UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2012

OR
 
o 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
 


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 x No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o
Accelerated filer o
Non-accelerated filer o
Smaller reporting company x
 
 
(Do not check if smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
 
The number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 27,082,825 shares of the Company's Common Stock (no par value) were outstanding as of July 26, 2012.
 


 
 

 

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 "may", "should", "will", "is likely", or is "probable" to occur or "continue", has "begun" or "is scheduled" or "on track" or that the Company or its management "anticipates", "believes", "estimates", "plans", "forecasts", "intends", "predicts", "projects", or "expects" a particular result, or is "committed", "confident", "optimistic" or has an "opinion" that an event will occur, or other words or phrases such as "ongoing", "future", "signs", "efforts", "tend", "exploring", "appearing", "until", "near term", "going forward", "starting", “initiative” and variations of such words and similar expressions. Such statements are based upon current beliefs and expectations and involve substantial risks and uncertainties which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These statements include, among others, statements related to trends in credit quality metrics, future capital levels, real estate valuation, future levels of repossessed and foreclosed properties and non-performing assets and losses and costs associated with administration and disposition of repossessed and foreclosed properties and non-performing assets, future levels of loan charge-offs, future levels of other real estate owned, future levels of provisions for loan losses, the rate of asset dispositions, dividends, future growth and funding sources, future cost of funds, future liquidity levels, future profitability levels, future trust service income levels, future FDIC assessment levels, future net interest margin levels, building our investment portfolio, diversifying our credit risk, the effects on earnings of changes in interest rates, future economic conditions, future effects of new or changed accounting standards, future loss recoveries 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 goodwill, mortgage servicing rights and 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. Our ability to sell other real estate owned at its carrying value or at all, successfully implement new programs and initiatives, increase efficiencies, obtain continuing regulatory approval to make interest payments on our subordinated notes, maintain our current levels of deposits and other sources of funding, maintain liquidity, respond to declines in collateral values and credit quality, increase loan volume, originate high quality loans, maintain or improve mortgage banking income, realize the benefit of our deferred tax assets, resume payment of dividends and improve profitability is not entirely within our control and is not assured. The future effect of changes in the real estate, financial and credit markets and the national and regional economy on the banking industry, generally, and 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, 2011. 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
 
9
 
 
 
 
Item 2.
 
 
37
 
 
 
 
Item 4.
 
 
52
 
 
 
Part II.
Other Information:
 
 
 
 
 
Item 6.
 
 
53
 
 
 
55
 
 
 

 
Part I Financial Information
Item 1.
MACATAWA BANK CORPORATION
CONSOLIDATED BALANCE SHEETS
As of June 30, 2012 (unaudited) and December 31, 2011

   
June 30,
   
December 31,
 
(dollars in thousands, except per share data)
 
2012
   
2011
 
ASSETS
 
 
   
 
 
Cash and due from banks
  $ 25,673     $ 30,971  
Federal funds sold and other short -term investments
    218,721       212,071  
Cash and cash equivalents
    244,394       243,042  
                 
Securities available for sale, at fair value
    96,518       54,746  
Securities held to maturity (fair value 2012 and 2011 - $300)
    300       300  
Federal Home Loan Bank (FHLB) stock
    11,236       11,236  
Loans held for sale, at fair value
    6,630       1,026  
Total loans
    1,036,965       1,070,975  
Allowance for loan losses
    (27,180 )     (31,641 )
Net loans
    1,009,785       1,039,334  
                 
Premises and equipment – net
    54,534       55,358  
Accrued interest receivable
    3,525       3,595  
Bank-owned life insurance
    26,404       25,957  
Other real estate owned
    62,046       66,438  
Other assets
    4,963       6,635  
Total assets
  $ 1,520,335     $ 1,507,667  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Deposits
               
Noninterest-bearing
  $ 330,626     $ 324,253  
Interest-bearing
    904,891       891,036  
Total deposits
    1,235,517       1,215,289  
Other borrowed funds
    127,489       148,603  
Long-term debt
    41,238       41,238  
Subordinated debt
    1,650       1,650  
                 
Accrued expenses and other liabilities
    12,042       6,461  
Total liabilities
    1,417,936       1,413,241  
                 
Commitments and contingent liabilities
    ---       ---  
                 
Shareholders' equity
               
Preferred stock, no par value, 500,000 shares authorized;
               
Series A Noncumulative Convertible Perpetual Preferred Stock, liquidation value of $1,000 per share, 31,290 shares issued and outstanding
    30,604       30,604  
Series B Noncumulative Convertible Perpetual Preferred Stock, liquidation value of $1,000 per share, 2,600 shares issued and outstanding
    2,560       2,560  
Common stock, no par value, 200,000,000 shares authorized; 27,082,825 and 27,082,823 shares issued and outstanding at June 30, 2012 and December 31, 2011
    187,709       187,709  
Retained deficit
    (119,154 )     (126,825 )
Accumulated other comprehensive income
    680       378  
Total shareholders' equity
    102,399       94,426  
Total liabilities and shareholders' equity
  $ 1,520,335     $ 1,507,667  
 

See accompanying notes to consolidated financial statements.
 
