64,251								56,968
Other		3,793								4,006
Common stock subject to repurchase obligation		1,371								1,089
Shareholders’ equity		49,467								46,874

Total liabilities and shareholders’ equity	$	498,550							$	471,964

Net interest income				$	12,117							$	12,560

Interest rate spread							3.49	%							3.86	%

Net yield on interest earning assets							3.63	%							4.02	%

(1)	Includes tax equivalent adjustment of interest (assuming a 34% tax rate) for securities and loans of $345,000 and $11,000, respectively, for 2011 and $298,000 and $60,000, respectively, for 2010.

(2)	Average balance includes average non-accrual loan balances of $6,092,000 in 2011 and $7,473,000 in 2010.

(3)	Interest income includes loan fees of $385,000 in 2011 and $360,000 in 2010.

(4)	Average balance includes average unrealized gain of $569,000 in 2011 and $626,000 in 2010 on available for sale securities.

(5)	Includes $15,310,000 in 2011 and $15,656,000 in 2010 relating to goodwill and other intangible assets.

(6)	Includes $51,666,000 in 2011 and $34,271,000 in 2010 of federal reserve deposit accounts.

Table 2 – Changes in Tax-Equivalent Net Interest Income

(Dollars in Thousands)


	Nine Months Ended September 30 2011 Over 2010 Increase (Decrease) Due To									Nine Months Ended September 30 2010 Over 2009 Increase (Decrease) Due To
	Rate			Volume			Net			Rate			Volume			Net
Interest income on:
Loans	$	(393	)	$	(724	)	$	(1,117	)	$	(75	)	$	(405	)	$	(480	)
Taxable securities		(264	)		263			(1	)		(273	)		(148	)		(421	)
Tax-exempt securities		(59	)		197			138			(70	)		(99	)		(169	)
Federal funds sold		(7	)		37			30			2			55			57

Total interest earning assets	$	(723	)	$	(227	)	$	(950	)	$	(416	)	$	(597	)	$	(1,013	)

Interest expense on:
Demand deposits	$	(69	)	$	56		$	(13	)	$	(115	)	$	23		$	(92	)
Savings deposits		(27	)		3			(24	)		(20	)		(8	)		(28	)
Time deposits		(320	)		(88	)		(408	)		(582	)		4			(578	)
Securities sold under agreements to repurchase and federal funds purchased		4			(2	)		2			1			3			4
Other borrowings		55			(115	)		(60	)		(14	)		22			8
Subordinated debentures		(4	)		—			(4	)		(41	)		—			(41	)

Total interest bearing liabilities	$	(361	)	$	(146	)	$	(507	)	$	(771	)	$	44		$	(727	)

Net interest income	$	(362	)	$	(81	)	$	(443	)	$	355		$	(641	)	$	(286	)

Tax equivalent net interest income decreased $443,000, or 3.5%, in the first nine months of 2011 compared to the same period in 2010. This was a result of an $81,000 net decrease due to volume changes comparing the first nine months of 2011 with the first nine months of 2010 on a tax equivalent basis and a $362,000 net decrease due to rate changes for the same comparable period.

The presentation of net interest income on a tax equivalent basis is not in accordance with generally accepted accounting principles (“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 net interest income on a tax equivalent basis were $356,000 and $358,000, respectively, for the nine months ended September 30, 2011 and 2010. These adjustments were computed using a 34% federal income tax rate.

Provision for Loan Losses

The provision for loan losses is based on an analysis of additions to the allowance for loan losses believed to be appropriate. The provision is charged to income to bring the allowance for loan losses to a level believed adequate by management to absorb probable incurred losses in the loan portfolio. Some factors considered by management in determining the level at which the allowance is maintained include specific credit reviews, historical loan loss experience, current economic conditions and trends, results of examinations by regulatory agencies and the volume, growth and composition of the loan portfolio. The provision is adjusted quarterly, if necessary, to reflect changes in the factors above, and actual charge-off experience and any known losses.

