UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2020

OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _______ to _______

Commission file number: 000-25927

MACATAWA BANK CORPORATION
(Exact name of registrant as specified in its charter)

Michigan

38-3391345
(State or other jurisdiction of  incorporation or organization)
 
(I.R.S. Employer Identification No.)

10753 Macatawa Drive, Holland, Michigan 49424
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (616) 820-1444

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

 
Title of each class
 
Trading Symbol
 
Name of each exchange on which registered
 
Common stock
 
MCBC
 
NASDAQ

Indicate by checkmark 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 No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes No

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

Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company
Emerging Growth Company

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No
 
The number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 34,101,320 shares of the Company's Common Stock (no par value) were outstanding as of October 22, 2020.
 


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 Macatawa Bank Corporation. Forward-looking statements are identifiable by words or phrases such as “outlook”, “plan” or “strategy”; that an event or trend “could”, “may”, “should”, “will”, “is likely”, or is “possible” or “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”, “signs”, “efforts”, “tend”, “exploring”, “appearing”, “until”, “near term”, “concern”, “going forward”, “focus”, “starting”, “initiative,” “trend” 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, those related to the risks and uncertainties related to, and the impact of, the global coronavirus (COVID-19) pandemic on the business, financial condition and results of operations of our company and our customers, future levels of earning assets, future composition of our loan portfolio, trends in credit quality metrics, future capital levels and capital needs, real estate valuation, future levels of repossessed and foreclosed properties and nonperforming assets, future levels of losses and costs associated with the administration and disposition of repossessed and foreclosed properties and nonperforming assets, future levels of loan charge-offs, future levels of other real estate owned, future levels of provisions for loan losses and reserve recoveries, the rate of asset dispositions, future dividends, future growth and funding sources, future cost of funds, future liquidity levels, future profitability levels, future interest rate levels, future net interest margin levels, the effects on earnings of changes in interest rates, future economic conditions, future effects of new or changed accounting standards, future loss recoveries, loan demand and loan growth and the future level of other revenue sources. Management's determination of the provision and allowance for loan losses, the appropriate carrying value of intangible assets (including 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 statements with references to future time periods are forward-looking. All of the information concerning interest rate sensitivity is forward-looking. 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 Macatawa Bank Corporation, 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. Macatawa Bank Corporation does not undertake to update forward-looking statements to reflect the impact of circumstances or events that may arise after the date of the forward-looking statements.
 
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, 2019. 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.


INDEX

   
Page
Number
     
Part I.
Financial Information:
 
     
 
Item 1.
 
 
4
     
 
10
     
 
Item 2.
 
 
38
     
 
Item 3.
 
 
55
     
 
Item 4.
 
 
56
     
Part II.
Other Information:
 
     
 
Item 1A
 
 
57
     
 
Item 2.
 
 
58
     
 
Item 6.
 
 
58
     
 
59


Part I  Financial Information
Item 1.

MACATAWA BANK CORPORATION
CONSOLIDATED BALANCE SHEETS
As of September 30, 2020 (unaudited) and December 31, 2019
(Dollars in thousands, except per share data)


   
September 30,
2020
   
December 31,
2019
 
ASSETS
           
Cash and due from banks
 
$
28,294
   
$
31,942
 
Federal funds sold and other short-term investments
   
504,706
     
240,508
 
Cash and cash equivalents
   
533,000
     
272,450
 
Debt securities available for sale, at fair value
   
229,928
     
225,249
 
Debt securities held to maturity (fair value 2020 - $95,142 and 2019 - $85,128)
   
91,394
     
82,720
 
Federal Home Loan Bank (FHLB) stock
   
11,558
     
11,558
 
Loans held for sale, at fair value
   
3,508
     
3,294
 
Total loans
   
1,542,335
     
1,385,627
 
Allowance for loan losses
   
(16,558
)
   
(17,200
)
Net loans
   
1,525,777
     
1,368,427
 
Premises and equipment – net
   
43,733
     
43,417
 
Accrued interest receivable
   
6,895
     
4,866
 
Bank-owned life insurance
   
42,368
     
42,156
 
Other real estate owned - net
   
2,624
     
2,748
 
Net deferred tax asset
   
2,437
     
2,078
 
Other assets
   
15,496
     
9,807
 
Total assets
 
$
2,508,718
   
$
2,068,770
 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Deposits
               
Noninterest-bearing
 
$
738,471
   
$
482,499
 
Interest-bearing
   
1,432,108
     
1,270,795
 
Total deposits
   
2,170,579
     
1,753,294
 
Other borrowed funds
   
70,000
     
60,000
 
Long-term debt
   
20,619
     
20,619
 
Accrued expenses and other liabilities
   
13,655
     
17,388
 
Total liabilities
   
2,274,853
     
1,851,301
 
Commitments and contingent liabilities
   
     
 
Shareholders' equity
               
Common stock, no par value, 200,000,000 shares authorized; 34,101,320 and 34,103,542 shares issued and outstanding at September 30, 2020 and December 31, 2019
   
218,445
     
218,109
 
Retained earnings (deficit)
   
10,825
     
(2,184
)
Accumulated other comprehensive income
   
4,595
     
1,544
 
Total shareholders' equity
   
233,865
     
217,469
 
Total liabilities and shareholders' equity
 
$
2,508,718
   
$
2,068,770
 

See accompanying notes to consolidated financial statements.

-4-

MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Three and nine month periods ended September 30, 2020 and 2019
(unaudited)
(Dollars in thousands, except per share data)


   
Three Months
Ended
September 30,
2020
   
Three Months
Ended
September 30,
2019
   
Nine Months
Ended
September 30,
2020
   
Nine Months
Ended
September 30,
2019
 
Interest income
                       
Loans, including fees
 
$
13,854
   
$
15,604
   
$
43,194
   
$
48,179
 
Securities
                               
Taxable
   
867
     
968
     
2,881
     
2,952
 
Tax-exempt
   
861
     
919
     
2,607
     
2,623
 
FHLB Stock
   
100
     
158
     
339
     
476
 
Federal funds sold and other short-term investments
   
140
     
1,430
     
802
     
3,278
 
Total interest income
   
15,822
     
19,079
     
49,823
     
57,508
 
Interest expense
                               
Deposits
   
621
     
2,343
     
3,118
     
6,965
 
Other borrowings
   
364
     
349
     
1,069
     
1,021
 
Long-term debt
   
163
     
551
     
612
     
1,710
 
Total interest expense
   
1,148
     
3,243
     
4,799
     
9,696
 
Net interest income
   
14,674
     
15,836
     
45,024
     
47,812
 
Provision for loan losses
   
500
     
     
2,200
     
(450
)
Net interest income after provision for loan losses
   
14,174
     
15,836
     
42,824
     
48,262
 
Noninterest income
                               
Service charges and fees
   
987
     
1,139
     
2,957
     
3,267
 
Net gains on mortgage loans
   
1,546
     
824
     
4,045
     
1,650
 
Trust fees
   
921
     
920
     
2,801
     
2,813
 
ATM and debit card fees
   
1,542
     
1,469
     
4,199
     
4,276
 
Gain on sales of securities
   
     
     
     
 
Bank owned life insurance ("BOLI") income
   
215
     
252
     
688
     
737
 
Other
   
881
     
609
     
2,214
     
1,896
 
Total noninterest income
   
6,092
     
5,213
     
16,904
     
14,639
 
Noninterest expense
                               
Salaries and benefits
   
6,480
     
6,272
     
18,937
     
18,895
 
Occupancy of premises
   
1,026
     
966
     
2,984
     
3,055
 
Furniture and equipment
   
967
     
887
     
2,704
     
2,597
 
Legal and professional
   
260
     
211
     
798
     
652
 
Marketing and promotion
   
239
     
228
     
716
     
689
 
Data processing
   
761
     
735
     
2,309
     
2,226
 
FDIC assessment
   
131
     
     
207
     
239
 
Interchange and other card expense
   
367
     
347
     
1,041
     
1,057
 
Bond and D&O Insurance
   
104
     
103
     
313
     
309
 
Net (gains) losses on repossessed and foreclosed properties
   
     
     
32
     
(69
)
Administration and disposition of problem assets
   
25
     
46
     
71
     
183
 
Other
   
1,173
     
1,214
     
3,647
     
3,749
 
Total noninterest expenses
   
11,533
     
11,009
     
33,759
     
33,582
 
Income before income tax
   
8,733
     
10,040
     
25,969
     
29,319
 
Income tax expense
   
1,613
     
1,882
     
4,800
     
5,512
 
Net income
 
$
7,120
   
$
8,158
   
$
21,169
   
$
23,807
 
Basic earnings per common share
 
$
0.21
   
$
0.24
   
$
0.62
   
$
0.70
 
Diluted earnings per common share
 
$
0.21
   
$
0.24
   
$
0.62
   
$
0.70
 
Cash dividends per common share
 
$
0.08
   
$
0.07
   
$
0.24
   
$
0.21
 

See accompanying notes to consolidated financial statements.

-5-

MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Three and nine month periods ended September 30, 2020 and 2019
(unaudited)
(Dollars in thousands)


   
Three Months
Ended
September 30,
2020
   
Three Months
Ended
September 30,
2019
   
Nine Months
Ended
September 30,
2020
   
Nine Months
Ended
September 30,
2019
 
Net income
 
$
7,120
   
$
8,158
   
$
21,169
   
$
23,807
 
Other comprehensive income:
                               
Unrealized gains (losses):
                               
Net change in unrealized gains (losses) on debt securities available for sale
   
39
     
468
     
3,865
     
5,049
 
Tax effect
   
(8
)
   
(98
)
   
(814
)
   
(1,060
)
Net change in unrealized gains (losses) on debt securities available for sale, net of tax
   
31
     
370
     
3,051
     
3,989
 
Less: reclassification adjustments:
                               
Reclassification for gains included in net income
   
     
     
     
 
Tax effect
   
     
     
     
 
Reclassification for gains included in net income, net of tax
   
     
     
     
 
Other comprehensive income (loss), net of tax
   
31
     
370
     
3,051
     
3,989
 
Comprehensive income
 
$
7,151
   
$
8,528
   
$
24,220
   
$
27,796
 

See accompanying notes to consolidated financial statements.

-6-

MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Three and nine month periods ended September 30, 2020 and 2019
(unaudited)
(Dollars in thousands, except per share data)


   
Common
Stock
   
Retained
Earnings
(Deficit)
   
Accumulated
Other
Comprehensive
Income (Loss)
   
Total
Shareholders'
Equity
 
Balance, July 1, 2019
 
$
217,942
   
$
(13,764
)
 
$
1,341
   
$
205,519
 
Net income for the three months ended September 30, 2019
   
     
8,158
     
     
8,158
 
Cash dividends at $.07 per share
   
     
(2,372
)
   
     
(2,372
)
Net change in unrealized gain on debt securities available for sale, net of tax
   
     
     
370
     
370
 
Stock compensation expense
   
110
     
     
     
110
 
Balance, September 30, 2019
 
$
218,052
   
$
(7,978
)
 
$
1,711
   
$
211,785
 
                                 
Balance, July 1, 2020
 
$
218,349
   
$
6,425
   
$
4,564
   
$
229,338
 
Net income for the three months ended September 30, 2020
   
     
7,120
     
     
7,120
 
Cash dividends at $.08 per share
   
     
(2,720
)
   
     
(2,720
)
Repurchase of 1,696 shares for taxes withheld on vested restricted stock
   
(13
)
   
     
     
(13
)
Net change in unrealized gain on debt securities available for sale, net of tax
   
     
     
31
     
31
 
Stock compensation expense
   
109
     
     
     
109
 
Balance, September 30, 2020
 
$
218,445
   
$
10,825
   
$
4,595
   
$
233,865
 

   
Common
Stock
   
Retained
Earnings
(Deficit)
   
Accumulated
Other
Comprehensive
Income (Loss)
   
Total
Shareholders'
Equity
 
Balance, January 1, 2019
 
$
217,783
   
$
(24,652
)
 
$
(2,278
)
 
$
190,853
 
Net income for the nine months ended September 30, 2019
   
     
23,807
     
     
23,807
 
Cash dividends at $.21 per share
   
     
(7,133
)
   
     
(7,133
)
Repurchase of 452 shares for taxes withheld on vested restricted stock
   
(5
)
   
     
     
(5
)
Net change in unrealized gain on debt securities available for sale, net of tax
   
     
     
3,989
     
3,989
 
Stock compensation expense
   
274
     
     
     
274
 
Balance, September 30, 2019
 
$
218,052
   
$
(7,978
)
 
$
1,711
   
$
211,785
 
                                 
Balance, January 1, 2020
 
$
218,109
   
$
(2,184
)
 
$
1,544
   
$
217,469
 
Net income for the nine months ended September 30, 2020
   
     
21,169
     
     
21,169
 
Cash dividends at $.24 per share
   
     
(8,160
)
   
     
(8,160
)
Repurchase of 3,304 shares for taxes withheld on vested restricted stock
   
(24
)
   
     
     
(24
)
Net change in unrealized gain on debt securities available for sale, net of tax
   
     
     
3,051
     
3,051
 
Stock compensation expense
   
360
     
     
     
360
 
Balance, September 30, 2020
 
$
218,445
   
$
10,825
   
$
4,595
   
$
233,865
 

See accompanying notes to consolidated financial statements.

-7-

MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine month periods ended September 30, 2020 and 2019
(unaudited)
(Dollars in thousands)


   
Nine Months
Ended
September 30,
2020
   
Nine Months
Ended
September 30,
2019
 
Cash flows from operating activities
           
Net income
 
$
21,169
   
$
23,807
 
Adjustments to reconcile net income to net cash from operating activities:
               
Depreciation and amortization
   
2,105
     
1,675
 
Stock compensation expense
   
360
     
274
 
Provision for loan losses
   
2,200
     
(450
)
Origination of loans for sale
   
(120,171
)
   
(53,709
)
Proceeds from sales of loans originated for sale
   
124,002
     
54,457
 
Net gains on mortgage loans
   
(4,045
)
   
(1,650
)
Write-down of other real estate
   
32
     
10
 
Net (gain) loss on sales of other real estate
   
     
(79
)
Deferred income tax expense
   
(1,174
)
   
222
 
Change in accrued interest receivable and other assets
   
(7,450
)
   
(5,173
)
Earnings in bank-owned life insurance
   
(688
)
   
(737
)
Change in accrued expenses and other liabilities
   
4,483
     
4,391
 
Net cash from operating activities
   
20,823
     
23,038
 
Cash flows from investing activities
               
Loan originations and payments, net
   
(159,550
)
   
29,150
 
Purchases of securities available for sale
   
(102,158
)
   
(23,023
)
Purchases of securities held to maturity
   
(29,745
)
   
(17,778
)
Proceeds from:
               
Maturities and calls of securities
   
86,667
     
45,839
 
Principal paydowns on securities
   
27,423
     
6,324
 
Sales of other real estate
   
92
     
340
 
Additions to premises and equipment
   
(2,103
)
   
(1,001
)
Net cash from investing activities
   
(179,374
)
   
39,851
 
Cash flows from financing activities
               
Change in deposits
   
417,285
     
143,401
 
Repayments and maturities of other borrowed funds
   
     
(10,000
)
Proceeds from other borrowed funds
   
10,000
     
10,000
 
Repurchase of shares for taxes withheld on vested restricted stock
   
(24
)
   
(5
)
Cash dividends paid
   
(8,160
)
   
(7,133
)
Net cash from financing activities
   
419,101
     
136,263
 
Net change in cash and cash equivalents
   
260,550
     
199,152
 
Cash and cash equivalents at beginning of period
   
272,450
     
171,284
 
Cash and cash equivalents at end of period
 
$
533,000
   
$
370,436
 

See accompanying notes to consolidated financial statements.

-8-

MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Nine month periods ended September 30, 2020 and 2019
(unaudited)
(Dollars in thousands)


   
Nine Months
Ended
September 30,
2020
   
Nine Months
Ended
September 30,
2019
 
Supplemental cash flow information
           
Interest paid
 
$
5,043
   
$
9,646
 
Income taxes paid
   
5,315
     
5,100
 
Supplemental noncash disclosures:
               
Security settlement
   
1,937
     
650
 

See accompanying notes to consolidated financial statements.

-9-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Principles of Consolidation: The accompanying consolidated financial statements include the accounts of Macatawa Bank Corporation ("the Company", "our", "we") and its wholly-owned subsidiary, Macatawa Bank ("the Bank"). All significant intercompany accounts and transactions have been eliminated in consolidation.
 
Macatawa Bank is a Michigan chartered bank with depository accounts insured by the Federal Deposit Insurance Corporation. The Bank operates 26 full service branch offices providing a full range of commercial and consumer banking and trust services in Kent County, Ottawa County, and northern Allegan County, Michigan.
 
The Company owns all of the common stock of Macatawa Statutory Trust II. This is a grantor trust that issued trust preferred securities and is not consolidated with the Company under accounting principles generally accepted in the United States of America.

Recent Events: In December 2019, news began to surface regarding an influenza pandemic in China, known as the novel coronavirus, or COVID-19. In January 2020, the United States restricted entry to anyone traveling from China.  In February 2020, the pandemic spread broadly and swiftly throughout Europe and the Middle East. Cases began to surface in the United States in February 2020 and accelerated in early March 2020.  The Federal Reserve reduced the overnight federal funds rate by 50 basis points on March 3, 2020 and by another 100 basis points on March 15, 2020 and announced the resumption of quantitative easing.  During the week of March 9, 2020, individual states began implementing restrictions and promoting “social distancing”.  These restrictions included closure of schools, restrictions on the number of public gatherings, restrictions on businesses, including closures and mandatory work at home orders, and other measures.

In Michigan, beginning March 24, 2020, Governor Gretchen Whitmer issued a series of executive orders, which severely limited economic activity in Michigan, requiring businesses not deemed to be essential, to severely limit or shut down operations.  Under later executive orders, Governor Whitmer permitted a phased reopening of businesses, subject to stringent health and safety requirements and strict social distancing measures.  As of September 30, 2020, most businesses in Michigan were allowed to be open in some capacity, subject to stringent health and safety requirements, strict social distancing measures and nonsurgical face mask requirements. Congress passed a number of measures in late March 2020, designed to infuse cash into the economy to offset the negative impacts of business closings and restrictions.

The Company quickly responded to the changing environment by successfully executing its business continuity plan, including implementing work from home arrangements and limiting branch activities.  As of September 30, 2020, branches were fully open with additional health and safety requirements to comply with Governor Whitmer’s then-current executive orders, including, among other things, daily deep cleaning, nonsurgical face mask requirements and strict social distancing measures.

On October 2, and 12, 2020, the Michigan Supreme Court issued decisions invalidating all of Governor Whitmer’s executive orders effective immediately.  In response, Governor Whitmer, acting through various state agencies, has sought to substantially re-implement the requirements of the executive orders by way of state agency emergency orders.  Also, certain county and municipal governments have issued emergency orders seeking to keep elements of the executive orders in place.  Legal challenges to these orders may occur.  Finally, the Michigan legislature has passed legislation – which Governor Whitmer is expected to sign and enact into law – codifying certain elements of the executive orders.  The patchwork implementation of state agency and local government executive orders – coupled with the possibility of legal challenges to these orders – creates uncertainty as to legal requirements applicable to businesses, institutions and individuals in Michigan.  This uncertainty may have a negative impact on the business, financial condition, and results of operations of the Company and its customers.

On March 22, 2020, the federal banking agencies issued an “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus”.  This guidance encourages financial institutions to work prudently with borrowers that may be unable to meet their contractual obligations because of the effects of COVID-19.  The guidance goes on to explain that in consultation with the FASB staff the federal banking agencies conclude that short-term modifications (e.g. six months) made on a good faith basis to borrowers who were current as of the implementation date of a relief program are not Troubled Debt Restructurings (“TDRs”).  The Coronavirus Aid, Relief and Economic Security (“CARES”) Act was passed by Congress on March 27, 2020.  Section 4013 of the CARES Act also addressed COVID-19 related modifications and specified that COVID-19 related modifications on loans that were current as of December 31, 2019 are not TDRs.  Through September 30, 2020, the Bank had applied this guidance and modified 726 individual loans with aggregate principal balances totaling $337.2 million.  The majority of these modifications involved three-month extensions.

-10-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

By September 30, 2020, most of these modifications had expired, other than those receiving a second short-term modification as allowed under the guidance.  At September 30, 2020, there were 26 such loans under COVID-19 modification, totaling $79.9 million.  This is down from a quarter end peak of $297.3 million at June 30, 2020.

The CARES Act, as amended, included an allocation of $659 billion for loans to be issued by financial institutions through the Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”).   PPP loans are forgivable, in whole or in part, if the proceeds are used for payroll and other permitted purposes in accordance with the requirements of the PPP.  These loans carry a fixed rate of 1.00% and a term of two years (loans made before June 5, 2020) or five years (loans made on or after June 5, 2020), if not forgiven, in whole or in part.  Payments are deferred until either the date on which the SBA remits the amount of forgiveness proceeds to the lender or the date that is 10 months after the last day of the covered period if the borrower does not apply for forgiveness within that 10 month period. Through September 30, 2020, the Bank had originated 1,738 PPP loans totaling $346.7 million in principal, with an average loan size of $200,000.   Fees totaling $10.0 million were collected from the SBA for these loans in the nine months ended September 30, 2020.  These fees are deferred and amortized into interest income over the contractual period of 24 months or 60 months, as applicable.  Upon SBA forgiveness, unamortized fees are then recognized into interest income.  Participation in the PPP had a significant impact on the Bank’s asset mix and net interest income in the second and third quarters of 2020 and will continue to impact both asset mix and net interest income for the remainder of 2020.  The PPP program expired on August 8, 2020.
 