 
- 4 -


MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Three and Six Month Periods Ended June 30, 2012 and 2011
(unaudited)

   
Three Months
   
Three Months
   
Six Months
   
Six Months
 
   
Ended
   
Ended
   
Ended
   
Ended
 
   
June 30,
   
June 30,
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Interest income
 
 
   
 
   
 
   
 
 
Loans, including fees
  $ 13,237     $ 15,194     $ 26,763     $ 30,776  
Securities
                               
Taxable
    384       85       701       112  
Tax-exempt
    65       ---       108       ---  
FHLB Stock
    84       74       169       150  
Federal funds sold and other short-term investments
    130       137       257       305  
Total interest income
    13,900       15,490       27,998       31,343  
                                 
Interest expense
                               
Deposits
    1,525       2,416       3,175       5,327  
Debt and other borrowed funds
    1,053       1,292       2,221       2,636  
Total interest expense
    2,578       3,708       5,396       7,963  
                                 
Net interest income
    11,322       11,782       22,602       23,380  
Provision for loan losses
    (1,750 )     (2,000 )     (5,350 )     (3,450 )
Net interest income after provision for loan losses
    13,072       13,782       27,952       26,830  
                                 
Noninterest income
                               
Service charges and fees
    776       969       1,571       1,918  
Net gains on mortgage loans
    780       262       1,251       697  
Trust fees
    598       620       1,207       1,270  
Gain on sale of securities
    59       ---       59       ---  
ATM and debit card fees
    1,064       1,027       2,045       1,946  
Other
    723       738       1,578       1,464  
Total noninterest income
    4,000       3,616       7,711       7,295  
                                 
Noninterest expense
                               
Salaries and benefits
    5,723       5,600       11,443       10,947  
Occupancy of premises
    941       989       1,912       2,001  
Furniture and equipment
    858       829       1,685       1,646  
Legal and professional
    180       322       392       591  
Marketing and promotion
    210       224       420       448  
Data processing
    368       334       719       638  
FDIC assessment
    479       841       1,188       1,819  
ATM and debit card processing
    308       311       596       581  
Bond and D&O Insurance
    215       378       483       757  
Losses on repossessed and foreclosed properties
    1,934       2,121       3,531       4,613  
Administration and disposition of problem assets
    1,256       1,620       2,718       3,562  
Other
    1,414       1,428       2,905       2,830  
Total noninterest expenses
    13,886       14,997       27,992       30,433  
                                 
Income before income tax
    3,186       2,401       7,671       3,692  
Income tax expense (benefit)
    ---       ---       ---       ---  
                                 
Net income
    3,186       2,401       7,671       3,692  
Dividends declared on preferred shares
    ---       ---       ---       ---  
Net income available to common shares
  $ 3,186     $ 2,401     $ 7,671     $ 3,692  
                                 
Basic earnings per common share
  $ 0.12     $ 0.13     $ 0.28     $ 0.2  
Diluted earnings per common share
  $ 0.12     $ 0.13     $ 0.28     $ 0.2  
Cash dividends per common share
  $ ---     $ ---     $ ---     $ ---  


See accompanying notes to consolidated financial statements.

 
- 5 -

 
MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Three and Six Month Periods Ended June 30, 2012 and 2011
(unaudited)

   
Three Months
   
Three Months
   
Six Months
   
Six Months
 
   
Ended
   
Ended
   
Ended
   
Ended
 
   
June 30,
   
June 30,
   
June 30,
   
June 30,
 
(dollars in thousands)  
2012
   
2011
   
2012
   
2011
 
                         
Net income
  $ 3,186     $ 2,401     $ 7,671     $ 3,692  
                                 
Other comprehensive income, net of tax:
                               
Net unrealized gains on securities available for sale arising during period
    385       149       361       152  
                                 
Less: reclassification adjustment for gain recognized in earnings, net of tax
    (59 )     ---       (59 )     ---  
Other comprehensive income, net of tax
    326       149       302       152  
                                 
Comprehensive income
  $ 3,512     $ 2,550     $ 7,973     $ 3,844  
 

See accompanying notes to consolidated financial statements.
 
 
- 6 -


MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Six Month Periods Ended June 30, 2012 and 2011
(unaudited)

   
Preferred Stock
   
Common
   
Retained
   
Accumulated Other Comprehensive
   
Total Shareholders'
 
(dollars in thousands, except per share data)
 
Series A
   
Series B
   
Stock
   
Deficit
   
Income
   
Equity
 
   
 
   
 
   
 
   
 
   
 
   
 
 
Balance, January 1, 2011
  $ 30,604     $ 2,560     $ 167,321     $ (132,654 )   $ 11     $ 67,842  
                                                 
Net income for six months ended June 30, 2011
                            3,692               3,692  
                                                 
Net change in unrealized gain on securities available for sale, net of tax
                                    152       152  
                                                 
Net proceeds from sale of 8,912,372shares of common stock on June 7, 2011 and June 29, 2011
                    19,426                       19,426  
                                                 
Conversion of subordinated note to 491,830shares of common stock on June 29, 2011
                    1,003                       1,003  
                                                 
Stock compensation expense
                    38                       38  
                                                 
Balance, June 30, 2011
  $ 30,604     $ 2,560     $ 187,788     $ (128,962 )   $ 163     $ 92,153  
                                                 
Balance, January 1, 2012
  $ 30,604     $ 2,560     $ 187,709     $ (126,825 )   $ 378     $ 94,426  
                                                 
Net income for six months ended June 30, 2012
                            7,671               7,671  
                                                 
Net change in unrealized gain on securities available for sale, net of tax
                                    302       302  
                                                 
Balance, June 30, 2012
  $ 30,604     $ 2,560     $ 187,709     $ (119,154 )   $ 680     $ 102,399  
 
 

See accompanying notes to consolidated financial statements.
 