The provision for loan losses for the three and nine month periods ended September 30, 2011 was $375,000 and $875,000, respectively, compared to a provision for loan losses in the three and nine month periods ended September 30, 2010 of $425,000 and $775,000, respectively.

The allowance for loan losses was 1.72% of total loans at September 30, 2011 compared to 1.84% at December 31, 2010 and 1.79% at September 30, 2010.

Charge-offs and recoveries for respective loan categories for the nine months ended September 30, 2011 and 2010 were as follows:

(Dollars in Thousands)


	September 30, 2011				September 30, 2010
	Charge-offs		Recoveries		Charge-offs		Recoveries
Commercial	$	570	$	63	$	361	$	29
Residential real estate		562		13		687		28
Consumer		187		72		213		82

Total	$	1,319	$	148	$	1,261	$	139

Net charge-offs in the first nine months of 2011 were $1,171,000, or 0.50%, of loans on an annualized basis. Net charge-offs in the first nine months of 2010 were $1,122,000, or 0.47%, of loans on an annualized basis.

Non-interest income

Non-interest income for the three month periods ended September 30, 2011 and 2010 was $1,721,000 and $1,838,000, respectively. Non-interest income for the nine month periods ended September 30, 2011 and 2010 was $5,030,000 and $5,176,000, respectively.

Service charges on deposit accounts decreased 25.0%, or $163,000, in the third quarter of 2011 compared to the third quarter of 2010. Service charges on deposit accounts decreased 14.5%, or $266,000, in the first nine months of 2011 compared to the same period in 2010. The Company made changes to its overdraft protection program in July of 2010 and in June of 2011 to comply with regulatory guidance that became effective in August of 2010 and July of 2011, respectively. These changes resulted in a lower volume of non-sufficient fund items which reduced income.

Trust fees increased 16.4%, or $40,000, in the third quarter of 2011 compared to the third quarter of 2010. Trust fees increased $112,000, or 15.1%, in the first nine months of 2011 compared to the same period in 2010. Changes to the trust department fee structure and new account relationships are the primary causes for the increase.

Net gains on loan sales decreased 23.3%, or $94,000, in the third quarter of 2011 compared to the third quarter of 2010. Net gains on loan sales increased 21.5%, or $147,000, in the first nine months of 2011 compared to the same period in 2010. Fixed rate long term residential mortgages are generally sold in the secondary market, while adjustable rate mortgages are retained in the loan portfolio. An increase in mortgage lending staff during the second half of 2010 resulted in higher production volumes during the third quarter of 2010 and the first half of 2011, as compared to the third quarter of 2011 and first half of 2010.

Income from loan servicing increased 24.1%, or $19,000, in the third quarter of 2011 compared to the third quarter of 2010. Income from loan servicing increased 33.5%, or $81,000, in the first nine months of 2011 compared to the same period in 2010. Increased balances in loans sold in the secondary market in 2010 and the first nine months of 2011 resulted in higher loan servicing income.

ATM and debit card fee income increased 11.9%, or $28,000, in the third quarter of 2011 compared to the third quarter of 2010 and increased 14.4%, or $95,000, in the first nine months of 2011 compared to the same period of 2010. Increases are primarily due to increased volumes of approved transactions.

During the first quarter of 2010, the Company recorded a $156,000 gain from life insurance proceeds. During the second quarter of 2010, the Company recorded income on security calls and sales of $207,000.

Non-interest expense

Non-interest expense for the three month period ended September 30, 2011 was $4,238,000 compared to $4,428,000 for the same period in 2010, a decrease of 4.3% or $190,000. Non-interest expense for the nine month period ended September 30, 2011 was $12,882,000 compared to $13,675,000 for the same period of 2010, a decrease of $793,000, or 5.8%. Various cost saving initiatives were implemented during 2010 and continued into 2011 which have started to positively impact results.

Salaries & employee benefits decreased in both the three and nine month periods ending September 30, 2011 as a result of branch closures and other staff reductions.

Occupancy costs decreased $94,000, or 29.0% and $129,000 or 12.1%, respectively in the third quarter and first nine month of 2011 as compared to 2010. Between December 2010 and April 2011 the Bank closed three branches reducing occupancy costs.