Basis of Presentation: 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 to Form 10-Q and Article 10 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 (consisting only of normal recurring accruals) believed necessary for a fair presentation have been included.
 
Operating results for the three and nine month periods ended September 30, 2020 are not necessarily indicative of the results that may be expected for the year ending December 31, 2020. For further information, refer to the consolidated financial statements and related notes included in the Company's Annual Report on Form 10-K for the year ended December 31, 2019.
 
Use of Estimates:  To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ.  The allowance for loan losses, valuation of deferred tax assets, loss contingencies, fair value of other real estate owned and fair values of financial instruments are particularly subject to change.
 
Allowance for Loan Losses: The allowance for loan losses (allowance) is a valuation allowance for probable incurred credit losses inherent in our loan portfolio, increased by the provision for loan losses and recoveries, and decreased by charge-offs of loans. Management believes the allowance for loan losses balance to be adequate based on known and inherent risks in the portfolio, past loan loss experience, information about specific borrower situations and estimated collateral values, economic conditions and other relevant 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. Management continues its collection efforts on previously charged-off balances and applies recoveries as additions to the allowance for loan losses.
 
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-classified loans and is based on historical loss experience adjusted for current qualitative factors. The Company maintains a loss migration analysis that tracks loan losses and recoveries based on loan class and the loan risk grade assignment for commercial loans. PPP loans receive $0 allocation as they are fully guaranteed by the SBA and are subject to be forgiven under the SBA forgiveness criteria.  At September 30, 2020, an 18 month annualized historical loss experience was used for commercial loans and a 12 month historical loss experience period was applied to residential mortgage loans and consumer loans. These historical loss percentages are adjusted (both upwards and downwards) for certain qualitative factors, including economic trends, credit quality trends, valuation trends, concentration risk, quality of loan review, changes in personnel, external factors and other considerations.  At March 31, 2020 and June 30, 2020, the qualitative factor allocations for economic trends and at September 30, 2020 the external factors were increased to provide additional coverage related to the COVID-19 pandemic.  In addition, at September 30, 2020, an additional qualitative allocation was provided on loans that remained in modified status under the CARES Act.
 
A loan is impaired when, based on current information and events, it is believed to be probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified and a concession has been made, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired.
 
-11-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
 
Commercial and commercial real estate loans with relationship balances exceeding $500,000 and an internal risk grading of 6 or worse are evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated and the loan is reported at the present value of estimated future cash flows using the loan’s existing interest rate or at the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment and they are not separately identified for impairment disclosures.
 
Troubled debt restructurings are also considered impaired with impairment generally measured at the present value of estimated future cash flows using the loan’s effective rate at inception or using the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral.

Foreclosed Assets: Assets acquired through or instead of loan foreclosure, primarily other real estate owned, are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Costs after acquisition are expensed unless they add value to the property.
 
Income Taxes: Income tax expense is the sum of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
 
The Company recognizes a tax position as a benefit only if it is "more likely than not" that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the "more likely than not" test, no tax benefit is recorded. The Company recognizes interest and penalties related to income tax matters in income tax expense.
 
Revenue Recognition:  The Company recognizes revenues as they are earned based on contractual terms, as transactions occur, or as services are provided and collectability is reasonably assured.  The Company’s primary source of revenue is interest income from the Bank’s loans and investment securities.  The Company also earns noninterest revenue from various banking services offered by the Bank.
 
Interest Income: The Company’s largest source of revenue is interest income which is primarily recognized on an accrual basis based on contractual terms written into loans and investment contracts.
 
Noninterest Revenue:  The Company derives the majority of its noninterest revenue from: (1) service charges for deposit related services, (2) gains related to mortgage loan sales, (3) trust fees and (4) debit and credit card interchange income.  Most of these services are transaction based and revenue is recognized as the related service is provided.
 
Derivatives:  Certain of the Bank’s commercial loan customers have entered into interest rate swap agreements directly with the Bank.  At the same time the Bank enters into a swap agreement with its customer, the Bank enters into a corresponding interest rate swap agreement with a correspondent bank at terms mirroring the Bank’s interest rate swap with its commercial loan customer.   This is known as a back-to-back swap agreement.  Under this arrangement the Bank has five freestanding interest rate swaps, each of which is carried at fair value.  As the terms mirror each other, there is no income statement impact to the Bank.  At September 30, 2020 and December 31, 2019, the total notional amount of such agreements was $149.8 million and $70.3 million, respectively, and resulted in a derivative asset with a fair value of $5.1 million and $1.8 million, respectively, which were included in other assets and a derivative liability of $5.1 million and $1.8 million, respectively, which were included in other liabilities.
 
Reclassifications: Some items in the prior period financial statements were reclassified to conform to the current presentation.

-12-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Adoption of New Standards:  On March 12, 2020, the Securities Exchange Commission finalized amendments to the definitions of “accelerated” and “large accelerated filer” definitions. The amendments increase the threshold criteria for meeting these categories and are effective on April 27, 2020.  Prior to these changes, the Company was designated as an “accelerated” filer as it had more than $75 million in public float but less than $700 million at the end of the Company’s most recent second quarter.  The rule change expands the definition of “smaller reporting companies” to include entities with public float of less than $700 million and less than $100 million in annual revenues in its most recent fiscal year.  The Company has met this expanded category of smaller reporting company at the June 30, 2020 measurement date and will no longer be considered an accelerated filer.  If the Company’s annual revenues exceed $100 million in a given fiscal year, its category will change back to “accelerated filer”.  The categorization of “accelerated” or “large accelerated filer” drives the requirement for a public company to obtain an auditor attestation of its internal control over financial reporting.  Smaller reporting companies also have additional time to file quarterly and annual financial statements.  All public companies are required to obtain and file annual financial statement audits, as well as provide management’s assertion on effectiveness of internal control over financial reporting, but the external auditor attestation of internal control over financial reporting is not required if a company is not an accelerated or large accelerated filer.  As the Bank has total assets exceeding $1.0 billion, it remains subject to FDICIA, which requires an auditor attestation of internal controls over the Bank’s regulatory financial reporting.  As such, other than the additional time provided to file quarterly and annual financial statements, this change did not significantly change the Company’s annual reporting and audit requirements.

Newly Issued Not Yet Effective Standards:  FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.  This ASU provides financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date by replacing the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates.  The new guidance eliminates the probable initial recognition threshold and, instead, reflects an entity’s current estimate of all expected credit losses. The new guidance broadens the information that an entity must consider in developing its expected credit loss estimate for assets measured either collectively or individually to include forecasted information, as well as past events and current conditions. There is no specified method for measuring expected credit losses, and an entity is allowed to apply methods that reasonably reflect its expectations of the credit loss estimate. Although an entity may still use its current systems and methods for recording the allowance for credit losses, under the new rules, the inputs used to record the allowance for credit losses generally will need to change to appropriately reflect an estimate of all expected credit losses and the use of reasonable and supportable forecasts. Additionally, credit losses on available-for-sale debt securities will now have to be presented as an allowance rather than as a write-down.

ASU No. 2019-10 Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842) – Effective Dates updated the effective date of this ASU for smaller reporting companies, such as the Company, to fiscal years beginning after December 15, 2022.  The Company selected a software vendor for applying this new ASU, began implementation of the software in the second quarter of 2018, completed integration during the third quarter of 2018 and ran parallel computations with both systems using the current GAAP incurred loss model in the fourth quarter of 2018.  The Company went live with this software beginning in January 2019 for its monthly incurred loss computations and began modeling the new current expected credit loss model assumptions to the allowance for loan losses computation.  In the second, third and fourth quarters of 2019, the Company modeled the various methods prescribed in the ASU against the Company’s identified loan segments.  The Company anticipates continuing to run parallel computations and fine tune assumptions as it continues to evaluate the impact of adoption of the new standard.  The COVID-19 pandemic that broke out in the United States in the first quarter of 2020 may have a significant impact on allowance computations under the incurred loss model which would be amplified under the new standard.

-13-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 2 – SECURITIES
 
The amortized cost and fair value of securities at period-end were as follows (dollars in thousands):

   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
September 30, 2020
                       
Available for Sale
                       
U.S. Treasury and federal agency securities
 
$
59,606
   
$
425
   
$
(52
)
 
$
59,979
 
U.S. Agency MBS and CMOs
   
60,110
     
1,629
     
(2
)
   
61,737
 
Tax-exempt state and municipal bonds
   
45,243
     
1,928
     
(1
)
   
47,170
 
Taxable state and municipal bonds
   
53,220
     
1,714
     
(20
)
   
54,914
 
Corporate bonds and other debt securities
   
5,933
     
195
     
     
6,128
 
   
$
224,112
   
$
5,891
   
$
(75
)
 
$
229,928
 
Held to Maturity
                               
Tax-exempt state and municipal bonds
 
$
91,394
   
$
3,748
   
$
   
$
95,142
 

   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
December 31, 2019
                       
Available for Sale
                       
U.S. Treasury and federal agency securities
 
$
74,839
   
$
95
   
$
(185
)
 
$
74,749
 
U.S. Agency MBS and CMOs
   
45,795
     
474
     
(68
)
   
46,201
 
Tax-exempt state and municipal bonds
   
44,718
     
1,244
     
     
45,962
 
Taxable state and municipal bonds
   
51,683
     
404
     
(65
)
   
52,022
 
Corporate bonds and other debt securities
   
6,263
     
55
     
(3
)
   
6,315
 
   
$
223,298
   
$
2,272
   
$
(321
)
 
$
225,249
 
Held to Maturity
                               
Tax-exempt state and municipal bonds
 
$
82,720
   
$
2,408
   
$
   
$
85,128
 

There were no sales of securities in the three and nine month periods ended September 30, 2020 and 2019.
 
Contractual maturities of debt securities at September 30, 2020 were as follows (dollars in thousands):

   
Held–to-Maturity Securities
   
Available-for-Sale Securities
 
   
Amortized
Cost
   
Fair
Value
   
Amortized
Cost
   
Fair
Value
 
Due in one year or less
 
$
28,636
   
$
28,833
   
$
34,257
   
$
34,479
 
Due from one to five years
   
29,384
     
30,567
     
64,101
     
66,323
 
Due from five to ten years
   
14,749
     
16,076
     
68,427
     
70,321
 
Due after ten years
   
18,625
     
19,666
     
57,327
     
58,805
 
   
$
91,394
   
$
95,142
   
$
224,112
   
$
229,928
 

-14-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 2 – SECURITIES (Continued)

Securities with unrealized losses at September 30, 2020 and December 31, 2019, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (dollars in thousands):

   
Less than 12 Months
   
12 Months or More
   
Total
 
September 30, 2020
 
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
 
Available for Sale
                                   
U.S. Treasury and federal agency securities
 
$
12,948
   
$
(52
)
 
$
   
$
   
$
12,948
   
$
(52
)
U.S. Agency MBS and CMOs
   
1,971
     
(2
)
   
     
     
1,971
     
(2
)
Tax-exempt state and municipal bonds
   
755
     
(1
)
   
     
     
755
     
(1
)
Taxable state and municipal bonds
   
3,343
     
(20
)
   
     
     
3,343
     
(20
)
Corporate bonds and other debt securities
   
     
     
     
     
     
 
Total
 
$
19,017
   
$
(75
)
 
$
   
$
   
$
19,017
   
$
(75
)
                                                 
Held to Maturity
                                               
Tax-exempt state and municipal bonds
 
$
   
$
   
$
   
$
   
$
   
$
 

   
Less than 12 Months
   
12 Months or More
   
Total
 
December 31, 2019
 
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
 
Available for Sale
                                   
U.S. Treasury and federal agency securities
 
$
15,009
   
$
(97
)
 
$
27,026
   
$
(87
)
 
$
42,035
   
$
(184
)
U.S. Agency MBS and CMOs
   
19,117
     
(56
)
   
1,196
     
(12
)
   
20,313
     
(68
)
Tax-exempt state and municipal bonds
   
319
     
     
     
     
319
     
 
Taxable state and municipal bonds
   
8,569
     
(57
)
   
2,981
     
(9
)
   
11,550
     
(66
)
Corporate bonds and other debt securities
   
932
     
     
852
     
(3
)
   
1,784
     
(3
)
Total temporarily impaired
 
$
43,946
   
$
(210
)
 
$
32,055
   
$
(111
)
 
$
76,001
   
$
(321
)
                                                 
Held to Maturity
                                               
Tax-exempt state and municipal bonds
 
$
   
$
   
$
   
$
   
$
   
$
 

Other-Than-Temporary-Impairment
 
Management evaluates securities for other-than-temporary impairment ("OTTI") at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. At September 30, 2020, 16 securities available for sale with fair values totaling $19.0 million had unrealized losses totaling $75,000.  At September 30, 2020, there were no securities held to maturity which had unrealized losses.  Management has the intent and ability to hold the securities classified as held to maturity until they mature, at which time the Company will receive full value for the securities.  In addition, management believes it is more likely than not that the Company will not be required to sell any of its investment securities before a recovery of cost.  Management determined that the unrealized losses for the three and nine month periods ended September 30, 2020 and 2019 were attributable to changes in interest rates and not due to credit quality.  As such, no OTTI charges were necessary during each period.
 
Securities with a carrying value of approximately $6.1 million and $3.0 million were pledged as security for public deposits, letters of credit and for other purposes required or permitted by law at September 30, 2020 and December 31, 2019, respectively.
 
-15-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS
 
Portfolio loans were as follows (dollars in thousands):

   
September 30,
2020
   
December 31,
2019
 
Commercial and industrial:
           
Commercial and industrial, excluding PPP
 
$
413,702
   
$
499,572
 
Paycheck protection program (PPP)
   
339,216
     
 
Total commercial and industrial
   
752,918
     
499,572
 
Commercial real estate:
               
Residential developed
   
10,072
     
14,705
 
Vacant and unimproved
   
45,534
     
41,796
 
Commercial development
   
605
     
665
 
Residential improved
   
117,202
     
130,861
 
Commercial improved
   
273,355
     
292,799
 
Manufacturing and industrial
   
112,155
     
117,632
 
Total commercial real estate
   
558,923
     
598,458
 
Consumer
               
Residential mortgage
   
164,818
     
211,049
 
Unsecured
   
189
     
274
 
Home equity
   
61,276
     
70,936
 
Other secured
   
4,211
     
5,338
 
Total consumer
   
230,494
     
287,597
 
Total loans
   
1,542,335
     
1,385,627
 
Allowance for loan losses
   
(16,558
)
   
(17,200
)
   
$
1,525,777
   
$
1,368,427
 

Included in commercial and industrial loans at September 30, 2020 are $339.2 million in loans issued under the PPP. This program was created by the CARES Act in March 2020 to support businesses through the COVID-19 pandemic.  Under the program, borrowers who use the funds for payroll and certain other expenses are eligible to have the loan balances forgiven by the SBA.  Applications for forgiveness can be submitted to the Bank beginning 8 weeks after loan disbursement.  The loans are 100% guaranteed by the SBA.  We expect the majority of PPP loans to qualify for and receive forgiveness from the SBA by early 2021.  This expectation is subject to change due to borrower behavior, changing SBA requirements and processes related to loan forgiveness and other relevant factors.

-16-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS (Continued)

Activity in the allowance for loan losses by portfolio segment was as follows (dollars in thousands):

Three months ended September 30, 2020
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
 
$
5,431
   
$
7,262
   
$
3,138
   
$
24
   
$
15,855
 
Charge-offs
   
     
     
(24
)
   
     
(24
)
Recoveries
   
22
     
168
     
37
     
     
227
 
Provision for loan losses
   
513
     
237
     
(242
)
   
(8
)
   
500
 
Ending Balance
 
$
5,966
   
$
7,667
   
$
2,909
   
$
16
   
$
16,558
 

Three months ended September 30, 2019
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
 
$
7,231
   
$
6,309
   
$
3,296
   
$
50
   
$
16,886
 
Charge-offs
   
     
     
(48
)
   
     
(48
)
Recoveries
   
233
     
51
     
23
     
     
307
 
Provision for loan losses
   
23
     
105
     
(105
)
   
(23
)
   
 
Ending Balance
 
$
7,487
   
$
6,465
   
$
3,166
   
$
27
   
$
17,145
 

Nine months ended September 30, 2020
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
 
$
7,658
   
$
6,521
   
$
3,009
   
$
12
   
$
17,200
 
Charge-offs
   
(1,192
)
   
(2,957
)
   
(97
)
   
     
(4,246
)
Recoveries
   
124
     
1,159
     
121
     
     
1,404
 
Provision for loan losses
   
(624
)
   
2,944
     
(124
)
   
4
     
2,200
 
Ending Balance
 
$
5,966
   
$
7,667
   
$
2,909
   
$
16
   
$
16,558
 

Nine months ended September 30, 2019
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
 
$
6,856
   
$
6,544
   
$
3,449
   
$
27
   
$
16,876
 
Charge-offs
   
     
(132
)
   
(114
)
   
     
(246
)
Recoveries
   
510
     
342
     
113
     
     
965
 
Provision for loan losses
   
121
     
(289
)
   
(282
)
   
     
(450
)
Ending Balance
 
$
7,487
   
$
6,465
   
$
3,166
   
$
27
   
$
17,145
 

-17-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS (Continued)
 
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method (dollars in thousands):

September 30, 2020
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
                             
Ending allowance attributable to loans:
                             
Individually reviewed for impairment
 
$
660
   
$
26
   
$
330
   
$
   
$
1,016
 
Collectively evaluated for impairment
   
5,306
     
7,641
     
2,579
     
16
     
15,542
 
Total ending allowance balance
 
$
5,966
   
$
7,667
   
$
2,909
   
$
16
   
$
16,558
 
Loans:
                                       
Individually reviewed for impairment
 
$
2,803
   
$
2,175
   
$
4,356
   
$
   
$
9,334
 
Collectively evaluated for impairment
   
750,115
     
556,748
     
226,138
     
     
1,533,001
 
Total ending loans balance
 
$
752,918
   
$
558,923
   
$
230,494
   
$
   
$
1,542,335
 

December 31, 2019
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
                             
Ending allowance attributable to loans:
                             
Individually reviewed for impairment
 
$
1,213
   
$
32
   
$
379
   
$
   
$
1,624
 
Collectively evaluated for impairment
   
6,445
     
6,489
     
2,630
     
12
     
15,576
 
Total ending allowance balance
 
$
7,658
   
$
6,521
   
$
3,009
   
$
12
   
$
17,200
 
Loans:
                                       
Individually reviewed for impairment
 
$
5,797
   
$
2,928
   
$
5,140
   
$
   
$
13,865
 
Collectively evaluated for impairment
   
493,775
     
595,530
     
282,457
     
     
1,371,762
 
Total ending loans balance
 
$
499,572
   
$
598,458
   
$
287,597
   
$
   
$
1,385,627
 

-18-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS (Continued)
 
The following table presents loans individually evaluated for impairment by class of loans as of September 30, 2020 (dollars in thousands):

September 30, 2020
 
Unpaid
Principal
Balance
   
Recorded
Investment
   
Allowance
Allocated
 
With no related allowance recorded:
                 
Commercial and industrial
 
$
168
   
$
168
   
$
 
Commercial real estate:
                       
Residential improved
   
120
     
120
     
 
Commercial improved
   
1,290
     
1,290
     
 
     
1,410
     
1,410
     
 
Consumer
   
     
     
 
Total with no related allowance recorded
 
$
1,578
   
$
1,578
   
$
 
With an allowance recorded:
                       
Commercial and industrial
 
$
2,635
   
$
2,635
   
$
660
 
Commercial real estate:
                       
Residential developed
   
70
     
70
     
3
 
Commercial improved
   
350
     
350
     
13
 
Manufacturing and industrial
   
345
     
345
     
10
 
     
765
     
765
     
26
 
Consumer:
                       
Residential mortgage
   
3,784
     
3,784
     
286
 
Unsecured
   
142
     
142
     
11
 
Home equity
   
406
     
406
     
31
 
Other secured
   
24
     
24
     
2
 
     
4,356
     
4,356
     
330
 
Total with an allowance recorded
 
$
7,756
   
$
7,756
   
$
1,016
 
Total
 
$
9,334
   
$
9,334
   
$
1,016
 

-19-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS (Continued)
 
The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2019 (dollars in thousands):

December 31, 2019
 
Unpaid
Principal
Balance
   
Recorded
Investment
   
Allowance
Allocated
 
With no related allowance recorded:
                 
Commercial and industrial
 
$
180
   
$
180
   
$
 
Commercial real estate:
                       
Vacant and unimproved
   
130
     
130
     
 
Residential improved
   
377
     
377
     
 
Commercial improved
   
1,380
     
1,380
     
 
     