 
- 7 -


MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Month Periods Ended June 30, 2012 and 2011
(unaudited)

(dollars in thousands)
 
Six Months Ended
 
 
Six Months Ended
 
June 30,
June 30,
2012
2011
Cash flows from operating activities
 
 
 
 
 
 
Net income
 
$
7,671
 
 
$
3,692
 
Adjustments to reconcile net income to net cash from operating activities:
 
 
 
 
 
 
 
 
Depreciation and amortization
 
 
1,416
 
 
 
1,539
 
Stock compensation expense
 
 
---
 
 
 
38
 
Provision for loan losses
 
 
(5,350
)
 
 
(3,450
)
Origination of loans for sale
 
 
(59,412
)
 
 
(28,945
)
Proceeds from sales of loans originated for sale
 
 
55,059
 
 
 
31,712
 
Net gains on mortgage loans
 
 
(1,251
)
 
 
(697
)
Gain on sale of securities
   
(59
)
   
---
 
Write-down of other real estate
 
 
3,550
 
 
 
5,351
 
Net gain on sales of other real estate
 
 
(20
)
 
 
(745
)
Decrease (increase) in accrued interest receivable and other assets
 
 
1,579
 
 
 
(230
)
Earnings in bank-owned life insurance
 
 
(447
)
 
 
(466
)
Increase in accrued expenses and other liabilities
 
 
911
 
 
 
1,193
 
Net cash from operating activities
 
 
3,647
 
 
 
8,992
 
 
 
 
 
 
 
 
 
 
Cash flows from investing activities
 
 
 
 
 
 
 
 
Loan originations and payments, net
 
 
27,174
 
 
 
88,137
 
Purchases of securities available for sale
 
 
(67,461
)
 
 
(21,415
)
Proceeds from:
 
 
 
 
 
 
 
 
Maturities and calls of securities available for sale
 
 
25,613
 
 
 
7,988
 
Sale of securities available for sale
   
4,050
     
---
 
Principal paydowns on securities
 
 
1,035
 
 
 
87
 
Sales of other real estate
 
 
8,587
 
 
 
11,330
 
Redemption of FHLB stock
   
---
     
696
 
Additions to premises and equipment
 
 
(407
)
 
 
(533
)
Net cash from investing activities
 
 
(1,409
)
 
 
86,290
 
 
 
 
 
 
 
 
 
 
Cash flows from financing activities
 
 
 
 
 
 
 
 
Net increase (decrease) in in-market deposits
 
 
20,228
 
 
 
(39,255
)
Decrease in brokered deposits
 
 
---
 
 
 
(34,809
)
Proceeds from other borrowed funds
   
---
     
10,000
 
Repayments of other borrowed funds
   
(21,114
)
   
(21,066
)
Proceeds from issuance of subordinated note
   
---
     
1,000
 
Proceeds from sale of common stock, net
 
 
---
   
 
19,426
 
Net cash from financing activities
 
 
(886
)
 
 
(64,704
)
 
 
 
 
 
 
 
 
 
Net change in cash and cash equivalents
 
 
1,352
 
 
 
30,578
 
Cash and cash equivalents at beginning of period
 
 
243,042
 
 
 
236,127
 
Cash and cash equivalents at end of period
 
$
244,394
 
 
$
266,705
 
Supplemental cash flow information
 
 
 
 
 
 
 
 
Interest paid
 
$
4,727
 
 
$
7,446
 
Federal income taxes
   
100
     
---
 
Supplemental noncash disclosures:
 
 
 
 
 
 
 
 
Transfers from loans to other real estate
 
 
7,725
 
 
 
23,384
 
Securities purchased not settled
 
 
4,670
 
 
 
---
 
Conversion of subordinated note to 491,830 shares of common stock
 
 
---
 
 
 
1,003
 


See accompanying notes to consolidated financial statements.
 
 
- 8 -


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 I and Macatawa Statutory Trust II. These are grantor trusts that issued trust preferred securities and are not consolidated with the Company under accounting principles generally accepted in the United States of America.
 
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 six month periods ended June 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. 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, 2011.

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.

Regulatory Developments:

Termination of Consent Order with Macatawa Bank and its Regulators

On February 22, 2010, the Bank entered into a Consent Order with the Federal Deposit Insurance Corporation (“FDIC”) and the Michigan Office of Financial and Insurance Regulation ("OFIR"), the primary banking regulators of the Bank. The Bank agreed to the terms of the negotiated Consent Order without admitting or denying any charges of unsafe or unsound banking practices.  The Consent Order imposed no fines or penalties on the Bank.  As a result of the improvement in our financial condition and results of operations, our implementation of additional corporate governance practices and disciplined business and banking principles, and our compliance with the Consent Order, upon completion of the Bank’s 2011 joint examination by the FDIC and OFIR, the FDIC and OFIR terminated the Consent Order effective March 2, 2012.

In connection with the termination of the Consent Order, the Bank reached an understanding with the regulators in the form of a memorandum of understanding (“MOU”), which maintains many of the controls and procedures put in place by the Bank in response to the Consent Order, including: maintenance of a Tier 1 Leverage Capital Ratio of at least 8%, formulating and submitting a written plan of action on each asset classified as Substandard in the Report of Examination (“ROE”), charge-off of all assets classified as “Loss” in the ROE, submission of a written Profit Plan, Board review of the adequacy of the allowance for loan losses each quarter and the receipt of prior written consent of the FDIC and OFIR before the Bank declares or pays any dividends.  We believe the Bank was in compliance in all material respects with all of the provisions of the MOU as of June 30, 2012.
 