FDIC assessment expense decreased $56,000 and $97,000, respectively, for the three and nine month periods ending September 30, 2011 due to the formula change used to calculate the FDIC assessments. The new formula was effective April 1, 2011.

Expenses relating to OREO property increased $40,000 and decreased $181,000, respectively in the third quarter and first nine months of 2011 as compared to the same periods of 2010. Year to date property expenses are down as the Company had fewer OREO properties throughout the year than during the same period of 2010.

Federal income taxes

The Company had an income tax provision of $637,000 for the nine months ended September 30, 2011 compared to $553,000 for the comparable period of 2010. The $156,000 gain on life insurance proceeds was a non-taxable event which, along with tax-exempt income from securities and loans, reduced the effective tax rate for the nine month period ended September 30, 2010 to 18.9%. The effective tax rate for the nine month period ended September 30, 2011 was 21.0%. Tax-exempt income continues to have a major impact on the Company’s tax provision and effective tax rate. The benefit offsetting lower coupon rates on municipal instruments is the nontaxable feature of the income earned on such investments. This resulted in a lower effective tax rate and reduced the federal income tax provision.

Financial Condition

Assets

Total assets at September 30, 2011 were $515.4 million, an increase of $21.5 million compared to December 31, 2010. Securities available-for-sale totaled $85.9 million at September 30, 2011, an increase of $26.7 million compared to December 31, 2010. Gross loans totaled $313.6 million at September 30, 2011, an increase of $4.1 million, or 1.3%, compared to December 31, 2010.

Nonperforming assets

Nonperforming assets include non-accrual loans, loans modified under troubled debt restructurings, accruing loans past due 90 days or more, and other real estate owned, which includes real estate acquired through foreclosure and in lieu of foreclosure.

A loan generally is classified as nonaccrual when full collectability of principal or interest is doubtful or a loan becomes 90 days past due as to principal or interest, unless management determines that the estimated net realizable value of the collateral is sufficient to cover the principal balance and accrued interest. When interest accruals are discontinued, unpaid interest is reversed. Nonperforming loans are returned to performing status when the loan is brought current and has performed in accordance with contract terms for a period of time.

In the course of working with borrowers, the Company may choose to restructure the contractual terms of certain loans. The Company attempts to work-out an alternative payment schedule with the borrower in order to optimize collectability of the loan. Any loans that are modified are reviewed by the Company to identify if a troubled debt restructuring (“TDR”) has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Company grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and the restructuring of the loan may include the transfer of assets from the borrower to satisfy the debt, a modification of loan terms, or a combination of the two.

The following table sets forth the aggregate amount of nonperforming assets in each of the following categories:

(Dollars in thousands)


	9/30/11			12/31/10			9/30/10
Nonaccrual loans:
Commercial and commercial real estate	$	4,317		$	3,755		$	4,470
Real estate mortgage		1,847			1,451			2,277
Consumer		39			87			83

		6,203			5,293			6,830

Loans contractually past due 90 days or more and still on accrual:
Commercial and commercial real estate		27			1			39
Real estate mortgage		—			—			—
Consumer		—			—			—

		27			1			39

Accruing loans modified under troubled debt restructurings:
Commercial and commercial real estate		1,946			1,745			815
Real estate mortgage		1,317			1,552			839
Consumer		—			—			—

		3,263			3,297			1,654

Total nonperforming loans		9,493			8,591			8,523
Other real estate		1,233			1,247			1,042

Total nonperforming assets	$	10,726		$	9,838		$	9,565

Nonperforming loans to total loans		3.03	%		2.78	%		2.66	%

Nonperforming assets to total assets		2.08	%		1.99	%		1.97	%

The balance of nonaccrual restructured loans, which is included in nonaccrual loans, was $942,000 at September 30, 2011, $1,375,000 at December 31, 2010 and $2,273,000 at September 30, 2010.

Nonperforming loans are subject to continuous monitoring by management and estimated losses are specifically allocated for in the allowance for loan losses where appropriate. At September 30, 2011, December 31, 2010 and September 30, 2010, the Company had loans of $9.9 million, $10.8 million and $10.7 million, respectively, which were considered impaired.