1,887
     
1,887
     
 
Consumer
   
     
     
 
Total with no related allowance recorded
 
$
2,067
   
$
2,067
   
$
 
With an allowance recorded:
                       
Commercial and industrial
 
$
5,617
   
$
5,617
   
$
1,213
 
Commercial real estate:
                       
Residential developed
   
76
     
76
     
3
 
Residential improved
   
28
     
28
     
2
 
Commercial improved
   
578
     
578
     
16
 
Manufacturing and industrial
   
359
     
359
     
11
 
     
1,041
     
1,041
     
32
 
Consumer:
                       
Residential mortgage
   
4,242
     
4,242
     
313
 
Unsecured
   
198
     
198
     
14
 
Home equity
   
677
     
677
     
50
 
Other secured
   
23
     
23
     
2
 
     
5,140
     
5,140
     
379
 
Total with an allowance recorded
 
$
11,798
   
$
11,798
   
$
1,624
 
Total
 
$
13,865
   
$
13,865
   
$
1,624
 

-20-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS (Continued)
 
The following table presents information regarding average balances of impaired loans and interest recognized on impaired loans for the three and nine month periods ended September 30, 2020 and 2019 (dollars in thousands):

 
Three
Months
Ended
September 30,
2020
   
Three
Months
Ended
September 30,
2019
   
Nine
Months
Ended
September 30,
2020
   
Nine
Months
Ended
September 30,
2019
 
Average of impaired loans during the period:
                       
Commercial and industrial
 
$
2,208
   
$
3,781
   
$
4,362
   
$
5,304
 
Commercial real estate:
                               
Residential developed
   
71
     
146
     
72
     
161
 
Vacant and unimproved
   
     
62
     
     
107
 
Residential improved
   
168
     
538
     
211
     
421
 
Commercial improved
   
1,650
     
2,071
     
4,652
     
2,187
 
Manufacturing and industrial
   
347
     
366
     
352
     
372
 
Consumer
   
4,441
     
5,599
     
4,687
     
5,900
 
Interest income recognized during impairment:
                               
Commercial and industrial
   
23
     
174
     
303
     
692
 
Commercial real estate
   
33
     
45
     
193
     
141
 
Consumer
   
41
     
70
     
153
     
210
 
Cash-basis interest income recognized
                               
Commercial and industrial
   
13
     
160
     
298
     
707
 
Commercial real estate
   
33
     
48
     
218
     
149
 
Consumer
   
43
     
71
     
148
     
210
 

-21-

Index
MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS (Continued)

Nonaccrual loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.  The following tables present the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of September 30, 2020 and December 31, 2019 (dollars in thousands):

September 30, 2020
 
Nonaccrual
   
Over 90
days
Accruing
 
Commercial and industrial
 
$
   
$
 
Commercial real estate:
               
Residential improved
   
97
     
 
     
97
     
 
Consumer:
               
Residential mortgage
   
98
     
 
     
98
     
 
Total
 
$
195
   
$
 

December 31, 2019
 
Nonaccrual
   
Over 90 days
Accruing
 
Commercial and industrial
 
$
   
$
 
Commercial real estate:
               
Residential improved
   
98
     
 
     
98
     
 
Consumer:
               
Residential mortgage
   
105
     
 
     
105
     
 
Total
 
$
203
   
$
 

-22-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS (Continued)

The following table presents the aging of the recorded investment in past due loans as of September 30, 2020 and December 31, 2019 by class of loans (dollars in thousands):

September 30, 2020
 
30-90
Days
   
Greater Than
90 Days
   
Total
Past Due
   
Loans Not
Past Due
   
Total
 
Commercial and industrial
 
$
65
   
$
   
$
65
   
$
752,853
   
$
752,918
 
Commercial real estate:
                                       
Residential developed
   
     
     
     
10,072
     
10,072
 
Vacant and unimproved
   
     
     
     
45,534
     
45,534
 
Commercial development
   
     
     
     
605
     
605
 
Residential improved
   
     
97
     
97
     
117,105
     
117,202
 
Commercial improved
   
161
     
     
161
     
273,194
     
273,355
 
Manufacturing and industrial
   
     
     
     
112,155
     
112,155
 
     
161
     
97
     
258
     
558,665
     
558,923
 
Consumer:
                                       
Residential mortgage
   
     
97
     
97
     
164,721
     
164,818
 
Unsecured
   
     
     
     
189
     
189
 
Home equity
   
104
     
     
104
     
61,172
     
61,276
 
Other secured
   
     
     
     
4,211
     
4,211
 
     
104
     
97
     
201
     
230,293
     
230,494
 
Total
 
$
330
   
$
194
   
$
524
   
$
1,541,811
   
$
1,542,335
 

December 31, 2019
 
30-90
Days
   
Greater Than
90 Days
   
Total
Past Due
   
Loans Not
Past Due
   
Total
 
Commercial and industrial
 
$
   
$
   
$
   
$
499,572
   
$
499,572
 
Commercial real estate:
                                       
Residential developed
   
     
     
     
14,705
     
14,705
 
Vacant and unimproved
   
     
     
     
41,796
     
41,796
 
Commercial development
   
     
     
     
665
     
665
 
Residential improved
   
171
     
15
     
186
     
130,675
     
130,861
 
Commercial improved
   
103
     
     
103
     
292,696
     
292,799
 
Manufacturing and industrial
   
     
     
     
117,632
     
117,632
 
     
274
     
15
     
289
     
598,169
     
598,458
 
Consumer:
                                       
Residential mortgage
   
2
     
103
     
105
     
210,944
     
211,049
 
Unsecured
   
     
     
     
274
     
274
 
Home equity
   
8
     
     
8
     
70,928
     
70,936
 
Other secured
   
3
     
     
3
     
5,335
     
5,338
 
     
13
     
103
     
116
     
287,481
     
287,597
 
Total
 
$
287
   
$
118
   
$
405
   
$
1,385,222
   
$
1,385,627
 

-23-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS (Continued)

The Company had allocated $1,016,000 and $1,624,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings (“TDRs”) as of September 30, 2020 and December 31, 2019, respectively.  These loans may have involved the restructuring of terms to allow customers to mitigate the risk of foreclosure by meeting a lower loan payment requirement based upon their current cash flow.  These may also include loans that renewed at existing contractual rates, but below market rates for comparable credit.  The Company has been active at utilizing these programs and working with its customers to reduce the risk of foreclosure.  For commercial loans, these modifications typically include an interest only period and, in some cases, a lowering of the interest rate on the loan.  In some cases, the modification will include separating the note into two notes with the first note structured to be supported by current cash flows and collateral, and the second note made for the remaining unsecured debt.  The second note is charged off immediately and collected only after the first note is paid in full.  This modification type is commonly referred to as an A-B note structure.  For consumer mortgage loans, the restructuring typically includes a lowering of the interest rate to provide payment and cash flow relief.  For each restructuring, a comprehensive credit underwriting analysis of the borrower’s financial condition and prospects of repayment under the revised terms is performed to assess whether the structure can be successful and that cash flows will be sufficient to support the restructured debt.  An analysis is also performed to determine whether the restructured loan should be on accrual status.  Generally, if the loan is on accrual at the time of restructure, it will remain on accrual after the restructuring.  In some cases, a nonaccrual loan may be placed on accrual at restructuring if the loan’s actual payment history demonstrates it would have cash flowed under the restructured terms.  After six consecutive payments under the restructured terms, a nonaccrual restructured loan is reviewed for possible upgrade to accruing status.
 
In situations where there is a subsequent modification or renewal and the loan is brought to market terms, including a contractual interest rate not less than a market interest rate for new debt with similar credit risk characteristics, the TDR and impaired loan designations may be removed.  In addition, the TDR designation may also be removed from loans modified under an A-B note structure.  If the remaining “A” note is at a market rate at the time of restructuring (taking into account the borrower’s credit risk and prevailing market conditions), the loan can be removed from TDR designation in a subsequent calendar year after six months of performance in accordance with the new terms.  The market rate relative to the borrower’s credit risk is determined through analysis of market pricing information gathered from peers and use of a loan pricing model.  The general objective of the model is to achieve a consistent return on equity from one credit to the next, taking into consideration differences in credit risk.  In the model, credits with higher risk receive a higher potential loss allocation, and therefore require a higher interest rate to achieve the target return on equity.
 
As with other impaired loans, an allowance for loan loss is estimated for each TDR based on the most likely source of repayment for each loan.  For impaired commercial real estate loans that are collateral dependent, the allowance is computed based on the fair value of the underlying collateral, less estimated costs to sell.  For impaired commercial loans where repayment is expected from cash flows from business operations, the allowance is computed based on a discounted cash flow computation.  Certain groups of TDRs, such as residential mortgages, have common characteristics and for them the allowance is computed based on a discounted cash flow computation on the change in weighted rate for the pool.  The allowance allocations for commercial TDRs where we have reduced the contractual interest rate are computed by measuring cash flows using the new payment terms discounted at the original contractual rate.
 
The following table presents information regarding troubled debt restructurings as of September 30, 2020 and December 31, 2019 (dollars in thousands):

   
September 30, 2020
   
December 31, 2019
 
   
Number of
Loans
   
Outstanding
Recorded
Balance
   
Number of
Loans
   
Outstanding
Recorded
Balance
 
Commercial and industrial
   
7
   
$
2,803
     
7
   
$
5,797
 
Commercial real estate
   
13
     
2,175
     
15
     
2,770
 
Consumer
   
62
     
4,356
     
69
     
5,140
 
     
82
   
$
9,334
     
91
   
$
13,707
 
 
In late March 2020, the federal banking regulators issued guidance that modifications made to a borrower affected by the COVID-19 pandemic and governmental shutdown orders does not need to be identified as a TDR if the loan was current at the time a modification plan was implemented.  Section 4013 of the CARES Act also addressed COVID-19 related modifications and specified that such modifications made on loans that were current as of December 31, 2019 are not TDRs.  As of September 30, 2020, the Bank had applied this guidance and had made 726 such modifications with principal balances totaling $337.2 million.  The Bank continues to follow the guidance issued by the banking regulators in making any TDR determinations.  At September 30, 2020, there were 26 such loans still in their modification period, totaling $79.9 million.

-24-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS (Continued)

The following table presents information related to accruing troubled debt restructurings as of September 30, 2020 and December 31, 2019.  The table presents the amount of accruing troubled debt restructurings that were on nonaccrual status prior to the restructuring, accruing at the time of restructuring and those that were upgraded to accruing status after receiving six consecutive monthly payments in accordance with the restructured terms as of each period reported (dollars in thousands):

   
September 30,
2020
   
December 31,
2019
 
Accruing TDR - nonaccrual at restructuring
 
$
   
$
 
Accruing TDR - accruing at restructuring
   
6,884
     
8,295
 
Accruing TDR - upgraded to accruing after six consecutive payments
   
2,353
     
5,314
 
   
$
9,237
   
$
13,609
 

There were no troubled debt restructurings executed during the three month periods ended September 30, 2020 and 2019.  The following tables present information regarding troubled debt restructurings executed during the nine month periods ended September 30, 2020 and 2019 (dollars in thousands):

   
Nine Months Ended September 30, 2020
   
Nine Months Ended September 30, 2019
 
   
# of
Loans
   
Pre-TDR
Balance
   
Writedown
Upon
TDR
   
# of
Loans
   
Pre-TDR
Balance
   
Writedown
Upon
TDR
 
Commercial and industrial
   
   
$
   
$
     
   
$
   
$
 
Commercial real estate
   
     
     
     
     
     
 
Consumer
   
2
     
30
     
     
1
     
24
     
 
     
2
   
$
30
   
$
     
1
   
$
24
   
$
 

According to the accounting standards, not all loan modifications are TDRs.  TDRs are modifications or renewals where the Company has granted a concession to a borrower in financial distress.  The Company reviews all modifications and renewals for determination of TDR status.  In some situations a borrower may be experiencing financial distress, but the Company does not provide a concession.  These modifications are not considered TDRs.  In other cases, the Company might provide a concession, such as a reduction in interest rate, but the borrower is not experiencing financial distress.  This could be the case if the Company is matching a competitor’s interest rate.  These modifications would also not be considered TDRs.  Finally, any renewals at existing terms for borrowers not experiencing financial distress would not be considered TDRs.  As with other loans not considered TDR or impaired, allowance allocations are based on the historical based allocation for the applicable loan grade and loan class.
 
Payment defaults on TDRs have been minimal and during the three and nine month periods ended September 30, 2020 and 2019, the balance of loans that became delinquent by more than 90 days past due or that were transferred to nonaccrual within 12 months of restructuring were not material.
 
-25-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS (Continued)
 
Credit Quality Indicators:   The Company categorizes loans into risk categories based on relevant information about the ability of the 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 commercial loans individually and classifies these relationships by credit risk grading.  The Company uses an eight point grading system, with grades 5 through 8 being considered classified, or watch, credits.  All commercial loans are assigned a grade at origination, at each renewal or any amendment.  When a credit is first downgraded to a watch credit (either through renewal, amendment, loan officer identification or the loan review process), an Administrative Loan Review (“ALR”) is generated by the credit department and the loan officer.  All watch credits have an ALR completed quarterly which analyzes the collateral position and cash flow of the borrower and its guarantors.  Management meets quarterly with loan officers to discuss each of these credits in detail and to help formulate solutions where progress has stalled.  When necessary, the loan officer proposes changes to the assigned loan grade as part of the ALR.  Additionally, Loan Review reviews all loan grades upon origination, renewal or amendment and again as loans are selected though the loan review process.  The credit will stay on the ALR until either its grade has improved to a 4 or the credit relationship is at a zero balance.  The Company uses the following definitions for the risk grades:
 
1. Excellent - Loans supported by extremely strong financial condition or secured by the Bank’s own deposits. Minimal risk to the Bank and the probability of serious rapid financial deterioration is extremely small.
 
2. Above Average - Loans supported by sound financial statements that indicate the ability to repay or borrowings secured (and margined properly) with marketable securities. Nominal risk to the Bank and probability of serious financial deterioration is highly unlikely. The overall quality of these credits is very high.
 
3. Good Quality - Loans supported by satisfactory asset quality and liquidity, good debt capacity coverage, and good management in all critical positions. Loans are secured by acceptable collateral with adequate margins. There is a slight risk of deterioration if adverse market conditions prevail.
 
4. Acceptable Risk - Loans carrying an acceptable risk to the Bank, which may be slightly below average quality. The borrower has limited financial strength with considerable leverage. There is some probability of deterioration if adverse market conditions prevail. These credits should be monitored closely by the Relationship Manager.
 
5. Marginally Acceptable - Loans are of marginal quality with above normal risk to the Bank. The borrower shows acceptable asset quality but very little liquidity with high leverage. There is inconsistent earning performance without the ability to sustain adverse market conditions. The primary source of repayment is questionable, but the secondary source of repayment still remains an option. Very close attention by the Relationship Manager and management is needed.
 
6. Substandard - Loans are inadequately protected by the net worth and paying capacity of the borrower or the collateral pledged. The primary and secondary sources of repayment are questionable. Heavy debt condition may be evident and volume and earnings deterioration may be underway. It is possible that the Bank will sustain some loss if the deficiencies are not immediately addressed and corrected.
 
7. Doubtful - Loans supported by weak or no financial statements, as well as the ability to repay the entire loan, are questionable. Loans in this category are normally characterized less than adequate collateral, insolvent, or extremely weak financial condition. A loan classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses makes collection or liquidation in full highly questionable. The possibility of loss is extremely high, however, activity may be underway to minimize the loss or maximize the recovery.
 
8. Loss - Loans are considered uncollectible and of little or no value as a bank asset.
 
-26-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 3 – LOANS (Continued)
 
As of September 30, 2020 and December 31, 2019, the risk grade category of commercial loans by class of loans were as follows (dollars in thousands):

September 30, 2020
   
1
     
2
     
3
     
4
     
5
     
6
     
7
     
8
   
Total
 
Commercial and industrial
 
$
354,130
   
$
17,582
   
$
98,304
   
$
270,928
   
$
8,986
   
$
2,988
   
$
   
$
   
$
752,918
 
Commercial real estate:
                                                                       
Residential developed
   
     
     
132
     
9,940
     
     
     
     
     
10,072
 
Vacant and unimproved
   
     
4,221
     
10,708
     
29,078
     
1,527
     
     
     
     
45,534
 
Commercial development
   
     
     
309
     
296
     
     
     
     
     
605
 
Residential improved
   
     
     
26,426
     
90,445
     
234
     
     
97
     
     
117,202
 
Commercial improved
   
     
6,494
     
62,472
     
195,275
     
8,764
     
350
     
     
     
273,355
 
Manufacturing & industrial
   
     
     
33,965
     
74,400
     
3,790
     
     
     
     
112,155
 
   
$
354,130
   
$
28,297
   
$
232,316
   
$
670,362
   
$
23,301
   
$
3,338
   
$
97
   
$
   
$
1,311,841
 

December 31, 2019
   
1
     
2
     
3
     
4
     
5
     
6
     
7
     
8
   
Total
 
Commercial and industrial
 
$
15,000
   
$
11,768
   
$
158,851
   
$
290,267
   
$
17,664
   
$
6,022
   
$
   
$
   
$
499,572
 
Commercial real estate:
                                                                       
Residential developed
   
     
     
312
     
14,393
     
     
     
     
     
14,705
 
Vacant and unimproved
   
     
9,201
     
8,085
     
22,819
     
1,691
     
     
     
     
41,796
 
Commercial development
   
     
     
79
     
586
     
     
     
     
     
665
 
Residential improved
   
     
     
20,142
     
109,932
     
518
     
171
     
98
     
     
130,861
 
Commercial improved
   
     
6,893
     
67,915
     
213,790
     
3,847
     
354
     
     
     
292,799
 
Manufacturing & industrial
   
     
2,404
     
36,401
     
77,435
     
1,392
     
     
     
     
117,632
 
   
$
15,000
   
$
30,266
   
$
291,785
   
$
729,222
   
$
25,112
   
$
6,547
   
$
98
   
$
   
$
1,098,030
 

Commercial loans rated a 6 or worse per the Company’s internal risk rating system are considered substandard, doubtful or loss. Commercial loans classified as substandard or worse were as follows at period-end (dollars in thousands):

   
September 30,
2020
   
December 31,
2019
 
Not classified as impaired
 
$
591
   
$
591
 
Classified as impaired
   
2,844
     
6,054
 
Total commercial loans classified substandard or worse
 
$
3,435
   
$
6,645
 

The Company considers the performance of the loan portfolio and its impact on the allowance for loan losses. For consumer loan classes, the Company also evaluates credit quality based on the aging status of the loan, which was previously presented, and by payment activity. The following table presents the recorded investment in consumer loans based on payment activity (dollars in thousands):

September 30, 2020
 
Residential
Mortgage
   
Consumer
Unsecured
   
Home
Equity
   
Consumer
Other
 
Performing
 
$
164,721
   
$
189
   
$
61,276
   
$
4,211
 
Nonperforming
   
97
     
     
     
 
Total
 
$
164,818
   
$
189
   
$
61,276
   
$
4,211
 

December 31, 2019
 
Residential
Mortgage
   
Consumer
Unsecured
   
Home
Equity
   
Consumer
Other
 
Performing
 
$
210,946
   
$
274
   
$
70,936
   
$
5,338
 
Nonperforming
   
103
     
     
     
 
Total
 
$
211,049
   
$
274
   
$
70,936
   
$
5,338
 

-27-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 4 – OTHER REAL ESTATE OWNED
 
Other real estate owned was as follows (dollars in thousands):

   
Nine
Months Ended
September 30,
2020
   
Year
Ended
December 31,
2019
   
Nine
Months Ended
September 30,
2019
 
Beginning balance
 
$
3,112
   
$
4,183
   
$
4,183
 
Additions, transfers from loans
   
     
     
 
Proceeds from sales of other real estate owned
   
(92
)
   
(589
)
   
(340
)
Valuation allowance reversal upon sale
   
     
(453
)
   
(171
)
Gain / (loss) on sales of other real estate owned
   
     
(29
)
   
79
 
     
3,020
     
3,112
     
3,751
 
Less: valuation allowance
   
(396
)
   
(364
)
   
(642
)
Ending balance
 
$
2,624
   
$
2,748
   
$
3,109
 

Activity in the valuation allowance was as follows (dollars in thousands):

   
Nine
Months Ended
September 30,
2020
   
Nine
Months Ended
September 30,
2019
 
Beginning balance
 
$
364
   
$
803
 
Additions charged to expense
   
32
     
10
 
Reversals upon sale
   
     
(171
)
Ending balance
 
$
396
   
$
642
 

-28-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 5 – FAIR VALUE
 
ASC Topic 820, Fair Value Measurements and Disclosures, establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of inputs that may be used to measure fair value include:
 

Level 1:
Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
 

Level 2:
Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
 

Level 3:
Significant unobservable inputs that reflect a reporting entity's own assumptions about the assumptions that market participants would use in pricing an asset or liability.
 
Investment Securities: The fair values of investment securities are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities' relationship to other benchmark quoted securities (Level 2 inputs).  The fair values of certain securities held to maturity are determined by computing discounted cash flows using observable and unobservable market inputs (Level 3 inputs).
 