 
- 9 -

 
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Written Agreement with Macatawa and its Regulator

The Company has formally entered into a Written Agreement with the Federal Reserve Bank of Chicago ("FRB").  The Written Agreement became effective on July 29, 2010, when it was executed and published by the FRB, and was assigned an effective date of July 23, 2010.  Among other things, the Written Agreement provides that: (i) the Company must take appropriate steps to fully utilize its financial and managerial resources to serve as a source of strength to Macatawa Bank; (ii) the Company may not declare or pay any dividends without prior FRB approval; (iii) the Company may not take dividends or any other payment representing a reduction in capital from Macatawa Bank without prior FRB approval; (iv) the Company may not make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities without prior FRB approval; (v) the Company may not incur, increase or guarantee any debt without prior FRB approval; (vi) the Company may not purchase or redeem any shares of its stock without prior FRB approval; (vii) the Company must submit a written capital plan to the FRB within 60 days of the Written Agreement; and (viii) the Company may not appoint any new director or senior executive officer, or change the responsibilities of any senior executive officer so that the officer would assume a different senior executive officer position, without prior regulatory approval.  The Company separately requested and received approval from the FRB to make the second quarter 2012 quarterly interest payments on its $1.65 million in outstanding subordinated debt.  Each quarter the Company requests approval from the FRB to make the next quarter's interest payment on its subordinated debt and is continuing to accrue the interest amounts due.  We believe that as of June 30, 2012, the Company was in compliance in all material respects with all the provisions of the Written Agreement.

Reclassifications: Some items in the prior period financial statements were reclassified to conform to the current presentation.

Allowance for Loan Losses: The allowance for loan losses 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. At June 30, 2012, 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 and consumer loan portfolios. 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.

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.
 
 
- 10 -

 
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 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.

We recognize 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. We recognize interest and penalties related to income tax matters in income tax expense.

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 all relevant positive and negative evidence, including taxable income in carry-back years, scheduled reversals of deferred tax liabilities, expected future taxable income and available tax planning strategies.

As of January 1, 2010, we no longer have the ability to carryback losses to prior years. The realization of our deferred tax assets is largely dependent on generating income in future years. At June 30, 2012, the need to maintain a full valuation allowance was based primarily on our net operating losses for recent years and the continuing weak economic conditions that could impact our ability to generate future earnings. The valuation allowance may be reversed to income in future periods to the extent that the related deferred tax assets are realized or the valuation allowance is no longer required.

Adoption of New Accounting Standards: The FASB has issued ASU 2011-03, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements. The ASU is intended to improve financial reporting of repurchase agreements (“repos”) and other agreements that both entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. In a typical repo transaction, an entity transfers financial assets to a counterparty in exchange for cash with an agreement for the counterparty to return the same or equivalent financial assets for a fixed price in the future. Codification Topic 860, Transfers and Servicing, prescribes when an entity may or may not recognize a sale upon the transfer of financial assets subject to repo agreements. That determination is based, in part, on whether the entity has maintained effective control over the transferred financial assets. The amendments to the Codification in this ASU are intended to improve the accounting for these transactions by removing from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets. The guidance in the ASU is effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Adoption of this ASU did not have any effect as the Company does not currently hold any such repurchase agreements.
 
 
- 11 -


MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

The FASB has issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the IASB (the Boards) on fair value measurement. The collective efforts of the Boards and their staffs, reflected in ASU 2011-04, have resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The Boards have concluded the common requirements will result in greater comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRSs. The amendments to the Codification in this ASU are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. Early application by public entities is not permitted. Disclosure of the fair value levels of our financial assets and financial liabilities was added to Note 5 upon adoption of this standard in the first quarter of 2012.
 
The FASB has issued ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income. This ASU amends accounting standards to allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders' equity. The amendments in the ASU do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU 2011-05 should be applied retrospectively effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. We early adopted this standard with our 2011 annual financial statements by adding a statement of comprehensive income.
 
 
- 12 -

 
 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):
 
         
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
June 30, 2012
                       
Available for Sale:
                       
U.S. Treasury and federal agency securities
  $ 30,283     $ 248     $ (6 )   $ 30,525  
U.S. Agency MBS and CMOs
    23,248       162       (41 )     23,369  
Tax-exempt state and municipal bonds
    15,304       153       (77 )     15,380  
Taxable state and municipal bonds
    20,920       548       (20 )     21,448  
Corporate bonds and other debt securities
    4,216       23       (5 )     4,234  
Other equity securities
    1,500       62       ---       1,562  
    $ 95,471     $ 1,196     $ (149 )   $ 96,518  
Held to Maturity
                               
State and municipal bonds
  $ 300     $ ---     $ ---     $ 300  
                                 
December 31, 2011
                               
Available for Sale:
                               
U.S. Treasury and federal agency securities
  $ 27,408     $ 205     $ ---     $ 27,613  
U. S. Agency MBS and CMOs
    3,853       33       ---       3,886  
Tax-exempt state and municipal bonds
    4,292       116       ---       4,408  
Taxable state and municipal bonds
    16,531       239       (54 )     16,716  
Corporate bonds
    1,081       1       (1 )     1,081  
Other equity securities
    1,000       42       ---       1,042  
    $ 54,165     $ 636     $ (55 )   $ 54,746  
Held to Maturity:
                               
State and municipal bonds
  $ 300     $ ---     $ ---     $ 300  
 
Proceeds from the sale of securities available for sale were $4.1 million for the three and six month periods ended June 30, 2012, resulting in net gains of $59,000.  There were no sales of securities in the three and six month periods ended June 30, 2011.
 
Contractual maturities of debt securities at June 30, 2012 were as follows (dollars in thousands):
 
 
Held–to-Maturity Securities
 
Available-for-Sale Securities
 
 
Amortized
 
Fair
 
Amortized
 
Fair
 
 
Cost
 
Value
 
Cost
 
Value
 
 
 
 
 
         
Due in one year or less
  $ ---     $ ---     $ ---     $ ---  
Due from one to five years
    ---       ---       30,826       31,383  
Due from five to ten years
    ---       ---       33,715       34,069  
Due after ten years
    300       300       29,430       29,504  
                                 
    $ 300     $ 300     $ 93,971     $ 94,956  
 
 
- 13 -

 
 MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 2 – SECURITIES (Continued)
 
Securities with unrealized losses at June 30, 2012 and December 31, 2011, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, are as follows (dollars in thousands):
 