In management’s evaluation of the loan portfolio risks, any significant future increases in nonperforming loans is dependent to a large extent on the economic environment. In a deteriorating or uncertain economy, management applies more conservative assumptions when assessing the future prospects of borrowers and when estimating collateral values.

Liabilities

Deposits totaled $429.3 million at September 30, 2011, an increase of $19.4 million, or 4.7%, from December 31, 2010. The majority of deposits are derived from core client sources, relating to long term relationships with local individuals, businesses and public clients. A small amount of brokered deposits are maintained, but are not used to support growth.

The Company closed three branches during late 2010 and early 2011. Two of the locations are supported by other branch facilities in near proximity. One location, Cassopolis, was located outside of the Company’s primary market area. Deposit reductions from this location since December 31, 2010 totaled $5.9 million. In addition, the Company made the strategic decision based on current liquidity levels to reduce certificate of deposit rates and specials. As a result, certificate balances from non-core customers have declined in the first nine months of 2011.

Offsetting these decreases were third quarter increases due to retail deposit account balance increases as well as cyclical increases in balances for municipalities collecting property taxes and school systems receiving funds from the state. These cyclical balance increases are expected to return to more normal levels as the money is distributed and expended.

Shareholders’ equity

Total shareholders’ equity amounted to $51.0 million at September 30, 2011, an increase of $3.1 million from December 31, 2010. The increase was primarily attributable to the net income for the period, less dividends to shareholders, and an increase in accumulated other comprehensive income due to the increase in the fair value of securities held for sale.

The following table summarizes the Company’s regulatory capital ratios as of September 30, 2011 and December 31, 2010:


	September 30, 2011			December 31, 2010			Minimum Required for Capital Adequacy Purposes
Total risk-based capital ratio		14.1	%		13.7	%		8.0	%
Tier I capital ratio		12.8	%		12.4	%		4.0	%
Leverage ratio		8.7	%		8.2	%		4.0	%

Liquidity

Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. SMB&T maintains certain levels of liquid assets (the most liquid of which are cash and cash equivalents, federal funds sold and investment securities) in order to meet these demands. Maturing loans and investment securities are the principal sources of asset liquidity. Liquidity is monitored and closely managed by the Asset/Liability Management Committee (ALCO), whose members are comprised of senior management.

SMB&T maintains correspondent accounts with other banks for various purposes. At times, SMB&T is a participant in the federal funds market, either as a borrower or a seller. SMB&T has a $3 million federal funds line available from a correspondent bank. In addition, SMB&T has the ability to borrow $37.7 million from the Federal Home Loan Bank based on collateral pledged, and also has the ability to borrow at the discount window of the Federal Reserve Bank as an additional short term funding source.

The Company’s balances in federal funds sold and short term interest bearing balances with banks were $61.2 million at September 30, 2011, compared to $68.4 million at December 31, 2010 and $52.5 million at September 30, 2010. The Company continues to maintain high levels of liquidity, with investments, federal funds and cash equivalents held to improve the liquidity of the balance sheet during this period of economic uncertainty. The Company expects to maintain higher than normal levels of liquidity until economic conditions improve and more attractive investment opportunities emerge.

The Company’s principal source of funds to pay cash dividends is the earnings and dividends paid by SMB&T. The payment of dividends by SMB&T is subject to legal and regulatory restrictions. At September 30, 2011, using the most restrictive of these restrictions, the aggregate cash dividends that SMB&T could pay the Company without prior regulatory approval was approximately $6 million.

Impact of Inflation and Changing Prices

The majority of assets and liabilities of a financial institution are monetary in nature and therefore differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an important impact on the growth of total assets in the banking industry and the resulting need to increase equity capital at higher than normal rates in order to maintain an appropriate equity-to-assets ratio. Another significant effect of inflation is on other expenses, which tend to rise during periods of general inflation.

Item 4.