Loans Held for Sale: The fair value of loans held for sale is based upon binding quotes from third party investors (Level 2 inputs).
 
Impaired Loans: Loans identified as impaired are measured using one of three methods: the loan’s observable market price, the fair value of collateral or the present value of expected future cash flows.  For each period presented, no impaired loans were measured using the loan’s observable market price.  If an impaired loan has had a charge-off or if the fair value of the collateral is less than the recorded investment in the loan, we establish a specific reserve and report the loan as nonrecurring Level 3.  The fair value of collateral of impaired loans is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.
 
Other Real Estate Owned: Other real estate owned (OREO) properties are initially recorded at fair value, less estimated costs to sell when acquired, establishing a new cost basis.  Adjustments to OREO are measured at fair value, less costs to sell. Fair values are generally based on third party appraisals or realtor evaluations of the property. These appraisals and evaluations may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.  Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available.  Such adjustments are usually significant and typically result in a Level 3 classification.  In cases where the carrying amount exceeds the fair value, less estimated costs to sell, an impairment loss is recognized through a valuation allowance, and the property is reported as nonrecurring Level 3.
 
Interest Rate Swaps:    For interest rate swap agreements, we measure fair value utilizing pricing provided by a third-party pricing source that that uses market observable inputs, such as forecasted yield curves, and other unobservable inputs and accordingly, interest rate swap agreements are classified as Level 3.
 
-29-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 5 – FAIR VALUE (Continued)
 
Assets measured at fair value on a recurring basis are summarized below (in thousands):
   
Fair
Value
   
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
   
Significant Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
September 30, 2020
                       
U.S. Treasury and federal agency securities
 
$
59,979
   
$
   
$
59,979
   
$
 
U.S. Agency MBS and CMOs
   
61,737
     
     
61,737
     
 
Tax-exempt state and municipal bonds
   
47,170
     
     
47,170
     
 
Taxable state and municipal bonds
   
54,914
     
     
54,914
     
 
Corporate bonds and other debt securities
   
6,128
     
     
6,128
     
 
Other equity securities
   
1,518
     
     
1,518
     
 
Loans held for sale
   
3,508
     
     
3,508
     
 
Interest rate swaps
   
5,080
     
     
     
5,080
 
Interest rate swaps
   
(5,080
)
   
     
     
(5,080
)
                                 
December 31, 2019
                               
U.S. Treasury and federal agency securities
 
$
74,749
   
$
   
$
74,749
   
$
 
U.S. Agency MBS and CMOs
   
46,201
     
     
46,201
     
 
Tax-exempt state and municipal bonds
   
45,962
     
     
45,962
     
 
Taxable state and municipal bonds
   
52,022
     
     
52,022
     
 
Corporate bonds and other debt securities
   
6,315
     
     
6,315
     
 
Other equity securities
   
1,481
     
     
1,481
     
 
Loans held for sale
   
3,294
     
     
3,294
     
 
Interest rate swaps
   
1,830
     
     
     
1,830
 
Interest rate swaps
   
(1,830
)
   
     
     
(1,830
)

Assets measured at fair value on a non-recurring basis are summarized below (in thousands):

   
Fair
Value
   
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
   
Significant Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
September 30, 2020
                       
Impaired loans
 
$
2,481
   
$
   
$
   
$
2,481
 
Other real estate owned
   
281
     
     
     
281
 
                                 
December 31, 2019
                               
Impaired loans
 
$
5,151
   
$
   
$
   
$
5,151
 
Other real estate owned
   
405
     
     
     
405
 

-30-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 5 – FAIR VALUE (Continued)
 
Quantitative information about Level 3 fair value measurements measured on a non-recurring basis was as follows at period end (dollars in thousands):

   
Asset Fair
Value
 
Valuation
Technique
 
Unobservable
Inputs
 
Range (%)
September 30, 2020
             
Impaired Loans
 
$
2,481
 
Sales comparison approach
 
Adjustment for differences
between comparable sales
 
1.0 to 30.0
         
Income approach
 
Capitalization rate
 
9.5 to 11.0
Other real estate owned
   
281
 
Sales comparison approach
 
Adjustment for differences
between comparable sales
 
3.0 to 20.0
         
Income approach
 
Capitalization rate
 
9.5 to 11.0

   
Asset Fair
Value
 
Valuation
Technique
 
Unobservable
Inputs
 
Range (%)
December 31, 2019
                   
Impaired Loans
 
$
5,151
 
Sales comparison approach
 
Adjustment for differences
between comparable sales
 
1.5 to 20.0
         
Income approach
 
Capitalization rate
 
9.5 to 11.0
Other real estate owned
   
405
 
Sales comparison approach
 
Adjustment for differences
between comparable sales
 
3.0 to 20.0
         
Income approach
 
Capitalization rate
 
9.5 to 11.0

-31-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 5 – FAIR VALUE (Continued)

The carrying amounts and estimated fair values of financial instruments, not previously presented, were as follows at September 30, 2020 and December 31, 2019 (dollars in thousands):


  Level in
 
September 30, 2020
   
December 31, 2019
 

 
Fair Value
Hierarchy
 
Carrying
Amount
   
Fair
Value
   
Carrying
Amount
   
Fair
Value
 
Financial assets
                           
Cash and due from banks
 
Level 1
 
$
28,294
   
$
28,294
   
$
31,942
   
$
31,942
 
Cash equivalents
 
Level 2
   
504,706
     
504,706
     
240,508
     
240,508
 
Securities held to maturity
 
Level 3
   
91,394
     
95,142
     
82,720
     
85,128
 
FHLB stock
       
11,558
   

NA      
11,558
   
NA
 
Loans, net
 
Level 2
   
1,523,296
     
1,560,997
     
1,363,276
     
1,395,446
 
Bank owned life insurance
 
Level 3
   
42,368
     
42,368
     
42,156
     
42,156
 
Accrued interest receivable
 
Level 2
   
6,895
     
6,895
     
4,866
     
4,866
 
Financial liabilities
                                   
Deposits
 
Level 2
   
(2,170,579
)
   
(2,171,039
)
   
(1,753,294
)
   
(1,753,877
)
Other borrowed funds
 
Level 2
   
(70,000
)
   
(73,110
)
   
(60,000
)
   
(61,006
)
Long-term debt
 
Level 2
   
(20,619
)
   
(18,062
)
   
(20,619
)
   
(18,167
)
Accrued interest payable
 
Level 2
   
(274
)
   
(274
)
   
(518
)
   
(518
)
Off-balance sheet credit-related items
                                   
Loan commitments
       
     
     
     
 

The methods and assumptions used to estimate fair value are described as follows.
 
Carrying amount is the estimated fair value for cash and cash equivalents, bank owned life insurance, accrued interest receivable and payable, demand deposits, short-term borrowings and variable rate loans or deposits that reprice frequently and fully. Security fair values are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities as discussed above. For fixed rate loans, interest-bearing time deposits in other financial institutions, or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk (including consideration of widening credit spreads). Fair value of debt is based on current rates for similar financing. It was not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability. The fair value of off-balance sheet credit-related items is not significant.

The estimated fair values of financial instruments disclosed above as follow the guidance in ASU 2016-01 which prescribes an “exit price” approach in estimating and disclosing fair value of financial instruments incorporating discounts for credit, liquidity and marketability factors.
 
NOTE 6 – DEPOSITS
 
Deposits are summarized as follows (dollars in thousands):

   
September 30,
2020
   
December 31,
2019
 
Noninterest-bearing demand
 
$
738,471
   
$
482,499
 
Interest bearing demand
   
560,063
     
479,341
 
Savings and money market accounts
   
756,579
     
639,329
 
Certificates of deposit
   
115,466
     
152,125
 
   
$
2,170,579
   
$
1,753,294
 

Time deposits that exceed the FDIC insurance limit of $250,000 were approximately $32.0 million at September 30, 2020 and $37.7 million at December 31, 2019.

-32-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 7 - OTHER BORROWED FUNDS
 
Other borrowed funds include advances from the Federal Home Loan Bank and borrowings from the Federal Reserve Bank.
 
Federal Home Loan Bank Advances
 
At period-end, advances from the Federal Home Loan Bank were as follows (dollars in thousands):

Principal Terms
 
Advance
Amount
 
Range of Maturities
 
Weighted
Average
Interest Rate
 
September 30, 2020
             
Single maturity fixed rate advances
 
$
40,000
 
April 2021 to July 2024
   
2.50
%
Putable advances
   
30,000
 
November 2024 to February 2030
   
1.36
%
   
$
70,000
           

Principal Terms
 
Advance
Amount
 
Range of Maturities
 
Weighted
Average
Interest Rate
 
December 31, 2019
             
Single maturity fixed rate advances
 
$
40,000
 
April 2021 to July 2024
   
2.50
%
Putable advances
   
20,000
 
November 2024
   
1.81
%
   
$
60,000
           

-33-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 7 - OTHER BORROWED FUNDS (Continued)
 
Each advance is subject to a prepayment fee if paid prior to its maturity date.  Fixed rate advances are payable at maturity.   Amortizable mortgage advances are fixed rate advances with scheduled repayments based upon amortization to maturity.  These advances were collateralized by residential and commercial real estate loans totaling $451.8 million and $498.1 million under a blanket lien arrangement at September 30, 2020 and December 31, 2019, respectively.
 
Scheduled repayments of FHLB advances as of September 30, 2020 were as follows (in thousands):

2020
 
$
 
2021
   
10,000
 
2022
   
 
2023
   
10,000
 
2024
   
40,000
 
Thereafter
   
10,000
 
   
$
70,000
 

Federal Reserve Bank borrowings
 
The Company has a financing arrangement with the Federal Reserve Bank.  There were no borrowings outstanding at September 30, 2020 and December 31, 2019, and the Company had approximately $12.6 million and $13.0 million in unused borrowing capacity based on commercial and mortgage loans pledged to the Federal Reserve Bank totaling $14.0 million and $15.2 million at September 30, 2020 and December 31, 2019, respectively.
 
NOTE 8 - EARNINGS PER COMMON SHARE
 
A reconciliation of the numerators and denominators of basic and diluted earnings per common share for the three and nine month periods ended September 30, 2020 and 2019 are as follows (dollars in thousands, except per share data):

   
Three Months
Ended
September 30, 2020
   
Three Months
Ended
September 30, 2019
   
Nine Months
Ended
September 30, 2020
   
Nine Months
Ended
September 30, 2019
 
Net income available to common shares
 
$
7,120
   
$
8,158
   
$
21,169
   
$
23,807
 
Weighted average shares outstanding, including participating stock awards - Basic
   
34,109,901
     
34,060,796
     
34,108,676
     
34,048,087
 
Dilutive potential common shares:
                               
Stock options
   
     
     
     
 
Weighted average shares outstanding - Diluted
   
34,109,901
     
34,060,796
     
34,108,676
     
34,048,087
 
Basic earnings per common share
 
$
0.21
   
$
0.24
   
$
0.62
   
$
0.70
 
Diluted earnings per common share
 
$
0.21
   
$
0.24
   
$
0.62
   
$
0.70
 

There were no antidilutive shares of common stock in the three and nine month periods ended September 30, 2020 and 2019.

-34-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 9 - FEDERAL INCOME TAXES
 
Income tax expense was as follows (dollars in thousands):

   
Three Months
Ended
September 30,
2020
   
Three Months
Ended
September 30,
2019
   
Nine Months
Ended
September 30,
2020
   
Nine Months
Ended
September 30,
2019
 
Current
 
$
1,304
   
$
1,971
   
$
5,974
   
$
5,290
 
Deferred
   
309
     
(89
)
   
(1,174
)
   
222
 
   
$
1,613
   
$
1,882
   
$
4,800
   
$
5,512
 

The difference between the financial statement tax expense and amount computed by applying the statutory federal tax rate to pretax income was reconciled as follows (dollars in thousands):

   
Three Months
Ended
September 30,
2020
   
Three Months
Ended
September 30,
2019
   
Nine Months
Ended
September 30,
2020
   
Nine Months
Ended
September 30,
2019
 
Statutory rate
   
21
%
   
21
%
   
21
%
   
21
%
Statutory rate applied to income before taxes
 
$
1,834
   
$
2,108
   
$
5,454
   
$
6,157
 
Deduct
                               
Tax-exempt interest income
   
(178
)
   
(183
)
   
(533
)
   
(523
)
Bank-owned life insurance
   
(45
)
   
(53
)
   
(144
)
   
(155
)
Other, net
   
2
     
10
     
23
     
33
 
   
$
1,613
   
$
1,882
   
$
4,800
   
$
5,512
 

The realization of deferred tax assets (net of a recorded valuation allowance) is largely dependent upon future taxable income, future reversals of existing taxable temporary differences and the ability to carryback losses to available tax years. In assessing the need for a valuation allowance, we consider positive and negative evidence, including taxable income in carry-back years, scheduled reversals of deferred tax liabilities, expected future taxable income and tax planning strategies. At September 30, 2020 and December 31, 2019, a valuation allowance of $92,000 was established for a capital loss carryforward related to the liquidation of assets of a partnership interest the Bank acquired through a loan settlement.  Management believes it is more likely than not that all of the remaining deferred tax assets will be realized against deferred tax liabilities and projected future taxable income.

The net deferred tax asset recorded included the following amounts of deferred tax assets and liabilities (dollars in thousands):

   
September 30,
2020
   
December 31,
2019
 
Deferred tax assets
           
Allowance for loan losses
 
$
3,477
   
$
3,612
 
Net deferred loan fees
   
1,516
     
 
Nonaccrual loan interest
   
134
     
182
 
Valuation allowance on other real estate owned
   
83
     
76
 
Other
   
541
     
248
 
Gross deferred tax assets
   
5,751
     
4,118
 
Valuation allowance
   
(92
)
   
(92
)
Total net deferred tax assets
   
5,659
     
4,026
 
Deferred tax liabilities
               
Depreciation
   
(1,329
)
   
(1,053
)
Prepaid expenses
   
(170
)
   
(172
)
Unrealized gain on securities available for sale
   
(1,221
)
   
(406
)
Net deferred loan costs
   
     
(67
)
Other
   
(502
)
   
(250
)
Gross deferred tax liabilities
   
(3,222
)
   
(1,948
)
Net deferred tax asset
 
$
2,437
   
$
2,078
 

There were no unrecognized tax benefits at September 30, 2020 or December 31, 2019 and the Company does not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months. The Company is no longer subject to examination by the Internal Revenue Service for years before 2015.

-35-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 10 – COMMITMENTS AND OFF BALANCE-SHEET RISK
 
Some financial instruments are used to meet customer financing needs and to reduce exposure to interest rate changes.  These financial instruments include commitments to extend credit and standby letters of credit.  These involve, to varying degrees, credit and interest rate risk in excess of the amount reported in the financial statements.
 
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment, and generally have fixed expiration dates.  Collateral or other security is normally not obtained for these financial instruments prior to their use and many of the commitments are expected to expire without being used.  Standby letters of credit are conditional commitments to guarantee a customer’s performance to a third party.  Exposure to credit loss if the other party does not perform is represented by the contractual amount for commitments to extend credit and standby letters of credit.
 
A summary of the contractual amounts of financial instruments with off‑balance‑sheet risk was as follows at period-end (dollars in thousands):

   
September 30,
2020
   
December 31,
2019
 
Commitments to make loans
 
$
83,113
   
$
65,648
 
Letters of credit
   
12,475
     
15,303
 
Unused lines of credit
   
594,067
     
502,200
 

The notional amount of commitments to fund mortgage loans to be sold into the secondary market was approximately $5.0 million and $11.0 million at September 30, 2020 and December 31, 2019, respectively.

The Bank enters into commitments to sell mortgage backed securities, which it later buys back in order to hedge its exposure to interest rate risk in its mortgage pipeline.  These commitments were approximately $24.0 million at September 30, 2020 and $0 at December 31, 2019.
 
At September 30, 2020, approximately 52.4% of the Bank’s commitments to make loans were at fixed rates, offered at current market rates.  The remainder of the commitments to make loans were at variable rates tied to prime or one month LIBOR and generally expire within 30 days.  The majority of the unused lines of credit were at variable rates tied to prime.
 
NOTE 11 – CONTINGENCIES
 
The Company and its subsidiaries periodically become defendants in certain claims and legal actions arising in the ordinary course of business. As of September 30, 2020, there were no material pending legal proceedings to which the Company or any of its subsidiaries are a party or which any of its properties are the subject.
 
NOTE 12 – SHAREHOLDERS' EQUITY
 
Regulatory Capital
 
The Company and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements.
 
The prompt corrective action regulations provide five categories, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If a bank is only adequately capitalized, regulatory approval is required to, among other things, accept, renew or roll-over brokered deposits. If a bank is undercapitalized, capital distributions and growth and expansion are limited, and plans for capital restoration are required.
 
In July 2013, the Board of Governors of the Federal Reserve Board and the FDIC approved the rules implementing the Basel Committee on Banking Supervision's capital guidelines for U.S. banks (commonly known as Basel III). The rules include a common equity Tier 1 capital to risk-weighted assets ratio (CET1 ratio) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, which effectively results in a minimum CET1 ratio of 7.0%. The minimum ratio of Tier 1 capital to risk-weighted assets is 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5%), which effectively results in a minimum total capital to risk-weighted assets ratio of 10.5% (with the capital conservation buffer), and requires a minimum leverage ratio of 4.0%.

-36-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 12 – SHAREHOLDERS' EQUITY (Continued)
 
At September 30, 2020 and December 31, 2019, actual capital levels and minimum required levels were (dollars in thousands):

               
Minimum
Capital
   
Minimum Capital
Adequacy With
   
To Be Well
Capitalized Under
Prompt Corrective
 
   
Actual
   
Adequacy
   
Capital Buffer
   
Action Regulations
 
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
September 30, 2020
                                               
CET1 capital (to risk weighted assets)
                                               
Consolidated
 
$
229,270
     
15.3
%
 
$
67,421
     
4.5
%
 
$
104,876
     
7.0
%
   
N/A
     
N/A
 
Bank
   
242,425
     
16.2
     
67,435
     
4.5
     
104,899
     
7.0
   
$
97,406
     
6.5
%
Tier 1 capital (to risk weighted assets)
                                                               
Consolidated
   
249,270
     
16.6
     
89,894
     
6.0
     
127,350
     
8.5
     
N/A
     
N/A
 
Bank
   
242,425
     
16.2
     
89,914
     
6.0
     
127,378
     
8.5
     
119,885
     
8.0
 
Total capital (to risk weighted assets)
                                                               
Consolidated
   
265,828
     
17.7
     
119,859
     
8.0
     
157,315
     
10.5
     
N/A
     
N/A
 
Bank
   
258,983
     
17.3
     
119,885
     
8.0
     
157,349
     
10.5
     
149,856
     
10.0
 
Tier 1 capital (to average assets)
                                                               
Consolidated
   
249,270
     
9.8
     
101,930
     
4.0
     
N/A
     
N/A
     
N/A
     
N/A
 
Bank
   
242,425
     
9.5
     
101,900
     
4.0
     
N/A
     
N/A
     
127,374
     
5.0
 
                                                                 
December 31, 2019
                                                               
CET1 capital (to risk weighted assets)
                                                               
Consolidated
 
$
215,925
     
13.5
%
 
$
72,187
     
4.5
%
 
$
112,290
     
7.0
%
   
N/A
     
N/A
 
Bank
   
228,761
     
14.3
     
72,182
     
4.5
     
112,284
     
7.0
   
$
104,263
     
6.5
%
Tier 1 capital (to risk weighted assets)
                                                               
Consolidated
   
235,925
     
14.7
     
96,249
     
6.0
     
136,353
     
8.5
     
N/A
     
N/A
 
Bank
   
228,761
     
14.3
     
96,243
     
6.0
     
136,344
     
8.5
     
128,324
     
8.0
 
Total capital (to risk weighted assets)
                                                               
Consolidated
   
253,125
     
15.8
     
128,332
     
8.0
     
168,436
     
10.5
     
N/A
     
N/A
 
Bank
   
245,961
     
15.3
     
128,324
     
8.0
     
168,425
     
10.5
     
160,405
     
10.0
 
Tier 1 capital (to average assets)
                                                               
Consolidated
   
235,925
     
11.5
     
82,130
     
4.0
     
N/A
     
N/A
     
N/A
     
N/A
 
Bank
   
228,761
     
11.2
     
82,070
     
4.0
     
N/A
     
N/A
     
102,587
     
5.0
 

The full $20.0 million balance of trust preferred securities outstanding at September 30, 2020 and December 31, 2019, respectively, qualified as Tier 1 capital. Refer to our 2019 Form 10-K for more information on the trust preferred securities.
 
The Bank was categorized as "well capitalized" at September 30, 2020 and December 31, 2019.
 