   
Less than 12 Months
   
12 Months or More
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
June 30, 2012
 
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
   
 
   
 
   
 
   
 
   
 
   
 
 
U.S. Treasury and federal agency securities
  $ 2,014     $ (6 )   $ ---     $ ---     $ 2,014     $ (6 )
U.S. Agency MBS and CMOs
    11,532       (41 )     ---       ---       11,532       (41 )
Tax-exempt state and municipal bonds
    7,654       (77 )     ---       ---       7,654       (77 )
Taxable state and municipal bonds
    1,407       (20 )     ---       ---       1,407       (20 )
Corporate bonds and other debt securities
    536       (5 )     ---       ---       536       (5 )
Other equity securities
    ---       ---       ---       ---       ---       ---  
                                                 
Total temporarily impaired
  $ 23,143     $ (149 )   $ ---     $ ---     $ 23,143     $ (149 )
 
 
 
Less than 12 Months
 
 
12 Months or More
 
 
Total
 
 
 
Fair
 
 
Unrealized
 
 
Fair
 
 
Unrealized
 
 
Fair
 
 
Unrealized
 
December 31, 2011
 
Value
 
 
Loss
 
 
Value
 
 
Loss
 
 
Value
 
 
Loss
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury and federal agency securities
 
$
---
 
 
$
---
 
 
$
---
 
 
$
---
 
 
$
---
 
 
$
---
 
U.S. Agency MBS and CMOs
   
---
     
---
     
---
     
---
     
---
     
---
 
Tax-exempt state and municipal bonds
 
 
---
 
 
 
---
 
 
 
---
 
 
 
---
 
 
 
---
 
 
 
---
 
Taxable state and municipal bonds
 
 
6,196
 
 
 
(54
)
 
 
---
 
 
 
---
 
 
 
6,196
 
 
 
(54
)
Corporate bonds
   
539
     
(1
)
                   
539
     
(1
)
Other equity securities
 
 
---
 
 
 
---
 
 
 
---
 
 
 
---
 
 
 
---
 
 
 
---
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total temporarily impaired
 
$
6,735
 
 
$
(55
)
 
$
---
 
 
$
---
 
 
$
6,735
 
 
$
(55
)

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. Management determined that no OTTI charges were necessary during the three and six month periods ended June 30, 2012 and 2011.

At both June 30, 2012 and December 31, 2011, securities with a carrying value of approximately $2.0 million were pledged as security for public deposits, letters of credit and for other purposes required or permitted by law.
 
 
- 14 -

 
 MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 3 – LOANS

Portfolio loans were as follows (dollars in thousands):

 
 
June 30,
 
 
December 31,
 
2012
2011
 
 
 
 
 
 
 
Commercial and industrial
 
$
221,628
 
 
$
227,051
 
 
 
 
 
 
 
 
 
 
Commercial real estate:
 
 
 
 
 
 
 
 
Residential developed
 
 
28,464
 
 
 
33,829
 
Unsecured to residential developers
 
 
589
 
 
 
5,937
 
Vacant and unimproved
 
 
60,115
 
 
 
66,046
 
Commercial development
 
 
4,772
 
 
 
4,586
 
Residential improved
 
 
79,169
 
 
 
82,337
 
Commercial improved
 
 
283,293
 
 
 
304,070
 
Manufacturing and industrial
 
 
75,531
 
 
 
71,462
 
Total commercial real estate
 
 
531,933
 
 
 
568,267
 
 
 
 
 
 
 
 
 
 
Consumer
 
 
 
 
 
 
 
 
Residential mortgage
 
 
170,983
 
 
 
156,891
 
Unsecured
 
 
1,776
 
 
 
1,952
 
Home equity
 
 
96,535
 
 
 
101,074
 
Other secured
 
 
14,110
 
 
 
15,740
 
Total consumer
 
 
283,404
 
 
 
275,657
 
 
 
 
 
 
 
 
 
 
Total loans
 
 
1,036,965
 
 
 
1,070,975
 
Allowance for loan losses
 
 
(27,180
)
 
 
(31,641
)
 
 
 
 
 
 
 
 
 
 
 
$
1,009,785
 
 
$
1,039,334
 

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

   
Commercial
and
    Commercial                    
Three months ended June 30, 2012:
 
Industrial
   
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
  $ 7,507     $ 17,565     $ 4,366     $ 13     $ 29,451  
Charge-offs
    (21 )     (799 )     (79 )     ---       (899 )
Recoveries
    110       201       67       ---       378  
Provision for loan losses
    (958 )     (1,728 )     900       36       (1,750 )
Ending balance
  $ 6,638     $ 15,239     $ 5,254     $ 49     $ 27,180  

   
Commercial
and
    Commercial                    
Three months ended June 30, 2011:
 
Industrial
   
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
  $ 7,191     $ 30,707     $ 4,423     $ 22     $ 42,343  
Charge-offs
    (783 )     (3,129 )     (518 )     ---       (4,430 )
Recoveries
    1,083       387       94       ---       1,564  
Provision for loan losses
    (2,000 )     (1,150 )     1,116       34       (2,000 )
Ending balance
  $ 5,491     $ 26,815     $ 5,115     $ 56     $ 37,477  
 
 
- 15 -

 
 MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 3 – LOANS (Continued)

Six months ended June 30, 2012:
 
Commercial
and
Industrial
 
 
Commercial
Real Estate
 
 
Consumer
 
 
Unallocated
 
 
Total
 
Beginning balance
 
$
6,313
 
 
$
20,475
 
 
$
4,821
 
 
$
32
 
 
$
31,641
 
Charge-offs
 
 
(989
)
 
 
(2,506
)
 
 
(901
)
 
 
---
 
 
 
(4,396
)
Recoveries
 
 
280
 
 
 
4,885
 
 
 