Controls and Procedures

An evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 15d – 15(e) under the Exchange Act) as of September 30, 2011. Based on and as of the time of that evaluation, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that as of the end of the period covered by this report the Company’s disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms and is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

There was no change in the Company’s internal control over financial reporting that occurred during the three months ended September 30, 2011 that has materially affected, or that is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II. Other Information

Item 6.

Exhibits

Exhibits. The following exhibits are filed as part of this report on Form 10-Q:


Exhibit Number		Document

3.1		Articles of Incorporation of Southern Michigan Bancorp, Inc., as amended. Previously filed with the Commission on July 13, 2007 in Southern Michigan Bancorp Inc.’s Form S-4 Registration Statement, Exhibit 3.1. Here incorporated by reference.

3.2		Amended and Restated Bylaws of Southern Michigan Bancorp, Inc., as amended. Previously filed with the Commission on July 13, 2007 in Southern Michigan Bancorp Inc.’s Form S-4 Registration Statement, Exhibit 3.2. Here incorporated by reference.

4.1		Articles of Incorporation of Southern Michigan Bancorp, Inc., as amended. Exhibit 3.1 is here incorporated by reference.

4.2		Amended and Restated Bylaws of Southern Michigan Bancorp, Inc., as amended. Exhibit 3.2 is here incorporated by reference.

4.3		Long-Term Debt. The registrant has outstanding long-term debt which at the time of this report does not exceed 10% of the registrant’s total consolidated assets. The registrant agrees to furnish copies of the agreements defining the rights of holders of such long-term debt to the Securities and Exchange Commission upon request.

31.1		Certification of Chairman of the Board and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Senior Vice President, Chief Financial Officer, Secretary and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002.

32		Certification pursuant to 18 U.S.C. § 1350.

101.INS		XBRL Instance Document (1)

101.SCH		XBRL Taxonomy Extension Schema Document (1)

101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document (1)



101.LAB		XBRL Taxonomy Extension Label Linkbase Document (1)

101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document (1)

101.DEF		XBRL Taxonomy Extension Definitions Linkbase Document (1)

(1)	As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	SOUTHERN MICHIGAN BANCORP, INC.

Date: November 14, 2011	By:	/S/ JOHN H. CASTLE
		John H. Castle
		Chairman of the Board and Chief Executive Officer (Principal Executive Officer)

Date: November 14, 2011	By:	/S/ DANICE L. CHARTRAND
		Danice L. Chartrand
		Senior Vice President, Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)

Exhibit Index


Exhibit Number		Document

3.1		Articles of Incorporation of Southern Michigan Bancorp, Inc., as amended. Previously filed with the Commission on July 13, 2007 in Southern Michigan Bancorp Inc.’s Form S-4 Registration Statement, Exhibit 3.1. Here incorporated by reference.

3.2		Amended and Restated Bylaws of Southern Michigan Bancorp, Inc., as amended. Previously filed with the Commission on July 13, 2007 in Southern Michigan Bancorp Inc.’s Form S-4 Registration Statement, Exhibit 3.2. Here incorporated by reference.

4.1		Articles of Incorporation of Southern Michigan Bancorp, Inc., as amended. Exhibit 3.1 is here incorporated by reference.

4.2		Amended and Restated Bylaws of Southern Michigan Bancorp, Inc., as amended. Exhibit 3.2 is here incorporated by reference.

4.3		Long-Term Debt. The registrant has outstanding long-term debt which at the time of this report does not exceed 10% of the registrant’s total consolidated assets. The registrant agrees to furnish copies of the agreements defining the rights of holders of such long-term debt to the Securities and Exchange Commission upon request.

31.1		Certification of Chairman of the Board and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Senior Vice President, Chief Financial Officer, Secretary and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002.

32		Certification pursuant to 18 U.S.C. § 1350.

101.INS		XBRL Instance Document (1)

101.SCH		XBRL Taxonomy Extension Schema Document (1)

101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document (1)

101.LAB		XBRL Taxonomy Extension Label Linkbase Document (1)

101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document (1)

101.DEF		XBRL Taxonomy Extension Definitions Linkbase Document (1)

(1)	As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934

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