-37-

Item 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Macatawa Bank Corporation is a Michigan corporation and a registered bank holding company. It wholly-owns Macatawa Bank and Macatawa Statutory Trust II. Macatawa Bank is a Michigan chartered bank with depository accounts insured by the FDIC. The Bank operates twenty-six branch offices and a lending and operational service facility, providing a full range of commercial and consumer banking and trust services in Kent County, Ottawa County, and northern Allegan County, Michigan. Macatawa Statutory Trust II is a grantor trust and issued $20.0 million of pooled trust preferred securities.  Macatawa Statutory Trust II is not consolidated in our Consolidated Financial Statements. For further information regarding consolidation, see the Notes to Consolidated Financial Statements.
 
At September 30, 2020, we had total assets of $2.51 billion, total loans of $1.54 billion, total deposits of $2.17 billion and shareholders' equity of $233.9 million.  For the three months ended September 30, 2020, we recognized net income of $7.1 million compared to $8.2 million for the same period in 2019.  For the nine months ended September 30, 2020, we recognized net income of $21.2 million compared to $23.8 million for the same period in 2019.  The Bank was categorized as “well capitalized” under regulatory capital standards at September 30, 2020.
 
We paid a dividend of $0.07 per share in each quarter in 2019 and $0.08 per share in the first, second and third quarters of 2020.

In December 2019, news began to surface regarding an influenza pandemic in China, known as the novel coronavirus, or COVID-19. In January 2020, the United States restricted entry to anyone traveling from China.  In February 2020, the pandemic spread broadly and swiftly throughout Europe and the Middle East. Cases began to surface in the United States in February 2020 and accelerated in early March 2020.  The Federal Reserve reduced the overnight federal funds rate by 50 basis points on March 3, 2020 and by another 100 basis points on March 15, 2020 and announced the resumption of quantitative easing.  During the week of March 9, 2020, individual states began implementing restrictions and promoting “social distancing.”  These restrictions included closure of schools, restrictions on the number of public gatherings, restrictions on businesses, including closures and mandatory work at home orders and other measures. Congress passed a number of measures in late March 2020, designed to infuse cash into the economy to offset the negative impacts of business closings and restrictions.

In Michigan, beginning March 24, 2020, Governor Gretchen Whitmer issued a series of executive orders, which severely limited economic activity in Michigan, requiring businesses not deemed to be essential, to severely limit or shut down operations.  Under later executive orders, Governor Whitmer a phased reopening of businesses, subject to stringent health and safety requirements and strict social distancing measures.  As of September 30, 2020, most businesses in Michigan were allowed to be open in some capacity under the executive orders, subject to stringent health and safety requirements, strict social distancing measures and nonsurgical face mask requirements.

Congress passed a number of measures in late March 2020, designed to infuse cash into the economy to offset the negative impacts of business closings and restrictions.  The COVID-19 pandemic is a highly unusual, unprecedented and evolving public health and economic crisis and may have a negative material impact on the Company’s business, financial condition and results of operations and has had, and is likely to continue to have, a negative impact on many of our customers’ business, financial condition and results of operations.  Additionally, the negative consequences of the unprecedented economic shutdown nationally and in Michigan is likely to result in a higher level of future delinquencies, loan impairments and loan losses and require additional provisions for loan losses, which will have a negative impact on our results of operations.

The Company quickly responded to the changing environment by successfully executing its business continuity plan including implementing work from home arrangements and limiting branch activities.  As of September 30, 2020, branches were fully open with additional health and safety requirements to comply with Governor Whitmer’s then-current executive orders, including, among other things, daily deep cleaning, nonsurgical face mask requirements and strict social distancing measures.

On October 2, and 12, 2020, the Michigan Supreme Court issued decisions invalidating all of Governor Whitmer’s executive orders effective immediately.  In response, Governor Whitmer, acting through various state agencies, has sought to substantially re-implement the requirements of the executive orders by way of state agency emergency orders.  Also, certain county and municipal governments have issued emergency orders seeking to keep elements of the executive orders in place.  Legal challenges to these orders may occur.  Finally, the Michigan legislature has passed legislation – which Governor Whitmer is expected to sign and enact into law – codifying certain elements of the executive orders.  The patchwork implementation of state agency and local government executive orders – coupled with the possibility of legal challenges to these orders – creates uncertainty as to legal requirements applicable to businesses, institutions and individuals in Michigan.  This uncertainty may have a negative impact on the business, financial condition, and results of operations of the Company and its customers.

On March 22, 2020, the federal banking agencies issued an “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus”.  This guidance encourages financial institutions to work prudently with borrowers that may be unable to meet their contractual obligations because of the effects of COVID-19.  The guidance goes on to explain that in consultation with the FASB staff that the federal banking agencies conclude that short-term modifications (e.g. six months) made on a good faith basis to borrowers who were current as of the implementation date of a relief program are not Troubled Debt Restructurings (“TDRs”).  The Coronavirus Aid, Relief and Economic Security (“CARES”) Act was passed by Congress on March 27, 2020.  Section 4013 of the CARES Act also addressed COVID-19 related modifications and specified that COVID-19 related modifications on loans that were current as of December 31, 2019 are not TDRs.  Through September 30, 2020, the Bank had applied this guidance and modified 726 individual loans with aggregate principal balances totaling $337.2 million.  The majority of these modifications involved three-month extensions.

-38-

By September 30, 2020, most of these modifications had expired, other than those receiving a second short-term modification as allowed under the guidance.  At September 30, 2020, there were 26 such loans under COVID-19 modifications, totaling $79.9 million.  This is down from a quarter end peak of $297.3 million at June 30, 2020.  The table below shows the number and balances of loans with such modifications as of the last three quarter end dates (dollars in thousands):

   
Number of COVID-19
Modifications
   
Outstanding Balance of
COVID-19 Modifications
 
March 31, 2020
   
176
   
$
87,917
 
June 30, 2020
   
599
     
297,269
 
September 30, 2020
   
26
     
79,894
 

The CARES Act, as amended, included an allocation of $659 billion for loans to be issued by financial institutions through the Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”).   PPP loans are forgivable, in whole or in part, if the proceeds are used for payroll and other permitted purposes in accordance with the requirements of the PPP.  These loans carry a fixed rate of 1.00% and a term of two years (loans made before June 5, 2020) or five years (loans made on or after June 5, 2020), if not forgiven, in whole or in part.  Payments are deferred until either the date on which the SBA remits the amount of forgiveness proceeds to the lender or the date that is 10 months after the last day of the covered period if the borrower does not apply for forgiveness within that 10 month period. The loans are 100% guaranteed by the SBA.  Through September 30, 2020, the Bank had originated 1,738 PPP loans totaling $346.7 million in principal, with an average loan size of $200,000.   Fees totaling $10.0 million were collected from the SBA for these loans in the nine months ended September 30, 2020.  These fees are deferred and amortized into interest income over the contractual period of 24 months or 60 months, as applicable.  Upon SBA forgiveness, unamortized fees are then recognized into interest income.  Participation in the PPP had a significant impact on the Bank’s asset mix and net interest income in the second and third quarters of 2020 and will continue to impact both asset mix and net interest income for the remainder of 2020.  The PPP program expired on August 8, 2020.
 
We are in an asset-sensitive position, so decreases in short-term interest rates have a net negative impact on our net interest income as our interest-earning assets will reprice faster than our interest-bearing liabilities.  Given our asset-sensitivity, several years ago we established floors on our variable rate loans to help offset the negative impact of declining interest rates on net interest income.  The benefit of these floors has become more evident in the second and third quarters of 2020 and will be in future quarters if the Federal Reserve maintains short-term interest rates at the low level established in March 2020.  Additionally, our PPP loan origination activity should provide some offsetting positive impact on earnings in the remainder of 2020, considering interest income on the loans and the processing fees paid by the SBA.  The processing fees, alone, on the PPP loans originated in 2020 amount to $10.0 million, of which $938,000 was recognized in the second quarter of 2020 and $1.2 million was recognized in the third quarter of 2020. We expect the majority of the remaining fees will be recognized in the fourth quarter of 2020 and early 2021 as the related loans are forgiven by the SBA.  This expectation is subject to change due to borrower behavior, changing SBA requirements and processes related to loan forgiveness and other relevant factors. While the effects of COVID-19 are likely to have a far-reaching, long-lasting effect on the global, national, and Michigan economies, we believe we have sufficient capital and financial strength, as well as liquidity resources to mitigate the effects of the COVID-19 pandemic on our operations and financial condition, while continuing to serve our communities and protect shareholder value.
 
RESULTS OF OPERATIONS
 
Summary: Net income for the three months ended September 30, 2020 was $7.1 million, compared to $8.2 million for the same period in 2019.  Net income per share on a diluted basis for the three months ended September 30, 2020 was $0.21 compared to $0.24 for the same period in 2019.  Net income for the nine months ended September 30, 2020 was $21.2 million, compared to $23.8 million for the same period in 2019.  Net income per share on a diluted basis for the nine months ended September 30, 2020 was $0.62 compared to $0.70 for the same period in 2019.
 
The decrease in earnings in both the three and nine months ended September 30, 2020 compared to the same periods in 2019 was due primarily to decreased net interest income and higher provision for loan losses.  Net interest income decreased to $14.7 million in the three months ended September 30, 2020 compared to $15.8 million in the same period in 2019.  Net interest income decreased to $45.0 million in the nine months ended September 30, 2020 compared to $47.8 million in the nine months ended September 30, 2019.  These decreases in net interest income were primarily attributable to the decreases in short-term interest rates instituted by the Federal Reserve starting in July 2019 and through March 2020.
 
The provision for loan losses was $500,000 for the three months ended September 30, 2020, compared to $0 for the same period in 2019.  The provision for loan losses was $2.2 million for the nine months ended September 30, 2020, compared to a negative $450,000 for the same period in 2019.  We were in a net loan recovery position for the three months ended September 30, 2020, with $203,000 in net loan recoveries, compared to $259,000 in net loan recoveries in the same period in 2019.  We were in a net loan charge-off position for the nine months ended September 30, 2020, with $2.8 million in net loan charge-offs compared to $719,000 in net loan recoveries in the same period in 2019.  The nine month period ended September 30, 2020 was impacted by a $4.1 million charge-off taken in June 2020 related to a single loan relationship with a movie theater business where the underlying assets were sold through bankruptcy proceedings.  The increase in provision for loan losses in the 2020 periods was also impacted by increases to qualitative environmental factors to address increased risk of loss attributable to the COVID-19 pandemic.  Each of these items is discussed more fully below.
 
-39-

Net Interest Income: Net interest income totaled $14.7 million for the three months ended September 30, 2020 compared to $15.8 million for the same period in 2019.  Net interest income decreased to $45.0 million in the nine months ended September 30, 2020 compared to $47.8 million in the nine months ended September 30, 2019.
 
Net interest income was positively impacted in the three months ended September 30, 2020 by an increase in average earning assets of $494.7 million compared to the same period in 2019.  However, our average yield on earning assets for the three months ended September 30, 2020 decreased 134 basis points compared to the same period in 2019 from 3.96% to 2.62%, more than offsetting the positive impact of the earning assets growth. For the nine months ended September 30, 2020, our average earning assets increased by $305.2 million compared to the same period in 2019, while our average yield on earning assets decreased 105 basis points compared to the same period in 2019 from 4.12% to 3.07%.

Net interest income for the third quarter of 2020 decreased $1.2 million compared to the same period in 2019.  Of this decrease, $5.6 million was due to changes in rates earned or paid, partially offset by an increase of $4.4 million from changes in the volume of average interest assets and interest bearing liabilities.  The largest changes came from interest income on commercial loans (excluding PPP loans) which fluctuated significantly in the third quarter of 2020 compared to the same period in 2019.  The net change was $2.9 million with a decrease in interest income due to rate of $2.0 million and a decrease in interest income of $946,000 due to portfolio contraction.  PPP loans contributed $2.1 million in net interest income in the third quarter of 2020.  The other large change came in federal funds sold and other short-term investments interest income which decreased by $1.3 million in the third quarter of 2020 compared to the same period in 2019.  Of the $1.3 million decrease in interest income on federal funds sold and other short-term investments, $6.2 million was due to decreases in rates earned, partially offset by a $4.9 million increase from increases in average balances.

Average interest earning assets totaled $2.42 billion for the three months ended September 30, 2020 compared to $1.92 billion for the same period in 2019. An increase of $196.0 million in average loans between periods and an increase of $279.6 million in average federal funds sold and other short-term investments were the primary drivers of the increases.  The net interest margin was 2.43% for the three months ended September 30, 2020 compared to 3.29% for the same period in 2019.  Yield on commercial loans excluding PPP loans decreased from 4.67% for the three months ended September 30, 2019 to 3.88% for the same period in 2020.  Yield on residential mortgage loans decreased from 3.73% for the three months ended September 30, 2019 to 3.64% for the same period in 2020, while yields on consumer loans decreased from 5.22% for the third quarter of 2019 to 4.14% for the third quarter of 2020.  The decreases in yields on commercial loans and consumer loans, in particular, were the result of the predominance of loans in these categories with variable rates of interest tied to prime and LIBOR which decreased significantly from 2019 to 2020.
 
The Federal Reserve Board decreased the target federal funds rate by 50 basis points in the third quarter of 2019 and by 25 basis points in the fourth quarter of 2019 as the economy showed signs of slowing.   In response to the news and government action related to COVID-19, the Federal Reserve Board decreased the target federal funds rate by 150 basis points in March 2020.  As the Company is in an asset-sensitive position, reductions in market interest rates have a negative impact on margin as the Company’s interest earning assets reprice faster than its interest-bearing liabilities. Much of our asset-sensitivity is due to commercial and consumer loans that have variable interest rates.  For both loan types we established floor rates several years ago.  These floors provide protection to net interest income when short-term interest rates decline.  Our variable rate commercial and consumer loans tied to the prime rate or one-month LIBOR amounted to $506.2 million at September 30, 2020.  Of this total, approximately 75.1%, or $380.4 million have interest rate floors. Without these floors net interest income for the third quarter of 2020 would have been lower than stated by approximately $1.0 million.

The cost of funds decreased to 0.29% in the third quarter of 2020 compared to 0.96% in the third quarter of 2019. For the first nine months of 2020, the cost of funds decreased to 0.44% compared to 0.99% for the same period in 2019.  The sharp drop in the rates paid on our interest-bearing checking, savings and money market accounts in response to the federal funds rate decreases in the first quarter of 2020 and in the third and fourth quarters of 2019 caused the decrease in our cost of funds.  Also contributing to the reduction in the cost of funds is our redemption of $20.0 million in trust preferred securities on December 31, 2019, so there was no related interest expense in the 2020 periods.

-40-

The following table shows an analysis of net interest margin for the three month periods ended September 30, 2020 and 2019 (dollars in thousands):

   
For the three months ended September 30,
 
   
2020
   
2019
 
   
Average
Balance
   
Interest
Earned
or Paid
   
Average
Yield
or Cost
   
Average
Balance
   
Interest
Earned
or Paid
   
Average
Yield
or Cost
 
Assets
                                   
Taxable securities
 
$
179,887
   
$
867
     
1.92
%
 
$
171,290
   
$
968
     
2.26
%
Tax-exempt securities (1)
   
137,351
     
861
     
3.23
     
126,820
     
919
     
3.73
 
Commercial loans (2)
   
955,695
     
9,480
     
3.88
     
1,039,518
     
12,408
     
4.67
 
Paycheck protection program loans (3)
   
346,073
     
2,067
     
2.34
     
     
     
 
Residential mortgage loans
   
175,978
     
1,604
     
3.64
     
230,391
     
2,150
     
3.73
 
Consumer loans
   
67,549
     
703
     
4.14
     
79,372
     
1,045
     
5.22
 
Federal Home Loan Bank stock
   
11,558
     
100
     
3.41
     
11,558
     
159
     
5.37
 
Federal funds sold and other short-term investments
   
541,981
     
140
     
0.10
     
262,397
     
1,430
     
2.13
 
Total interest earning assets (1)
   
2,416,072
     
15,822
     
2.62
     
1,921,346
     
19,079
     
3.96
 
Noninterest earning assets:
                                               
Cash and due from banks
   
35,737
                     
35,471
                 
Other
   
102,389
                     
92,189
                 
Total assets
 
$
2,554,198
                   
$
2,049,006
                 
Liabilities
                                               
Deposits:
                                               
Interest bearing demand
 
$
587,356
   
$
78
     
0.05
%
 
$
455,799
   
$
342
     
0.30
%
Savings and money market accounts
   
743,612
     
121
     
0.07
     
632,632
     
1,236
     
0.78
 
Time deposits
   
128,551
     
422
     
1.31
     
152,091
     
765
     
1.99
 
Borrowings:
                                               
Other borrowed funds
   
72,057
     
364
     
1.97
     
60,000
     
349
     
2.27
 
Long-term debt
   
20,619
     
163
     
3.10
     
41,238
     
551
     
5.23
 
Total interest bearing liabilities
   
1,552,195
     
1,148
     
0.29
     
1,341,760
     
3,243
     
0.96
 
Noninterest bearing liabilities:
                                               
Noninterest bearing demand accounts
   
755,990
                     
488,135
                 
Other noninterest bearing liabilities
   
14,311
                     
11,080
                 
Shareholders' equity
   
231,702
                     
208,031
                 
Total liabilities and shareholders' equity
 
$
2,554,198
                   
$
2,049,006
                 
Net interest income
         
$
14,674
                   
$
15,836
         
Net interest spread (1)
                   
2.33
%
                   
3.00
%
Net interest margin (1)
                   
2.43
%
                   
3.29
%
Ratio of average interest earning assets to average interest bearing liabilities
   
155.66
%
                   
143.20
%
               

(1)
Yields are presented on a tax equivalent basis using an assumed tax rate of 21% at September 30, 2020 and 2019.
(2)
Includes loan fees of $152,000 and $146,000 for the three months ended September 30, 2020 and 2019, respectively.  Includes average nonaccrual loans of approximately $196,000 and $210,000 for the three months ended September 30, 2020 and 2019, respectively.  Excludes paycheck protection program loans.
(3)
Includes loan fees of $1.2 million for the three months ended September 30, 2020.

-41-

The following table shows an analysis of net interest margin for the nine month periods ended September 30, 2020 and 2019 (dollars in thousands):
 
   
For the nine months ended September 30,
 
   
2020
   
2019
 
   
Average
Balance
   
Interest
Earned
or Paid
   
Average
Yield
or Cost
   
Average
Balance
   
Interest
Earned
or Paid
   
Average
Yield
or Cost
 
Assets
                                   
Taxable securities
 
$
184,809
   
$
2,882
     
2.08
%
 
$
177,969
   
$
2,952
     
2.21
%
Tax-exempt securities (1)
   
132,471
     
2,607
     
3.38
     
120,505
     
2,623
     
3.73
 
Commercial loans (2)
   
1,035,247
     
31,882
     
4.06
     
1,055,873
     
38,428
     
4.80
 
Paycheck protection program loans (3)
   
203,875
     
3,682
     
2.38
     
     
     
 
Residential mortgage loans
   
190,782
     
5,275
     
3.69
     
234,823
     
6,541
     
3.71
 
Consumer loans
   
71,732
     
2,354
     
4.38
     
81,222
     
3,211
     
5.29
 
Federal Home Loan Bank stock
   
11,558
     
339
     
3.86
     
11,558
     
475
     
5.42
 
Federal funds sold and other short-term investments
   
346,900
     
802
     
0.30
     
190,245
     
3,278
     
2.27
 
Total interest earning assets (1)
   
2,177,374
     
49,823
     
3.07
     
1,872,195
     
57,508
     
4.12
 
Noninterest earning assets:
                                               
Cash and due from banks
   
30,572
                     
31,649
                 
Other
   
96,605
                     
88,587
                 
Total assets
 
$
2,304,551
                   
$
1,992,431
                 
Liabilities
                                               
Deposits:
                                               
Interest bearing demand
 
$
510,181
   
$
356
     
0.09
%
 
$
442,789
   
$
1,175
     
0.36
%
Savings and money market accounts
   
698,097
     
1,050
     
0.20
     
619,861
     
3,678
     
0.79
 
Time deposits
   
141,762
     
1,712
     
1.62
     
146,142
     
2,113
     
1.94
 
Borrowings:
                                               
Other borrowed funds
   
68,610
     
1,069
     
2.06
     
59,954
     
1,020
     
2.24
 
Long-term debt
   
20,619
     
612
     
3.90
     
41,238
     
1,710
     
5.47
 
Total interest bearing liabilities
   
1,439,269
     
4,799
     
0.44
     
1,309,984
     
9,696
     
0.99
 
Noninterest bearing liabilities:
                                               
Noninterest bearing demand accounts
   
625,759
                     
472,345
                 
Other noninterest bearing liabilities
   
13,327
                     
9,255
                 
Shareholders' equity
   
226,196
                     
200,847
                 
Total liabilities and shareholders' equity
 
$
2,304,551
                   
$
1,992,431
                 
Net interest income
         
$
45,024
                   
$
47,812
         
Net interest spread (1)
                   
2.63
%
                   
3.13
%
Net interest margin (1)
                   
2.77
%
                   
3.43
%
Ratio of average interest earning assets to average interest bearing liabilities
   
151.28
%
                   
142.92
%
               
 
(1)
Yields are presented on a tax equivalent basis using an assumed tax rate of 21% at September 30, 2020 and 2019.
(2)
Includes loan fees of $612,000 and $660,000 for the nine months ended September 30, 2020 and 2019, respectively. Includes average nonaccrual loans of approximately $2.8 million and $431,000 for the nine months ended September 30, 2020 and 2019, respectively. Excludes paycheck protection program loans.
(3)
Includes loan fees of $2.1 million for the nine months ended September 30, 2020.