120
 
 
 
---
 
 
 
5,285
 
Provision for loan losses
 
 
1,034
 
 
 
(7,615
)
 
 
1,214
 
 
 
17
 
 
 
(5,350
)
Ending balance
 
$
6,638
 
 
$
15,239
 
 
$
5,254
 
 
$
49
 
 
$
27,180
 
 
Six months ended June 30, 2011:
 
Commercial
and
Industrial
 
 
Commercial
Real Estate
 
 
Consumer
 
 
Unallocated
 
 
Total
 
Beginning balance
 
$
7,012
 
 
$
34,973
 
 
$
5,415
 
 
$
26
 
 
$
47,426
 
Charge-offs
 
 
(1,587
)
 
 
(5,526
)
 
 
(1,449
)
 
 
---
 
 
 
(8,562
)
Recoveries
 
 
1,277
 
 
 
637
 
 
 
149
 
 
 
---
 
 
 
2,063
 
Provision for loan losses
 
 
(1,211
)
 
 
(3,269
)
 
 
1,000
 
 
 
30
 
 
 
(3,450
)
Ending balance
 
$
5,491
 
 
$
26,815
 
 
$
5,115
 
 
$
56
 
 
$
37,477
 

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):
 
June 30, 2012:
 
   
Commercial
and
   
Commercial
                   
   
Industrial
   
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
                             
Ending allowance attributable to loans:
                             
Individually reviewed for impairment
  $ 4,230     $ 3,717     $ 2,520     $ ---     $ 10,467  
Collectively evaluated for impairment
    2,408       11,522       2,734       49       16,713  
Total ending allowance balance
  $ 6,638     $ 15,239     $ 5,254     $ 49     $ 27,180  
                                         
Loans:
                                       
Individually reviewed for impairment
  $ 12,829     $ 51,901     $ 16,199     $ ---     $ 80,929  
Collectively evaluated for impairment
    208,799       480,032       267,205       ---       956,036  
Total ending loans balance
  $ 221,628     $ 531,933     $ 283,404     $ ---     $ 1,036,965  

December 31, 2011:
   
Commercial
and
   
Commercial
                   
   
Industrial
   
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
 
 
   
 
   
 
   
 
   
 
 
Ending allowance attributable to loans:
 
 
   
 
   
 
   
 
   
 
 
Individually reviewed for impairment
  $ 3,478     $ 4,367     $ 1,752     $ ---     $ 9,597  
Collectively evaluated for impairment
    2,835       16,108       3,069       32       22,044  
Total ending allowance balance
  $ 6,313     $ 20,475     $ 4,821     $ 32     $ 31,641  
                                         
Loans:
                                       
Individually reviewed for impairment
  $ 17,331     $ 52,195     $ 15,085     $ ---     $ 84,611  
Collectively evaluated for impairment
    209,720       516,072       260,572       ---       986,364  
Total ending loans balance
  $ 227,051     $ 568,267     $ 275,657     $ ---     $ 1,070,975  
 
 
- 16 -

 
 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 June 30, 2012 (dollars in thousands):
 
   
Unpaid
             
   
Principal
   
Recorded
   
Allowance
 
   
Balance
   
Investment
   
Allocated
 
With no related allowance recorded:
 
 
   
 
   
 
 
Commercial and industrial
  $ 4,819     $ 2,446     $ ---  
                         
Commercial real estate:
                       
Residential developed
    6,481       5,584       ---  
Unsecured to residential developers
    ---       ---       ---  
Vacant and unimproved
    2,115       1,418       ---  
Commercial development
    217       217       ---  
Residential improved
    5,056       4,190       ---  
Commercial improved
    7,671       6,576       ---  
Manufacturing and industrial
    4,496       4,496       ---  
      26,036       22,481       ---  
Consumer:
                       
Residential mortgage
    ---       ---       ---  
Unsecured
    ---       ---       ---  
Home equity
    200       200       ---  
Other secured
    ---       ---       ---  
      200       200       ---  
    $ 31,055     $ 25,127     $ ---  
                         
With an allowance recorded:
                       
Commercial and industrial
  $ 10,383     $ 10,383     $ 4,230  
Commercial real estate:
                       
Residential developed
    2,648       2,648       1,200  
Unsecured to residential developers
    ---       ---       ---  
Vacant and unimproved
    2,995       2,995       651  
Commercial development
    ---       ---       ---  
Residential improved
    9,062       9,062       789  
Commercial improved
    9,900       9,900       904  
Manufacturing and industrial
    4,815       4,815       173  
      29,420       29,420       3,717  
Consumer:
                       
Residential mortgage
    15,213       15,213       2,469  
Unsecured
    ---       ---       ---  
Home equity
    786       786       51  
Other secured
    ---       ---       ---  
      15,999       15,999       2,520  
    $ 55,802     $ 55,802     $ 10,467  
                         
Total
  $ 86,857     $ 80,929     $ 10,467  
 
 
- 17 -


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, 2011 (dollars in thousands):
 
   
Unpaid
             
   
Principal
   
Recorded
   
Allowance
 
   
Balance
   
Investment
   
Allocated
 
With no related allowance recorded:
 
 
   
 
   
 
 
Commercial and industrial
  $ 3,485     $ 3,485     $ ---  
Commercial real estate:
                       
Residential developed
    6,432       2,021       ---  
Unsecured to residential developers
    ---       ---       ---  
Vacant and unimproved
    5,226       4,265       ---  
Commercial development
    ---       ---       ---  
Residential improved
    1,943       1,858       ---  
Commercial improved
    5,428       5,162       ---  
Manufacturing and industrial
    3,997       3,997       ---  
      23,026       17,303       ---  
Consumer:
                       