-42-

The following table presents the dollar amount of changes in net interest income due to changes in volume and rate (dollars in thousands):

   
For the three months ended September 30,
2020 vs 2019
Increase (Decrease) Due to
   
For the nine months ended September 30,
2020 vs 2019
Increase (Decrease) Due to
 
   
Volume
   
Rate
   
Total
   
Volume
   
Rate
   
Total
 
                                     
Interest income
                                   
Taxable securities
 
$
264
   
$
(365
)
 
$
(101
)
 
$
157
   
$
(227
)
 
$
(70
)
Tax-exempt securities
   
463
     
(521
)
   
(58
)
   
430
     
(446
)
   
(16
)
Commercial loans, excluding PPP loans
   
(946
)
   
(1,982
)
   
(2,928
)
   
(738
)
   
(5,808
)
   
(6,546
)
Paycheck protection program loans
   
2,067
     
     
2,067
     
3,682
     
     
3,682
 
Residential mortgage loans
   
(497
)
   
(49
)
   
(546
)
   
(1,218
)
   
(48
)
   
(1,266
)
Consumer loans
   
(142
)
   
(200
)
   
(342
)
   
(346
)
   
(511
)
   
(857
)
Federal Home Loan Bank stock
   
     
(59
)
   
(59
)
   
     
(136
)
   
(136
)
Federal funds sold and other short-term investments
   
4,948
     
(6,238
)
   
(1,290
)
   
2,438
     
(4,914
)
   
(2,476
)
Total interest income
   
6,157
     
(9,414
)
   
(3,257
)
   
4,405
     
(12,090
)
   
(7,685
)
Interest expense
                                               
Interest bearing demand
 
$
516
   
$
(780
)
 
$
(264
)
 
$
255
   
$
(1,074
)
 
$
(819
)
Savings and money market accounts
   
1,277
     
(2,392
)
   
(1,115
)
   
679
     
(3,307
)
   
(2,628
)
Time deposits
   
(106
)
   
(237
)
   
(343
)
   
(62
)
   
(339
)
   
(401
)
Other borrowed funds
   
226
     
(211
)
   
15
     
174
     
(125
)
   
49
 
Long-term debt
   
(214
)
   
(174
)
   
(388
)
   
(698
)
   
(400
)
   
(1,098
)
Total interest expense
   
1,699
     
(3,794
)
   
(2,095
)
   
348
     
(5,245
)
   
(4,897
)
Net interest income
 
$
4,458
   
$
(5,620
)
 
$
(1,162
)
 
$
4,057
   
$
(6,845
)
 
$
(2,788
)

Provision for Loan Losses: The provision for loan losses for the three months ended September 30, 2020 was $500,000 compared to $0 for the same period in 2019.  The provision for loan losses for the first nine months of 2020 was $2.2 million compared to a negative $450,000 for the same period in 2019.  The provisions for loan losses for the 2020 periods were impacted by additional qualitative adjustments made to provide for estimated losses associated with the COVID-19 pandemic as well as the large charge-off taken in June 2020, some of which was specifically reserved for previously. A $4.1 million charge-off was taken in June 2020 related to a single loan relationship with a movie theater business for which the underlying assets were sold through bankruptcy proceedings.  No other loans of this industry type remain in our portfolio.  This was partially offset by continued strong asset quality metrics and loan portfolio contraction.  The balances of loans graded 5 and 6, which receive higher allocations, decreased by $5.0 million from December 31, 2019 to September 30, 2020.  Specific reserves on impaired loans decreased by $608,000 from $1.6 million at December 31, 2019 to $1.0 million at September 30, 2020.  When excluding PPP loans, which are 100% guaranteed by the SBA, total loans decreased by $22.8 million in the three months ended September 30, 2020.  Net loan recoveries were $203,000 in the three months ended September 30, 2020 compared to net loan recoveries of $259,000 in the same period in 2019.
 
Gross loan recoveries were $227,000 for the three months ended September 30, 2020 and $307,000 for the same period in 2019.  In the three months ended September 30, 2020, we had $24,000 in charge-offs, compared to $48,000 in the same period in 2019.  For the nine months ended September 30, 2020, we experienced gross loan recoveries of $1.4 million compared to $965,000 for the same period in 2019.  Gross charge-offs for the nine months ended September 30, 2020 were $4.2 million compared to $246,000 for the same period in 2019.
 
The amounts of loan loss provision in both the most recent quarter and comparable prior year period were the result of establishing our allowance for loan losses at levels believed necessary based upon our methodology for determining the adequacy of the allowance.  More information about our allowance for loan losses and our methodology for establishing its level may be found under the heading "Allowance for Loan Losses" below.

-43-

Noninterest Income: Noninterest income for the three and nine month periods ended September 30, 2020 was $6.1 million and $16.9 million compared to $5.2 million and $14.6 million for the same periods in 2019, respectively.   The components of noninterest income are shown in the table below (in thousands):

   
Three Months
Ended
September 30,
2020
   
Three Months
Ended
September 30,
2019
   
Nine Months
Ended
September 30,
2020
   
Nine Months
Ended
September 30,
2019
 
Service charges and fees on deposit accounts
 
$
987
   
$
1,139
   
$
2,957
   
$
3,267
 
Net gains on mortgage loans
   
1,546
     
824
     
4,045
     
1,650
 
Trust fees
   
921
     
920
     
2,801
     
2,813
 
ATM and debit card fees
   
1,542
     
1,469
     
4,199
     
4,276
 
Bank owned life insurance (“BOLI”) income
   
215
     
252
     
688
     
737
 
Investment services fees
   
328
     
286
     
980
     
934
 
Other income
   
553
     
323
     
1,234
     
962
 
Total noninterest income
 
$
6,092
   
$
5,213
   
$
16,904
   
$
14,639
 
 
Net gains on mortgage loans were up $722,000 in the three months ended September 30, 2020 and were up $2.4 million in the nine months ended September 30, 2020 compared to the same periods in 2019 as a result of an increase in the volume of loans originated for sale in the 2020 periods due to a lower interest rate environment, spurring more refinancing of fixed rate loans which we sell into the secondary market.  Mortgage loans originated for sale in the three months ended September 30, 2020 were $40.8 million, compared to $24.9 million in the same period in 2019.  For the first nine months of 2020, mortgages originated for sale were $120.2 million, compared to $53.7 million for the same period in 2019.
 
Investment services fees were up $43,000 in the three months ended September 30, 2020 and were up $46,000 in the nine months ended September 30, 2020 compared to the three and nine months ended September 30, 2019, respectively.  ATM and debit card fees were up $73,000 in the three months ended September 30, 2020 and down $77,000 in the nine months ended September 30, 2020 as compared to the three and nine months ended September 30, 2019, respectively. We saw reduced volume of usage by our customers during the COVID-19 shutdown of the economy in the second quarter of 2020 and a return to normal volumes in the third quarter of 2020.  Service charges on deposit accounts decreased in the three and nine months ended September 30, 2020 as compared to the same periods in 2019 due to lower overdraft fees as our customers have generally retained higher deposit balances in the low interest rate environment and due to uncertainty related to the COVID-19 pandemic, thereby resulting in fewer overdrafts.  That said, these fees have increased in the third quarter of 2020 compared to the second quarter of 2020 as businesses reopened and economic activity began to recover.
 
Other income was up in the three and nine months ended September 30, 2020 due to fees collected on customer back-to-back interest rate swaps.  These fees were up $253,000 and $402,000 in the three and nine month periods ended September 30, 2020, respectively.
 
Noninterest Expense: Noninterest expense increased by $524,000 to $11.5 million for the three month period ended September 30, 2020 as compared to the same period in 2019.  Noninterest expense increased by $177,000 to $33.8 million for the nine months ended September 30, 2020 compared to $33.6 million for the same period in 2019.  The components of noninterest expense are shown in the table below (in thousands):

   
Three Months
Ended
September 30,
2020
   
Three Months
Ended
September 30,
2019
   
Nine Months
Ended
September 30,
2020
   
Nine Months
Ended
September 30,
2019
 
Salaries and benefits
 
$
6,480
   
$
6,272
   
$
18,937
   
$
18,895
 
Occupancy of premises
   
1,026
     
966
     
2,984
     
3,055
 
Furniture and equipment
   
967
     
887
     
2,704
     
2,597
 
Legal and professional
   
260
     
211
     
798
     
652
 
Marketing and promotion
   
239
     
228
     
716
     
689
 
Data processing
   
761
     
735
     
2,309
     
2,226
 
FDIC assessment
   
131
     
     
207
     
239
 
Interchange and other card expense
   
367
     
347
     
1,041
     
1,057
 
Bond and D&O insurance
   
104
     
103
     
313
     
309
 
Net (gains) losses on repossessed and foreclosed properties
   
     
     
32
     
(69
)
Administration and disposition of problem assets
   
25
     
46
     
71
     
183
 
Outside services
   
491
     
403
     
1,322
     
1,348
 
Other noninterest expense
   
682
     
811
     
2,325
     
2,401
 
Total noninterest expense
 
$
11,533
   
$
11,009
   
$
33,759
   
$
33,582
 

-44-

Most categories of noninterest expense were relatively unchanged compared to the three months ended September 30, 2019 due to our ongoing efforts to manage expenses and scale our operations. Our largest component of noninterest expense, salaries and benefits, increased by $208,000 in the three months ended September 30, 2020 from same period in 2019. This increase was due primarily to an increase in salaries and compensation and an increase in variable-based compensation due to higher mortgage origination volume. Salaries and benefits increased by $42,000 for the nine months ended September 30, 2020 compared to the nine months ended September 30, 2019 due to the same combination of factors.  Benefitting the 2020 periods was a decrease in our medical insurance plan as we experienced lower claims, and higher cost deferrals from commercial loan production associated with the origination of PPP loans. The 401k match and the bonus accruals that were curtailed in the second quarter of 2020 in reaction to the uncertainty surrounding the COVID-19 pandemic were reinstated during the third quarter of 2020. The table below identifies the primary components of salaries and benefits (in thousands):
 
   
Three Months
Ended
September 30,
2020
   
Three Months
Ended
September 30,
2019
   
Nine Months
Ended
September 30,
2020
   
Nine Months
Ended
September 30,
2019
 
Salaries and other compensation
   
5,678
     
5,520
     
16,919
     
16,333
 
Salary deferral from commercial loans
   
(229
)
   
(219
)
   
(899
)
   
(601
)
Bonus accrual
   
296
     
284
     
619
     
853
 
Mortgage production - variable comp
   
316
     
228
     
834
     
434
 
401k matching contributions
   
194
     
183
     
464
     
555
 
Medical insurance costs
   
225
     
276
     
1,000
     
1,321
 
Total salaries and benefits
 
$
6,480
   
$
6,272
   
$
18,937
   
$
18,895
 
 
Occupancy expenses were up $60,000 in the three months ended September 30, 2020 and were down $71,000 in the nine months ended September 30, 2020 compared to the same periods in 2019 due to maintenance costs incurred associated with branch facilities.  Furniture and equipment expenses were up $80,000 in the three months ended September 30, 2020 and were up $107,000 in the nine months ended September 30, 2020 compared to the same periods in 2019 due to costs associated with equipment and service contracts.
 
Our FDIC assessment costs increased by $131,000 in the three months ended September 30, 2020 compared to the same period in 2019 due to our full utilization of assessment credits. In January 2019, the FDIC notified us that the Bank would receive an assessment credit of approximately $400,000 to offset future assessments as the FDIC Deposit Insurance Fund had exceeded its target ratio of 1.35%. Assessment credits totaling $266,000 were applied in the third and fourth quarters of 2019, $136,000 was applied in the first quarter of 2020 and the remaining $36,000 was applied in the second quarter of 2020. Expenses for future periods will increase as the Bank has utilized all of its assessment credits.
 
Costs associated with administration and disposition of problem assets have decreased significantly over the past several years.  These expenses include legal costs and repossessed and foreclosed property administration expense. Repossessed and foreclosed property administration expense includes survey and appraisal, property maintenance and management and other disposition and carrying costs.  Net (gains) losses on repossessed and foreclosed properties include both net gains and losses on the sale of properties and unrealized losses from value declines for outstanding properties.
 
These costs are itemized in the following table (in thousands):

   
Three Months
Ended
September 30,
2020
   
Three Months
Ended
September 30,
2019
   
Nine Months
Ended
September 30,
2020
   
Nine Months
Ended
September 30,
2019
 
Legal and professional – nonperforming assets
 
$
14
   
$
19
   
$
38
   
$
69
 
Repossessed and foreclosed property administration
   
11
     
27
     
33
     
68
 
Net (gains) losses on repossessed and foreclosed properties
   
     
     
32
     
(69
)
Total
 
$
25
   
$
46
   
$
103
   
$
68
 

As the level of problem loans and assets has declined, the costs associated with these nonperforming assets have decreased significantly over the past several years.  Other real estate owned decreased from $3.1 million at September 30, 2019 to $2.6 million at September 30, 2020.
 
For the first nine months of 2020, net (gains) losses on repossessed and foreclosed properties swung unfavorably by $101,000 compared to the same period in 2019.  The net increase in expense was due to an improvement in net gains realized in the 2019 period. There were no valuation writedowns in the three month periods ended September 30, 2020 and 2019. In the nine month period ended September 30, 2020, valuation writedowns totaled $32,000 compared to valuation writedowns of $10,000 for the same period in 2019. There were no realized gains or losses on repossessed assets and foreclosed properties in the three months ended September 30, 2020 and 2019.  For the nine months ended September 30, 2020, net realized gains totaled $0, compared to net realized gains of $79,000 for the same period in 2019.

-45-

Outside services were up $88,000 in the three month period ended September 30, 2020 and were down $26,000 in the nine month period ended September 30, 2020 compared to the same periods in 2019 due to ongoing efforts to manage and scale these costs.
 
Federal Income Tax Expense: We recorded $1.6 million and $4.8 million in federal income tax expense for the three and nine month periods ended September 30, 2020 compared to $1.9 million and $5.5 million for the same periods in 2019.  Our effective tax rates for the three and nine month periods ended September 30, 2020 were 18.47% and 18.48%, respectively, compared to 18.75% and 18.80% for the same periods in 2019.
 
FINANCIAL CONDITION
 
Total assets were $2.51 billion at September 30, 2020, an increase of $439.9 million from December 31, 2019. This change reflected increases of $260.6 million in cash and cash equivalents, $4.7 million in securities available for sale, $8.7 million in securities held to maturity, $339.2 million in PPP loans, and $5.7 million in other assets, partially offset by decreases of $182.5 million in our loan portfolio excluding PPP loans. Total deposits increased by $417.3 million at September 30, 2020 compared to December 31, 2019.
 
Cash and Cash Equivalents: Our cash and cash equivalents, which include federal funds sold and short-term investments, were $533.0 million at September 30, 2020 compared to $272.5 million at December 31, 2019.  The increase in these balances related to an increase in our total deposits due to customers holding higher balances, particularly liquid deposits, in the low interest rate environment and due to uncertainty related to the COVID-19 pandemic.
 
Securities: Debt securities available for sale were $229.9 million at September 30, 2020 compared to $225.2 million at December 31, 2019. The balance at September 30, 2020 primarily consisted of U.S. agency securities, agency mortgage backed securities and various municipal investments. Our held to maturity portfolio was $91.4 million at September 30, 2020 compared to $82.7 million at December 31, 2019.  Our held to maturity portfolio is comprised of state, municipal and privately placed commercial bonds.
 
Portfolio Loans and Asset Quality: Total portfolio loans increased by $156.7 million in the first nine months of 2020 and were $1.54 billion at September 30, 2020 compared to $1.39 billion at December 31, 2019. During the first nine months of 2020, our commercial portfolio increased by $212.7 million.  The SBA created the Paycheck Protection Program to provide an efficient means to provide funding for small businesses to maintain payroll and operations during the COVID-19 pandemic.  We are an active participant in this program and originated a total of 1,738 loans totaling $346.7 million in principal in first nine months of 2020.  Borrowers who use the funds from their PPP loans to maintain payroll and for certain fixed expenses such as rent, occupancy, etc. are eligible to have 100% of their loans forgiven by the SBA.  We expect a substantial majority of our PPP borrowers will apply for and receive approval for loan forgiveness by early 2021.  This expectation is subject to change due to borrower behavior, changing SBA requirements and processes relating to loan forgiveness and other relevant factors.  In early October 2020, the SBA issued a streamlined forgiveness application for PPP loans under $50,000.  This should accelerate the forgiveness timeline for small loans.  Through October 20, 2020, we have received forgiveness proceeds from the SBA totaling $3.1 million for PPP forgiveness applications submitted to date amounting to $90.5 million.  Excluding the PPP originations, our commercial loans decreased by $125.4 million in the first nine months of 2020.  Our consumer portfolio decreased by $10.9 million and our residential mortgage portfolio decreased by $46.2 million in the first nine months of 2020.
 
Mortgage loans originated for portfolio are typically adjustable rate loans as well as fixed rate loans that conform to secondary market requirements and have a term of fifteen years or less.  Mortgage loans originated for portfolio in the first nine months of 2020 increased $127,000 compared to the same period in 2019, from $29.2 million in the first nine months of 2019 to $29.3 million in the same period in 2020.
 
The volume of residential mortgage loans originated for sale in the first nine months of 2020 increased $66.5 million compared to the same period in 2019. Residential mortgage loans originated for sale were $120.2 million in the first nine months of 2020 compared to $53.7 million in the first nine months of 2019.

-46-

The following table shows our loan origination activity for loans to be held in portfolio during the first nine months of 2020 and 2019, broken out by loan type and also shows average originated loan size (dollars in thousands):

   
Nine months ended September 30, 2020
   
Nine months ended September 30, 2019
 
   
Portfolio
Originations
   
Percent of
Total
Originations
   
Average
Loan Size
   
Portfolio
Originations
   
Percent of
Total
Originations
   
Average
Loan Size
 
Commercial real estate:
                                   
Residential developed
 
$
3,035
     
0.5
%
   
217
   
$
6,042
     
2.1
%
   
302
 
Unsecured to residential developers
   
170
     
     
170
     
     
     
 
Vacant and unimproved
   
23,943
     
3.7
     
2,394
     
2,179
     
0.7
     
436
 
Commercial development
   
     
     
     
     
     
 
Residential improved
   
45,463
     
7.0
     
425
     
39,059
     
13.6
     
315
 
Commercial improved
   
45,493
     
7.0
     
1,379
     
54,463
     
18.9
     
1,184
 
Manufacturing and industrial
   
12,098
     
1.9
     
432
     
14,384
     
5.0
     
899
 
Total commercial real estate
   
130,202
     
20.1
     
675
     
116,127
     
40.3
     
550
 
Commercial and industrial (1)
   
458,588
     
70.8
     
246
     
110,289
     
38.3
     
702
 
Total commercial
   
588,790
     
90.9
     
287
     
226,416
     
78.6
     
615
 
Consumer
                                               
Residential mortgage
   
29,327
     
4.5
     
333
     
29,174
     
10.1
     
260
 
Unsecured
   
21
     
     
11
     
     
     
 
Home equity
   
28,727
     
4.4
     
112
     
30,383
     
10.6
     
107
 
Other secured
   
1,003
     
0.2
     
15
     
2,090
     
0.7
     
23
 
Total consumer
   
59,078
     
9.1
     
142
     
61,647
     
21.4
     
127
 
Total loans
 
$
647,868
     
100.0
%
   
262
   
$
288,063
     
100.0
%
   
338
 


(1)
Nine months ended September 30, 2020 includes $346.7 million in PPP loan originations

The following table shows a breakout of our commercial loan activity during the first nine months of 2020 and 2019 (dollars in thousands):

   
Nine Months
Ended
September 30,
2020
   
Nine Months
Ended
September 30,
2019
 
Commercial loans originated (1)
 
$
588,790
   
$
226,416
 
Repayments of commercial loans
   
(288,049
)
   
(237,205
)
Change in undistributed - available credit
   
(86,930
)
   
1,286
 
Net increase (decrease) in total commercial loans
 
$
213,811
   
$
(9,503
)


(1)
Nine months ended September 30, 2020 includes $346.7 million in PPP loan originations

Overall, the commercial loan portfolio increased $213.8 million in the first nine months of 2020.  Our commercial and industrial portfolio increased by $253.3 million while our commercial real estate loans decreased by $39.5 million.  As discussed above, included in the commercial production for the first nine months of 2020 is $346.7 million in PPP loans.  Our overall production of commercial loans increased by $362.4 million, predominantly due to the PPP loans, from $226.4 million in the first nine months of 2019 to $588.8 million in the same period of 2020.  Beyond the effect of the PPP loan production, our commercial and industrial portfolio is subject to seasonal fluctuations includes floor plan loan lines to vehicle dealers, which were impacted by COVID-19.  The decline in borrowings in this sector was primarily the result of our dealers selling through their inventory but not being able to receive new inventory due to supply shortages from the COVID-19 shutdown of the economy.
 
Commercial and commercial real estate loans remained our largest loan segment and accounted for approximately 85.0% and 79.2% of the total loan portfolio at September 30, 2020 and December 31, 2019, respectively. Residential mortgage and consumer loans comprised approximately 15.0% and 20.8% of total loans at September 30, 2020 and December 31, 2019, respectively.

-47-

A further breakdown of the composition of the loan portfolio is shown in the table below (in thousands):

   
September 30, 2020
   
December 31, 2019
 
   
Balance
   
Percent of
Total Loans
   
Balance
   
Percent of
Total Loans
 
Commercial real estate: (1)
                       
Residential developed
 
$
10,072
     
0.6
%
 
$
14,705
     
1.1
%
Unsecured to residential developers
   
     
     
     
 
Vacant and unimproved
   
45,534
     
3.0
     
41,796
     
3.0
 
Commercial development
   
605
     
     
665
     
0.1
 
Residential improved
   
117,202
     
7.6
     
130,861
     
9.4
 
Commercial improved
   
273,355
     
17.7
     
292,799
     
21.1
 
Manufacturing and industrial
   
112,155
     
7.3
     
117,632
     
8.5
 
Total commercial real estate
   
558,923
     
36.2
     
598,458
     
43.2
 
Commercial and industrial (2)
   
752,918
     
48.8
     
499,572
     
36.0
 
Total commercial
   
1,311,841
     
85.0
     
1,098,030
     
79.2
 
Consumer
                               
Residential mortgage
   
164,818
     
10.7
     
211,049
     
15.3
 
Unsecured
   
189
     
     
274
     
 
Home equity
   
61,276
     
4.0
     
70,936
     
5.1
 
Other secured
   
4,211
     
0.3
     
5,338
     
0.4
 
Total consumer
   
230,494
     
15.0
     
287,597
     
20.8
 
Total loans
 
$
1,542,335
     
100.0
%
 
$
1,385,627
     
100.0
%


(1)
Includes both owner occupied and non-owner occupied commercial real estate.

(2)
September 30, 2020 balances include PPP loans totaling $339.2 million.
 
Commercial real estate loans accounted for 36.2% and 43.2% of the total loan portfolio at September 30, 2020 and December 31, 2019, respectively, and consisted primarily of loans to business owners and developers of owner and non-owner occupied commercial properties and loans to developers of single and multi-family residential properties. In the table above, we show our commercial real estate portfolio by loans secured by residential and commercial real estate, and by stage of development. Improved loans are generally secured by properties that are under construction or completed and placed in use. Development loans are secured by properties that are in the process of development or fully developed. Vacant and unimproved loans are secured by raw land for which development has not yet begun and agricultural land.
 
Our consumer residential mortgage loan portfolio, which also includes residential construction loans made to individual homeowners, comprised 10.7% of portfolio loans at September 30, 2020 and 15.3% at December 31, 2019.  We expect to continue to retain in our loan portfolio certain types of residential mortgage loans (primarily high quality, low loan-to-value loans) in an effort to continue to diversify our credit risk and deploy our excess liquidity.
 
The volume of residential mortgage loans originated for sale during the first nine months of 2020 increased significantly from the first nine months of 2019 as a result of interest rate conditions.  The decrease in market interest rates in early 2020 has caused an increase in refinancing of fixed rate mortgages which we sell into the secondary market.
 
Our portfolio of other consumer loans includes loans secured by personal property and home equity fixed term and line of credit loans. This portfolio decreased by $10.9 million to $65.7 million at September 30, 2020 from $76.5 million at December 31, 2019, due primarily to a decrease in home equity loans.  These other consumer loans comprised 4.3% of our portfolio loans at September 30, 2020 and 5.5% at December 31, 2019.
 
Our loan portfolio is reviewed regularly by our senior management, our loan officers, and an internal loan review team that is independent of our loan originators and credit administration. An administrative loan committee consisting of senior management and seasoned lending and collections personnel meets quarterly to manage our internal watch list and proactively manage high risk loans.
 
When reasonable doubt exists concerning collectability of interest or principal of one of our loans, the loan is placed in nonaccrual status. Any interest previously accrued but not collected is reversed and charged against current earnings.
 
Nonperforming assets are comprised of nonperforming loans, foreclosed assets and repossessed assets. At September 30, 2020, nonperforming assets totaled $2.8 million compared to $3.0 million at December 31, 2019. There were no additions to other real estate owned in the first nine months of 2020 or in the first nine months of 2019.  At September 30, 2020, there were no loans in redemption, so we expect there to be few additions to other real estate owned in the fourth quarter of 2020.  Proceeds from sales of foreclosed properties were $92,000 in the first nine months of 2020, resulting in net realized gain on sales of $0.  Proceeds from sales of foreclosed properties were $340,000 in the first nine months of 2019 resulting in net realized gain on sales of $79,000.

-48-

Nonperforming loans include loans on nonaccrual status and loans delinquent more than 90 days but still accruing.  Nonperforming loans at September 30, 2020 consisted of $97,000 of commercial real estate loans and $98,000 of consumer and residential mortgage loans.  As of September 30, 2020, nonperforming loans totaled $195,000, or 0.01% of total portfolio loans, compared to $203,000, or 0.01% of total portfolio loans, at December 31, 2019.
 
Foreclosed and repossessed assets include assets acquired in settlement of loans. Foreclosed assets totaled $2.6 million at September 30, 2020 and $2.7 million at December 31, 2019. The entire balance at September 30, 2020 was comprised of six commercial real estate properties. All properties acquired through or in lieu of foreclosure are initially transferred at their fair value less estimated costs to sell and then evaluated monthly for impairment after transfer using a lower of cost or market approach. Updated property valuations are obtained at least annually on all foreclosed assets.
 
At September 30, 2020, our foreclosed asset portfolio had a weighted average age held in portfolio of 8.6 years. Below is a breakout of our foreclosed asset portfolio at September 30, 2020 and December 31, 2019 by property type and the percentages the property has been written down since taken into our possession and the combined writedown percentage, including losses taken when the property was loan collateral (dollars in thousands):

   
September 30, 2020
   
December 31, 2019
 
Foreclosed Asset Property Type
 
Carrying
Value
   
Foreclosed
Asset
Writedown
   
Combined
Writedown
(Loan and
Foreclosed
Asset)
   
Carrying
Value
   
Foreclosed
Asset
Writedown
   
Combined
Writedown
(Loan and
Foreclosed
Asset)
 
Vacant Land
   
66
     
72.0
%
   
78.2
%
   
79
     
66.6
%
   
74.1
%
Residential Development
   
215
     
51.2
     
77.7
     
326
     
38.7
     
69.1
 
Commercial Improved
   
2,343
     
     
     
2,343
     
     
 
   
$
2,624
     
13.1
     
27.3
   
$
2,748
     
11.7
     
25.8
 

The following table shows the composition and amount of our nonperforming assets (dollars in thousands):
 
   
September 30,
2020
   
December 31,
2019
 
Nonaccrual loans
 
$
195
   
$
203
 
Loans 90 days or more delinquent and still accruing
   
     
 
Total nonperforming loans (NPLs)
   
195
     
203
 
Foreclosed assets
   
2,624
     
2,748
 
Repossessed assets
   
     
 
Total nonperforming assets (NPAs)
 
$
2,819
   
$
2,951
 
NPLs to total loans
   
0.01
%
   
0.01
%
NPAs to total assets
   
0.11
%
   
0.14
%

The following table shows the composition and amount of our troubled debt restructurings (TDRs) at September 30, 2020 and December 31, 2019 (dollars in thousands):

   
September 30, 2020
   
December 31, 2019
 
   
Commercial
   
Consumer
   
Total
   
Commercial
   
Consumer
   
Total
 
Performing TDRs
 
$
4,881
   
$
4,356
   
$
9,237
   
$
8,469
   
$
5,140
   
$
13,609
 
Nonperforming TDRs (1)
   
97
     
     
97
     
98
     
     
98
 
Total TDRs
 
$
4,978
   
$
4,356
   
$
9,334
   
$
8,567
   
$
5,140
   
$
13,707
 

(1)
Included in nonperforming asset table above
 
We had a total of $9.3 million and $13.7 million of loans whose terms have been modified in TDRs as of September 30, 2020 and December 31, 2019, respectively.  These loans may have involved the restructuring of terms to allow customers to mitigate the risk of foreclosure by meeting a lower loan payment requirement based upon their current cash flow.  These may also include loans that renewed at existing contractual rates, but below market rates for comparable credit.  For each restructuring, a comprehensive credit underwriting analysis of the borrower’s financial condition and prospects of repayment under the revised terms is performed to assess whether the structure can be successful and whether cash flows will be sufficient to support the restructured debt.  An analysis is also performed to determine whether the restructured loan should be on accrual status.  Generally, if the loan is on accrual at the time of restructure, it will remain on accrual after the restructuring.  In some cases, a nonaccrual loan may be placed on accrual at restructuring if the loan’s actual payment history demonstrates it would have cash flowed under the restructured terms.  After six consecutive payments under the restructured terms, a nonaccrual restructured loan is reviewed for possible upgrade to accruing status.  In situations where there is a subsequent modification or renewal and the loan is brought to market terms, including a contractual interest rate not less than a market interest rate for new debt with similar credit risk characteristics, the TDR and impaired designations may be removed.  Total TDRs decreased by $4.4 million from December 31, 2019 to September 30, 2020 due to payoffs and paydowns on existing TDRs exceeding new additions.  There were 82 loans identified as TDRs at September 30, 2020 compared to 91 loans at December 31, 2019.

-49-

As with other impaired loans, an allowance for loan loss is estimated for each TDR based on the most likely source of repayment for each loan.  For impaired commercial real estate loans that are collateral dependent, the allowance is computed based on the fair value of the underlying collateral, less estimated costs to sell.  For impaired commercial loans where repayment is expected from cash flows from business operations, the allowance is computed based on a discounted cash flow computation.  Certain groups of TDRs, such as residential mortgages, have common characteristics and for them the allowance is computed based on a discounted cash flow computation on the change in weighted rate for the pool.  The allowance allocations for commercial TDRs where we have reduced the contractual interest rate are computed by measuring cash flows using the new payment terms discounted at the original contractual rate.

On March 22, 2020, the federal banking agencies issued an “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus”.  This guidance encourages financial institutions to work prudently with borrowers that may be unable to meet their contractual obligations because of the effects of COVID-19.  The guidance goes on to explain that in consultation with the FASB staff that the federal banking agencies conclude that short-term modifications (e.g. six months) made on a good faith basis to borrowers who were current as of the implementation date of a relief program are not Troubled Debt Restructurings (“TDRs”).  The Coronavirus Aid, Relief and Economic Security (“CARES”) Act was passed by Congress on March 27, 2020.  Section 4013 of the CARES Act also addressed COVID-19 related modifications and specified that COVID-19 related modifications on loans that were current as of December 31, 2019 are not TDRs.  Through September 30, 2020, the Bank had applied this guidance and modified 726 individual loans with aggregate principal balances totaling $337.2 million.  The majority of these modifications involved three-month extensions.

By September 30, 2020, most of these modification had expired, other than those receiving a second short-term modification as allowed under the guidance.  At September 30, 2020, there were 26 such loans under COVID-19 modifications, totaling $79.9 million.  This is down from a quarter end peak of $297.3 million at June 30, 2020.  The table below shows the number and balances of loans with such modifications as of the past three quarter end dates (dollars in thousands):

   
Number of COVID-19 Modifications
   
Outstanding Balance of COVID-19 Modifications
 
March 31, 2020
   
176
   
$
87,917
 
June 30, 2020
   
599
     
297,269
 
September 30, 2020
   
26
     
79,894
 

Allowance for loan losses: The allowance for loan losses at September 30, 2020 was $16.6 million, a decrease of $642,000 from December 31, 2019.  The allowance for loan losses represented 1.07% of total portfolio loans at September 30, 2020 and 1.24% at December 31, 2019.  The ratio at September 30, 2020 is impacted by $339.2 million of PPP loans which were generated during the second and third quarters of 2020.  The ratio excluding these loans was 1.38% at September 30, 2020.  The allowance for loan losses to nonperforming loan coverage ratio increased from 8473% at December 31, 2019 to 8491% at September 30, 2020.
 
The table below shows the changes in certain credit metrics over the past five quarters (dollars in millions):

   
Quarter Ended
September 30,
2020
   
Quarter Ended
June 30,
2020
   
Quarter Ended
March 31,
2020
   
Quarter Ended
December 31,
2019
   
Quarter Ended
September 30,
2019
 
Commercial loans
 
$
1,311.9
   
$
1,310.7
   
$
1,120.0
   
$
1,098.0
   
$
1,072.5
 
Nonperforming loans
   
0.2
     
3.0
     
7.2
     
0.2
     
0.2
 
Other real estate owned and repo assets
   
2.6
     
2.6
     
2.6
     
2.7
     
3.1
 
Total nonperforming assets
   
2.8
     
5.6
     
9.9
     
3.0
     
3.3
 
Net charge-offs (recoveries)
   
(0.2
)
   
4.0
     
(1.0
)
   
(0.0
)
   
(0.3
)
Total delinquencies
   
0.5
     
3.3
     
0.5
     
0.4
     
0.2
 

A $4.1 million charge-off was taken in June 2020 related to a single loan relationship with a movie theater business for which the underlying assets were sold through bankruptcy proceedings.  This was an isolated charge-off, the amount of which was amplified by the COVID-19 shutdown of the economy.  No other loans of this industry type remain in our portfolio.  At September 30, 2020, we had net loan recoveries in twenty-one of the past twenty-three quarters.  Our total delinquencies were $524,000 at September 30, 2020 and $405,000 at December 31, 2019.  Our delinquency percentage at September 30, 2020 was 0.03%.
 
These factors all impact our necessary level of allowance for loan losses and our provision for loan losses. The allowance for loan losses decreased $642,000 in the first nine months of 2020.  We recorded a provision for loan losses of $2.2 million for the nine months ended September 30, 2020 compared to a negative $450,000 for the same period of 2019.  Net loan charge-offs were $2.8 million for the nine months ended September 30, 2020, compared to net loan recoveries of $719,000 for the same period in 2019. The ratio of net charge-offs (recoveries) to average loans was 0.25% on an annualized basis for the first nine months of 2020 and -0.07% for the first nine months of 2019.

-50-

Despite the large charge-off taken in the second quarter of 2020, we are encouraged by the reduced level of gross charge-offs over recent quarters. We do, however, recognize that future charge-offs and resulting provisions for loan losses are expected to be impacted by the timing and extent of changes in the overall economy and the real estate markets, in particular due to the impact of COVID-19.
 
Our allowance for loan losses is maintained at a level believed appropriate based upon our assessment of the probable estimated losses inherent in the loan portfolio. Our methodology for measuring the appropriate level of allowance and related provision for loan losses relies on several key elements, which include specific allowances for loans considered impaired, general allowance for commercial loans not considered impaired based upon applying our loan rating system, and general allocations based on historical trends for homogeneous loan groups with similar risk characteristics.
 
Overall, impaired loans declined by $4.5 million to $9.3 million at September 30, 2020 compared to $13.9 million at December 31, 2019.  The specific allowance for impaired loans decreased $608,000 to $1.0 million at September 30, 2020, compared to $1.6 million at December 31, 2019.  The specific allowance for impaired loans represented 10.9% of total impaired loans at September 30, 2020 and 11.7% at December 31, 2019.
 
The general allowance allocated to commercial loans that were not considered to be impaired was based upon the internal risk grade of such loans.  We use a loan rating method based upon an eight point system.  Loans are stratified between real estate secured and non-real estate secured.  The real estate secured portfolio is further stratified by the type of real estate.  Each stratified portfolio is assigned a loss allocation factor.  A higher numerical grade assigned to a loan category generally results in a greater allocation percentage.  Changes in risk grade of loans affect the amount of the allowance allocation.
 
The determination of our loss factors is based upon our actual loss history by loan grade and adjusted for significant factors that, in management's judgment, affect the collectability of the portfolio as of the analysis date.  We use a rolling 18 month actual net charge-off history as the base for our computation.  Over the past few years, the 18 month period computations have reflected sizeable decreases in net charge-off experience.  We addressed this volatility in the qualitative factor considerations applied in our allowance for loan losses computation. We also considered the extended period of strong asset quality in assessing the overall qualitative component.
 
At September 30, 2020, we also considered the effect that the COVID-19 pandemic has had and is having on our loan borrowers and our local economy.  An analysis of each credit in our commercial loan portfolio was performed during the quarter ended September 30, 2020 to evaluate the impact of the shutdown on each business and identify the potential loss exposure.  While this analysis revealed limited stress in our portfolio and significant stimulus and mitigation efforts are expected to soften the shutdown impact, we believe a downgrade to our economic qualitative factor was appropriate and, after adding 7 basis points to this qualitative factor at March 31, 2020, we added another 6 basis points at June 30, 2020 and maintained this level at September 30, 2020.  We also added 4 basis points to our valuation qualitative factor at June 30, 2020 due to the potential for devalued collateral in the current environment and maintained at this level at September 30, 2020. We also added 2 basis points to the external factors qualitative at September 30, 2020.
 
As discussed earlier, under the CARES Act, we provided payment relief, primarily in the form of interest-only periods, to a number of our borrowers.  Most of these modifications had expired by September 30, 2020, but 26 loans totaling $79.9 million remain under modified terms as of September 30, 2020, primarily those which received a second modification.  Recognizing that these loans may have higher risk of loss than other portfolio loans, we have isolated them in our allowance computation at September 30, 2020 and applied an additional 35 basis point allocation on these loans.
 
Certain industry sectors will be more negatively impacted than others by the economic effects of COVID-19 and governmental action.  For example, businesses that thrive on large masses of people assembling in close proximity, such as hospitality, restaurants and sporting events will likely incur longer lasting negative effects than other industries.  We believe our commercial portfolio is adequately diversified, with our largest commercial concentrations in Real Estate, Rental and Leasing (22.6%), followed by Manufacturing (13.7%) and Retail Trade (10.4%).

-51-

The table below breaks down our commercial loan portfolio by industry type at September 30, 2020 and identifies the percentage of loans in each type that have a pass rating within our grading system (4 or better) and criticized rating (5 or worse) (dollars in thousands):
 

   
September 30, 2020
 
   
Excluding PPP
   
PPP Loans
   
Total
   
Percent of
Total Loans
   
Percent Grade 4 or Better
   
Percent Grade 5 or Worse
 
Industry:
                                   
Agricultural Products
 
$
58,078
   
$
17,757
   
$
75,835
     
5.78
%
   
90.00
%
   
10.00
%
Mining and Oil Extraction
   
1,956
     
104
     
2,060
     
0.16
%
   
100.00
%
   
0.00
%
Utilities
   
     
43
     
43
     
0.00
%
   
100.00
%
   
0.00
%
Construction
   
74,089
     
52,473
     
126,562
     
9.65
%
   
99.07
%
   
0.93
%
Manufacturing
   
119,386
     
60,098
     
179,484
     
13.68
%
   
96.99
%
   
3.01
%
Wholesale Trade
   
58,974
     
16,573
     
75,547
     
5.76
%
   
99.89
%
   
0.11
%
Retail Trade
   
113,037
     
22,792
     
135,829
     
10.35
%
   
99.92
%
   
0.08
%
Transportation and Warehousing
   
44,666
     
21,047
     
65,713
     
5.01
%
   
99.27
%
   
0.73
%
Information
   
795
     
4,612
     
5,407
     
0.41
%
   
100.00
%
   
0.00
%
Finance and Insurance
   
43,419
     
6,633
     
50,052
     
3.82
%
   
100.00
%
   
0.00
%
Real Estate and Rental and Leasing
   
292,066
     
4,382
     
296,448
     
22.60
%
   
99.50
%
   
0.50
%
Professional, Scientific and Technical Services
   
5,157
     
24,634
     
29,791
     
2.27
%
   
99.13
%
   
0.87
%
Management of Companies and Enterprises
   
1,990
     
350
     
2,340
     
0.18
%
   
100.00
%
   
0.00
%
Administrative and Support Services
   
21,495
     
28,902
     
50,397
     
3.84
%
   
99.77
%
   
0.23
%
Education Services
   
3,060
     
10,089
     
13,149
     
1.00
%
   
99.25
%
   
0.75
%
Health Care and Social Assistance
   
55,091
     
32,549
     
87,640
     
6.68
%
   
99.99
%
   
0.01
%
Arts, Entertainment and Recreation
   
7,590
     
4,510
     
12,100
     
0.92
%
   
97.11
%
   
2.89
%
Accommodations and Food Services
   
42,036
     
13,215
     
55,251
     
4.21
%
   
83.30
%
   
16.70
%
Other Services
   
29,744
     
18,342
     
48,086
     
3.67
%
   
99.26
%
   
0.74
%
Public Administration
   
     
107
     
107
     
0.01
%
   
100.00
%
   
0.00
%
Private Households
   
     
     
     
0.00
%
   
0.00
%
   
0.00
%
Total commercial loans
 
$
972,629
   
$
339,212
   
$
1,311,841
     
100.00
%
   
97.96
%
   
2.04
%

Accommodations and Food Services in the table above includes our loans to restaurants and hotels.  We have reviewed each relationship in this industry group and have determined based upon their nature of operations and our loan structure that we believe our loss exposure is limited.
 