Residential mortgage
    ---       ---       ---  
Unsecured
    ---       ---       ---  
Home equity
    200       200       ---  
Other secured
    ---       ---       ---  
      200       200       ---  
    $ 26,711     $ 20,988     $ ---  
                         
With an allowance recorded:
                       
Commercial and industrial
  $ 17,052     $ 13,846     $ 3,478  
Commercial real estate:
                       
Residential developed
    4,941       4,941       1,960  
Unsecured to residential developers
    ---       ---       ---  
Vacant and unimproved
    3,378       2,462       154  
Commercial development
    220       220       17  
Residential improved
    12,312       11,809       1,176  
Commercial improved
    10,590       10,555       844  
Manufacturing and industrial
    4,905       4,905       216  
      36,346       34,892       4,367  
Consumer:
                       
Residential mortgage
    14,235       14,114       1,713  
Unsecured
    ---       ---       ---  
Home equity
    771       771       39  
Other secured
    ---       ---       ---  
      15,006       14,885       1,752  
    $ 68,404     $ 63,623     $ 9,597  
                         
Total
  $ 95,115     $ 84,611     $ 9,597  
 
 
- 18 -

 
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 six month periods ended June 30, 2012 and 2011 (dollars in thousands):
 
   
Three Months
 Ended
June 30,
2012
   
Three Months
Ended
June 30,
2011
   
Six Months
Ended
June 30,
2012
   
Six Months
Ended
June 30,
2011
 
Average of impaired loans during the period:
 
 
   
 
             
Commercial and industrial
  $ 14,788     $ 6,608     $ 16,874     $ 5,532  
                                 
Commercial real estate:
                               
Residential developed
    8,351       12,111       8,445       14,414  
Unsecured to residential developers
    ---       795       ---       864  
Vacant and unimproved
    3,862       6,197       3,672       5,483  
Commercial development
    217       223       218       567  
Residential improved
    13,440       9,741       13,993       9,144  
Commercial improved
    17,280       17,823       16,690       20,158  
Manufacturing and industrial
    9,299       6,632       9,384       7,613  
                                 
Consumer
    16,136       12,381       16,030       12,594  
                                 
Interest income recognized during impairment:
                               
Commercial and industrial
    465       79       827       65  
Commercial real estate
    626       446       1,211       969  
Consumer
    144       97       278       207  
                                 
Cash-basis interest income recognized
                               
Commercial and industrial
    487       70       815       122  
Commercial real estate
    627       398       1,215       907  
Consumer
    139       102       276       213  
 
 
- 19 -


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 table presents the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of June 30, 2012:

   
 
   
Over 90
 
         
days
 
   
Nonaccrual
   
Accruing
 
   
 
   
 
 
Commercial and industrial
  $ 6,146     $ 27  
Commercial real estate:
               
Residential developed
    5,461       ---  
Unsecured to residential developers
    ---       ---  
Vacant and unimproved
    118       ---  
Commercial development
    422       ---  
Residential improved
    2,149       ---  
Commercial improved
    2,710       ---  
Manufacturing and industrial
    257       ---  
      11,117       ---  
Consumer:
               
Residential mortgage
    978       ---  
Unsecured
    21       ---  
Home equity
    590       ---  
Other secured
    ---       ---  
      1,589       ---  
                 
Total
  $ 18,852     $ 27  
 
The following table presents the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of December 31, 2011:

   
 
   
Over 90
 
         
days
 
   
Nonaccrual
   
Accruing
 
   
 
   
 
 
Commercial and industrial
  $ 9,270     $ 290  
Commercial real estate:
               
Residential developed
    3,577       126  
Unsecured to residential developers
    ---       ---  
Vacant and unimproved
    3,715       ---  
Commercial development
    49       ---  
Residential improved
    5,144       286  
Commercial improved
    2,654       1,255  
Manufacturing and industrial
    134       ---  
      15,273       1,667  
Consumer:
               
Residential mortgage
    1,777       111  
Unsecured
    22       ---  
Home equity
    534       ---  
Other secured
    ---       2  
      2,333       113  
                 
Total
  $ 26,876     $ 2,070  
 
 
- 20 -

 
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 June 30, 2012 by class of loans (dollars in thousands):
 
      30-90    
Greater Than
   
Total
   
Loans Not
       
   
Days
   
90 Days
   
Past Due
   
Past Due
   
Total
 
           
 
   
 
   
 
   
 
 
Commercial and industrial
  $ 45     $ 150     $ 195     $ 221,433     $ 221,628  
                                         
Commercial real estate:
                                       
Residential developed
    312       37       349       28,115       28,464  
Unsecured to residential developers
    ---       ---       ---       589       589  
Vacant and unimproved
    963       50       1,013       59,102       60,115  
Commercial development
    ---       422       422       4,350       4,772  
Residential improved
    1,188       592       1,780       77,389       79,169  
Commercial improved
    269       1,159       1,428       281,865       283,293  
Manufacturing and industrial
    ---       32       32       75,499       75,531  
      2,732       2,292       5,024       526,909       531,933  
Consumer:
                                       
Residential mortgage
    74       686       760       170,223       170,983  
Unsecured
    ---       ---       ---       1,776       1,776  
Home equity
    330       555       885       95,650       96,535  
Other secured
    ---       ---       ---       14,110       14,110  
      404       1,241       1,645       281,759       283,404  
Total
  $ 3,181     $ 3,683     $ 6,864     $ 1,030,101     $ 1,036,965  
 
The following table presents the aging of the recorded investment in past due loans as of December 31, 2011 by class of loans (dollars in thousands):
 
      30-90    
Greater Than
   
Total
   
Loans Not
       
   
Days
   
90 Days
   
Past Due
   
Past Due
   
Total
 
           
 
   
 
   
 
   
 
 
Commercial and industrial
  $ 218     $ 1,230     $ 1,448     $ 225,603     $ 227,051  
                                         