Groups of homogeneous loans, such as residential real estate and open- and closed-end consumer loans, receive allowance allocations based on loan type.  A rolling 12 month (four quarter) historical loss experience period was applied to residential mortgage and consumer loan portfolios.  As with commercial loans that are not considered impaired, the determination of the allowance allocation percentage is based principally on our historical loss experience.  These allocations are adjusted for consideration of general economic and business conditions, credit quality and delinquency trends, collateral values, and recent loss experience for these similar pools of loans.  The homogeneous loan allowance was $2.6 million at September 30, 2020 and $2.6 million at December 31, 2019.
 
The allowance allocations are not intended to imply limitations on usage of the allowance for loan losses.  The entire allowance for loan losses is available for any loan losses without regard to loan type.
 
Premises and Equipment:   Premises and equipment totaled $43.7 million at September 30, 2020, up $316,000 from $43.4 million at December 31, 2019.
 
Other Assets: Other assets totaled $15.5 million at September 30, 2020, up $5.7 million from $9.8 million at December 31, 2019.  This increase is largely attributable to additional customer back-to-back interest rate swaps and changes in their market values.  The market value of these swaps was $5.1 million at September 30, 2020 and $1.8 million at December 31, 2019.
 
Deposits and Other Borrowings: Total deposits increased $417.3 million to $2.17 billion at September 30, 2020, as compared to $1.75 billion at December 31, 2019.  Non-interest checking account balances increased $256.0 million during the first nine months of 2020.  Interest bearing demand account balances increased $80.7 million and savings and money market account balances increased $198.0 million in the first nine months of 2020.  Certificates of deposits decreased by $36.7 million in the first nine months of 2020.  Our overall deposit balances are elevated as a result of customers holding higher level of liquid deposits in this low interest rate environment and due to uncertainty related to the COVID-19 pandemic.  Business deposits are also elevated partially due to PPP loan proceeds but also due to cash conservation efforts deployed by many of our customers given COVID-19 pandemic uncertainty.  We typically see seasonal deposit growth in the third quarter each year from municipal customers from property tax collections.  We believe our success in maintaining the balances of personal and business checking and savings accounts was primarily attributable to our focus on quality customer service, the desire of customers to deal with a local bank, the convenience of our branch network and the breadth and depth of our sophisticated product line.

-52-

Noninterest bearing demand accounts comprised 34.0% of total deposits at September 30, 2020 and 27.5% at December 31, 2019.  These balances typically increase at year end for many of our commercial customers, then decline in the first quarter.  Because of the generally low rates paid on interest bearing account alternatives, many of our business customers chose to keep their balances in these more liquid noninterest bearing demand account types.  Interest bearing demand, including money market and savings accounts, comprised 60.7% of total deposits at September 30, 2020 and 63.8% at December 31, 2019. Time accounts as a percentage of total deposits were 5.3% at September 30, 2020 and 8.7% December 31, 2019.
 
Borrowed funds totaled $90.6 million at September 30, 2020, including $70.0 million of Federal Home Loan Bank (“FHLB”) advances and $20.6 million in long-term debt associated with trust preferred securities.  Borrowed funds totaled $80.6 million at December 31, 2019, including $60.0 million of FHLB advances and $20.6 million in long-term debt associated with trust preferred securities.  The $10.0 million increase in borrowed funds in the nine months ended September 30, 2020 was due to the addition of a $10.0 million FHLB advance in February 2020.
 
CAPITAL RESOURCES
 
Total shareholders' equity of $233.9 million at September 30, 2020 increased $16.4 million from $217.5 million at December 31, 2019. The increase was primarily a result of net income of $21.2 million earned in the first nine months of 2020 and an increase of $3.1 million in accumulated other comprehensive income, partially offset by a payment of $8.2 million in cash dividends to shareholders.  The Bank was categorized as “well capitalized” at September 30, 2020.
 
Capital guidelines for U.S. banks are commonly known as Basel III guidelines. The rules include a common equity Tier 1 capital to risk-weighted assets ratio (CET1 ratio) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, effectively resulting in a minimum CET1 ratio of 7.0%. The Basel III minimum ratio of Tier 1 capital to risk-weighted assets is 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5%), and the minimum total capital to risk-weighted assets ratio is 10.5% (with the capital conservation buffer), and Basel III requires a minimum leverage ratio of 4.0%. The capital ratios for the Company and the Bank under Basel III have continued to exceed the well capitalized minimum capital requirements.
 
The following table shows our regulatory capital ratios (on a consolidated basis) for the past several quarters:

Macatawa Bank Corporation
 
Sept 30,
2020
   
June 30,
2020
   
March 31,
2020
   
Dec 31,
2019
   
Sept 30,
2019
 
Total capital to risk weighted assets
   
17.7
%
   
17.3
%
   
15.8
%
   
15.8
%
   
16.8
%
Common Equity Tier 1 to risk weighted assets
   
15.3
     
14.9
     
13.4
     
13.5
     
13.2
 
Tier 1 capital to risk weighted assets
   
16.6
     
16.3
     
14.7
     
14.7
     
15.8
 
Tier 1 capital to average assets
   
9.8
     
10.5
     
11.9
     
11.5
     
12.2
 
 
LIQUIDITY
 
Liquidity of Macatawa Bank: The liquidity of a financial institution reflects its ability to manage a variety of sources and uses of funds. Our Consolidated Statements of Cash Flows categorize these sources and uses into operating, investing and financing activities. We primarily focus on developing access to a variety of borrowing sources to supplement our deposit gathering activities and provide funds for our investment and loan portfolios. Our sources of liquidity include our borrowing capacity with the FRB's discount window, the Federal Home Loan Bank, federal funds purchased lines of credit and other secured borrowing sources with our correspondent banks, loan payments by our borrowers, maturity and sales of our securities available for sale, growth of our deposits, federal funds sold and other short-term investments, and the various capital resources discussed above.
 
Liquidity management involves the ability to meet the cash flow requirements of our customers. Our customers may be either borrowers with credit needs or depositors wanting to withdraw funds. Our liquidity management involves periodic monitoring of our assets considered to be liquid and illiquid, and our funding sources considered to be core and non-core and short-term (less than 12 months) and long-term. We have established parameters that monitor, among other items, our level of liquid assets to short-term liabilities, our level of non-core funding reliance and our level of available borrowing capacity. We maintain a diversified wholesale funding structure and actively manage our maturing wholesale sources to reduce the risk to liquidity shortages. We have also developed a contingency funding plan to stress test our liquidity requirements arising from certain events that may trigger liquidity shortages, such as rapid loan growth in excess of normal growth levels or the loss of deposits and other funding sources under extreme circumstances.
 
We have actively pursued initiatives to maintain a strong liquidity position.  The Bank has reduced its reliance on non-core funding sources, including brokered deposits, and focused on achieving a non-core funding dependency ratio below its peer group average.  We have had no brokered deposits on our balance sheet since December 2011.  We continue to maintain significant on-balance sheet liquidity.  At September 30, 2020, the Bank held $504.7 million of federal funds sold and other short-term investments.  In addition, the Bank had available borrowing capacity from correspondent banks of approximately $315.8 million as of September 30, 2020.

-53-

In the normal course of business, we enter into certain contractual obligations, including obligations which are considered in our overall liquidity management.  The table below summarizes our significant contractual obligations at September 30, 2020 (dollars in thousands):

   
Less than
1 year
   
1-3 years
   
3-5 years
   
More than
5 years
 
Long term debt
 
$
   
$
   
$
   
$
20,619
 
Time deposit maturities
   
93,946
     
19,114
     
2,349
     
57
 
Other borrowed funds
   
10,000
     
10,000
     
40,000
     
10,000
 
Operating lease obligations
   
383
     
479
     
271
     
26
 
Total
 
$
104,329
   
$
29,593
   
$
42,620
   
$
30,702
 

In addition to normal loan funding, we also maintain liquidity to meet customer financing needs through unused lines of credit, unfunded loan commitments and standby letters of credit.  The level and fluctuation of these commitments is also considered in our overall liquidity management.  At September 30, 2020, we had a total of $594.1 million in unused lines of credit, $83.1 million in unfunded loan commitments and $12.5 million in standby letters of credit.
 
Liquidity of Holding Company: The primary sources of liquidity for the Company are dividends from the Bank, existing cash resources and the capital markets if the need to raise additional capital arises.  Banking regulations and the laws of the State of Michigan in which our Bank is chartered limit the amount of dividends the Bank may declare and pay to the Company in any calendar year.  Under the state law limitations, the Bank is restricted from paying dividends to the Company in excess of retained earnings.  In 2019, the Bank paid dividends to the Company totaling $32.5 million.  In the same period, the Company paid $20.0 million to redeem trust preferred securities and paid $9.5 million in dividends to its shareholders.  On February 25, 2020, the Bank paid a dividend totaling $2.8 million to the Company in anticipation of the common share cash dividend of $0.08 per share paid on February 27, 2020 to shareholders of record on February 11, 2020.  The cash distributed for this cash dividend payment totaled $2.7 million.  On May 26, 2020, the Bank paid a dividend totaling $2.7 million to the Company in anticipation of the common share cash dividend of $0.08 per share paid on May 28, 2020 to shareholders of record on May 12, 2020.  The cash distributed for this cash dividend payment totaled $2.7 million.  On August 26, 2020, the Bank paid a dividend totaling $3.2 million to the Company in anticipation of the common share cash dividend of $0.08 per share paid on August 27, 2020 to shareholders of record on August 11, 2020.  The cash distributed for this cash dividend payment totaled $2.7 million.  The Company retained the remaining balance in each period for general corporate purposes.  At September 30, 2020, the Bank had a retained earnings balance of $80.0 million.
 
The Company has the right to defer interest payments for 20 consecutive quarters on its trust preferred securities if necessary for liquidity purposes.  During the deferral period, the Company may not declare or pay any dividends on its common stock or make any payment on any outstanding debt obligations that rank equally with or junior to the trust preferred securities.
 
The Company’s cash balance at September 30, 2020 was $7.5 million.  The Company believes that it has sufficient liquidity to meet its cash flow obligations.
 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES:
 
To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and future results could differ.  The allowance for loan losses, other real estate owned valuation, loss contingencies, revenue recognition and income taxes are deemed critical due to the required level of management judgment and the use of estimates, making them particularly subject to change.
 
Our methodology for determining the allowance for loan losses and the related provision for loan losses is described above in the "Allowance for Loan Losses" discussion.  This area of accounting requires significant judgment due to the number of factors which can influence the collectability of a loan.  Unanticipated changes in these factors could significantly change the level of the allowance for loan losses and the related provision for loan losses.  Although, based upon our internal analysis, and in our judgment, we believe that we have provided an adequate allowance for loan losses, there can be no assurance that our analysis has properly identified all of the probable losses in our loan portfolio.  As a result, we could record future provisions for loan losses that may be significantly different than the levels that we recorded in the first nine months of 2020.
 
Assets acquired through or instead of foreclosure, primarily other real estate owned, are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis.  New real estate appraisals are generally obtained at the time of foreclosure and are used to establish fair value.  If fair value declines, a valuation allowance is recorded through expense.  Estimating the initial and ongoing fair value of these properties involves a number of factors and judgments including holding time, costs to complete, holding costs, discount rate, absorption and other factors.
 
Loss contingencies are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated.  This, too, is an accounting area that involves significant judgment.  Although, based upon our judgment, internal analysis, and consultations with legal counsel we believe that we have properly accounted for loss contingencies, future changes in the status of such contingencies could result in a significant change in the level of contingent liabilities and a related impact to operating earnings.

-54-

Noninterest revenue is recognized in accordance with contractual requirements and as we fulfill our obligations under contractual terms.  Most of our noninterest revenue comes from services that are transaction based and such revenue is recognized as the related service is provided.
 
Our accounting for income taxes involves the valuation of deferred tax assets and liabilities primarily associated with differences in the timing of the recognition of revenues and expenses for financial reporting and tax purposes.  At September 30, 2020, we had gross deferred tax assets of $5.8 million and gross deferred tax liabilities of $3.2 million resulting in a net deferred tax asset of $2.5 million.  Accounting standards require that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a "more likely than not" standard.  At December 31, 2018, a valuation allowance of $92,000 was established against a capital loss carryforward created by the liquidation of the assets of a partnership interest the Bank acquired through a loan settlement thereby reducing net deferred tax assets.  This valuation allowance was maintained at September 30, 2020, resulting in a net deferred tax asset balance of $2.4 million.  With the positive results in 2019 and the first nine months of 2020, we concluded at September 30, 2020 that no other valuation allowance on our net deferred tax asset was required.  Changes in tax laws, changes in tax rates, changes in ownership and our future level of earnings can impact the ultimate realization of our net deferred tax asset.
 
Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
 
Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of our transactions are denominated in U.S. dollars with no specific foreign exchange exposure. Macatawa Bank has only limited agricultural-related loan assets, and therefore has no significant exposure to changes in commodity prices.
 
Our balance sheet has sensitivity, in various categories of assets and liabilities, to changes in prevailing rates in the U.S. for prime rate, mortgage rates, U.S. Treasury rates and various money market indexes. Our asset/liability management process aids us in providing liquidity while maintaining a balance between interest earning assets and interest bearing liabilities.
 
We utilize a simulation model as our primary tool to assess the direction and magnitude of variations in net interest income and the economic value of equity (“EVE”) resulting from potential changes in market interest rates. Key assumptions in the model include contractual cash flows and maturities of interest-sensitive assets and interest-sensitive liabilities, prepayment speeds on certain assets, and changes in market conditions impacting loan and deposit pricing. We also include pricing floors on discretionary priced liability products which limit how low various checking and savings products could go under declining interest rates. These floors reflect our pricing philosophy in response to changing interest rates.
 
We forecast the next twelve months of net interest income under an assumed environment of gradual changes in market interest rates under various scenarios. The resulting change in net interest income is an indication of the sensitivity of our earnings to directional changes in market interest rates. The simulation also measures the change in EVE, or the net present value of our assets and liabilities, under an immediate shift, or shock, in interest rates under various scenarios, as calculated by discounting the estimated future cash flows using market-based discount rates.
 
The following table shows the impact of changes in interest rates on net interest income over the next twelve months and EVE based on our balance sheet as of September 30, 2020 (dollars in thousands):

Interest Rate Scenario
 
Economic
Value of
Equity
   
Percent
Change
   
Net Interest
Income
   
Percent
Change
 
Interest rates up 200 basis points
 
$
283,472
     
4.34
%
 
$
59,505
     
12.75
%
Interest rates up 100 basis points
   
278,479
     
2.50
     
55,918
     
5.95
 
No change
   
271,682
     
     
52,776
     
 
Interest rates down 100 basis points
   
269,057
     
(0.97
)
   
53,041
     
0.50
 
Interest rates down 200 basis points
   
269,039
     
(0.97
)
   
53,231
     
0.86
 

If interest rates were to increase, this analysis suggests that we are positioned for an improvement in net interest income over the next twelve months.  If interest rates were to decrease, this analysis suggests we would experience an increase in net interest income over the next twelve months.  This is due to the impact of interest rate floors being triggered in a decrease scenario.
 
We also forecast the impact of immediate and parallel interest rate shocks on net interest income under various scenarios to measure the sensitivity of our earnings under extreme conditions.
 
The quarterly simulation analysis is monitored against acceptable interest rate risk parameters by the Asset/Liability Committee and reported to the Board of Directors.
 
In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including: the growth, composition and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; economic and competitive conditions; potential changes in lending, investing and deposit gathering strategies; and client preferences.

-55-

Item 4:
CONTROLS AND PROCEDURES
 
(a)
Evaluation of Disclosure Controls and Procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e) as of September 30, 2020, the end of the period covered by this report.
 
In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as the Company's are designed to do, and management necessarily was required to apply its judgment in evaluating whether the benefits of the controls and procedures that the Company adopts outweigh their costs.
 
Our CEO and CFO, after evaluating the effectiveness of the Company's disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered by this report, have concluded that the Company's disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms.
 
(b)
Changes in Internal Controls. During the period covered by this report, there have been no changes in the Company’s internal control over financial reporting that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.

-56-

PART II – OTHER INFORMATION

Item 1A.
Risk Factors.

Uncertainty as to legal requirements relating to the COVID-19 pandemic in Michigan may have a negative impact on the business, financial condition, and results of operations of the Company and its customers.

In December 2019, news began to surface regarding an influenza pandemic in China, known as the novel coronavirus, or COVID-19. In January 2020, the United States restricted entry to anyone traveling from China.  In February 2020, the pandemic spread broadly and swiftly throughout Europe and the Middle East. Cases began to surface in the United States in February 2020 and accelerated in early March 2020.  The Federal Reserve reduced the overnight federal funds rate by 50 basis points on March 3, 2020 and by another 100 basis points on March 15, 2020 and announced the resumption of quantitative easing.  During the week of March 9, 2020, individual states began implementing restrictions and promoting “social distancing”.  These restrictions included closure of schools, restrictions on the number of public gatherings, restrictions on businesses, including closures and mandatory work at home orders, and other measures.  Congress passed a number of measures in late March 2020, designed to infuse cash into the economy to offset the negative impacts of business closings and restrictions.

In Michigan, beginning March 24, 2020, Governor Gretchen Whitmer issued a series of executive orders, which severely limited economic activity in Michigan, requiring businesses not deemed to be essential, to severely limit or shut down operations.  Under later executive orders, Governor Whitmer permitted a phased reopening of businesses, subject to stringent health and safety requirements and strict social distancing measures.  As of September 30, 2020, most businesses in Michigan were allowed to be open in some capacity under the executive orders, subject to stringent health and safety requirements, strict social distancing measures and nonsurgical face mask requirements.

On October 2, and 12, 2020, the Michigan Supreme Court issued decisions invalidating all of Governor Whitmer’s executive orders effective immediately.  In response, Governor Whitmer, acting through various state agencies, has sought to substantially re-implement the requirements of the executive orders by way of state agency emergency orders.  Also, certain county and municipal governments have issued emergency orders seeking to keep elements of the executive orders in place.  Legal challenges to these orders may occur.  Finally, the Michigan legislature has passed legislation – which Governor Whitmer is expected to sign and enact into law – codifying certain elements of the executive orders.  The patchwork implementation of state agency and local government executive orders – coupled with the possibility of legal challenges to these orders – creates uncertainty as to legal requirements applicable to businesses, institutions and individuals in Michigan.  This uncertainty may have a negative impact on the business, financial condition, and results of operations of the Company and its customers.

-57-

Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds.

The following table provides information regarding the Company’s purchase of its own common stock during the third quarter of 2020.  All employee transactions are under stock compensation plans.  These include shares of Macatawa Bank Corporation common stock surrendered to satisfy tax withholding obligations that occur upon the vesting of restricted shares.  The value of the shares withheld is determined based on the closing price of Macatawa Bank Corporation common stock at the date of vesting.  The Company has no publicly announced repurchase plans or programs.

   
Total
Number of
Shares
Purchased
   
Average
Price Paid
Per Share
   
Total Number of Shares purchased as Part of Publicly Announced Plans or Programs
 
Period
                 
July 1 - July 31, 2020
                 
Employee Transactions
   
   
$
     
 
August 1 - August 31, 2020
                       
Employee Transactions
   
     
     
 
September 1 - September 30, 2020
                       
Employee Transactions
   
1,696
     
7.39
     
 
Total for Third Quarter ended September 30, 2020
                       
Employee Transactions
   
1,696
   
$
7.39
     
 

Item 6.
EXHIBITS.

 
Restated Articles of Incorporation. Previously filed with the Commission on October 27, 2016 in Macatawa Bank Corporation’s Quarterly Report on Form 10-Q, Exhibit 3.1. Here incorporated by reference.
 
Bylaws. Previously filed with the Commission on February 19, 2015 in Macatawa Bank Corporation's Annual Report on Form 10-K for the year ended December 31, 2014, Exhibit 3.2. Here incorporated by reference.
 
Restated Articles of Incorporation. Exhibit 3.1 is here incorporated by reference.
 
Bylaws. 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 SEC upon request.
 
Certification of Chief Executive Officer.
 
Certification of Chief Financial Officer.
 
Certification pursuant to 18 U.S.C. Section 1350.
101.INS
 
XBRL Instance Document
101.SCH
 
XBRL Taxonomy Extension Schema Document
101.CAL
 
XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF
 
XBRL Taxonomy Extension Definition Linkbase Document
101.LAB
 
XBRL Taxonomy Extension Label Linkbase Document
101.PRE
 
XBRL Taxonomy Extension Presentation Linkbase Document

-58-

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.

 
MACATAWA BANK CORPORATION
   
 
/s/ Ronald L. Haan
 
Ronald L. Haan
 
Chief Executive Officer
 
(Principal Executive Officer)
   
 
/s/ Jon W. Swets
 
Jon W. Swets
 
Senior Vice President and
 
Chief Financial Officer
 
(Principal Financial and Accounting Officer)
   
Dated: October 22, 2020


-59-