Commercial real estate:
                                       
Residential developed
    472       613       1,085       32,744       33,829  
Unsecured to residential developers
    ---       ---       ---       5,937       5,937  
Vacant and unimproved
    442       388       830       65,216       66,046  
Commercial development
    ---       49       49       4,537       4,586  
Residential improved
    549       1,343       1,892       80,445       82,337  
Commercial improved
    1,355       3,266       4,621       299,449       304,070  
Manufacturing and industrial
    ---       134       134       71,328       71,462  
      2,818       5,793       8,611       559,656       568,267  
Consumer:
                                       
Residential mortgage
    313       1,517       1,830       155,061       156,891  
Unsecured
    35       ---       35       1,917       1,952  
Home equity
    663       498       1,161       99,913       101,074  
Other secured
    51       2       53       15,687       15,740  
      1,062       2,017       3,079       272,578       275,657  
Total
  $ 4,098     $ 9,040     $ 13,138     $ 1,057,837     $ 1,070,975  
 
 
- 21 -

 
 
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 3 – LOANS (Continued)
 
The Company had allocated $8,922,000 and $6,905,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings (“TDRs”) as of June 30, 2012 and December 31, 2011, respectively.  These loans 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.

Typically, once a loan is identified as a TDR, it will retain that designation until it is paid off, since the restructured loans generally are not at market rates at the time of restructuring.  An exception to this would be a loan that is 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 their 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.  In general, when a loan is removed from TDR status it would no longer be considered impaired.  As a result, allowance allocations for loans removed from TDR status would be based on the historical based allocation for the applicable loan grade and loan class.  During the three and six month periods ended June 30, 2012 and throughout 2011, no loans were removed from TDR status.  Given the nature of the TDRs outstanding at June 30, 2012, it is unlikely that any such loans will be removed from TDR status in 2012.

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.  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 June 30, 2012 and December 31, 2011 (dollars in thousands):
 
 
 
June 30, 2012
 
 
December 31, 2011
 
 
 
 
Number of Loans
 
 
Outstanding Recorded Balance
 
 
 
Number of Loans
 
 
Outstanding Recorded Balance
 
Commercial and industrial
 
 
114
 
 
$
12,463
 
 
 
98
 
 
$
15,395
 
Commercial real estate
 
 
141
 
 
 
45,970
 
 
 
120
 
 
 
46,414
 
Consumer
 
 
97
 
 
 
15,935
 
 
 
90
 
 
 
15,373
 
 
 
 
352
 
 
$
74,368
 
 
 
308
 
 
$
77,182
 
 
 
- 22 -

 
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  
NOTE 3 – LOANS (Continued)

The following table presents information regarding troubled debt restructurings executed during the three month periods ended June 30, 2012 and 2011 (dollars in thousands):
 
   
Three Months Ended
   
Three Months Ended
 
    June 30, 2012     June 30, 2011  
   
Number of Loans
   
Outstanding Recorded Balance
   
Principal Writedown
upon Modification
   
Number of Loans
   
Outstanding Recorded Balance
   
Principal Writedown
upon Modification
 
                                     
Commercial and industrial
    3     $ 93     $ 9       14     $ 1,193     $ ---  
Commercial real estate
    9       1,301       ---       17       5,384       30  
Consumer
    2       275       ---       5       759       ---  
      14     $ 1,669     $ 9       36     $ 7,336     $ 30  
 
The following table presents information regarding troubled debt restructurings executed during the six month periods ended June 30, 2012 and 2011 (dollars in thousands):

 
 
Six Months Ended
June 30, 2012
 
 
Six Months Ended
June 30, 2011
 
 
 
 
Number of Loans
 
 
Outstanding Recorded Balance
 
 
Principal Writedown
upon Modification
 
 
 
Number of Loans
 
 
Outstanding Recorded Balance
 
 
Principal Writedown
upon Modification
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
       
 
Commercial and industrial
 
 
13
 
 
$
1,335
 
 
$
9
 
 
 
62
 
 
$
2,615
   
$
---
 
Commercial real estate
 
 
39
 
 
 
7,698
 
 
 
86
 
 
 
48
 
 
 
14,954
     
553
 
Consumer
 
 
9
 
 
 
1,462
 
 
 
260
 
 
 
11
 
 
 
1,670
     
---
 
     
61
   
$
10,495
   
$
355
     
121
   
$
19,239
   
$
553
 

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.  The following table presents information regarding modifications and renewals executed during the three month periods ended June 30, 2012 and 2011 that are not considered TDRs (dollars in thousands):

 
Three Months Ended
June 30, 2012
 
Three Months Ended
June 30, 2011
 
 
 
Number of
Loans
 
Outstanding Recorded Balance
 
Number of
Loans
 
Outstanding Recorded Balance
 
 
 
 
 
 
     
 
Commercial and industrial
156
 
$
27,628
 
195
 
$
27,551
 
Commercial real estate
85
 
 
28,906
 
110
   
37,128
 
Consumer
22
 
 
815
 
25
   
681
 
 
263
 
$
57,349
 
330
 
$
65,360
 
 
 
- 23 -


MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  
NOTE 3 – LOANS (Continued)

The following table presents information regarding modifications and renewals executed during the six month periods ended June 30, 2012 and 2011 that are not considered TDRs (dollars in thousands):

 
Six Months Ended
June 30, 2012
 
Six Months Ended
June 30, 2011
 
 
 
Number of
Loans
 
Outstanding Recorded Balance
 
Number of
Loans
 
Outstanding Recorded Balance
 
 
 
 
 
 
     
 
Commercial and industrial
250
 
$
60,918
 
305
 
$
57,661
 
Commercial real estate
164
 
 
65,706
 
227
   
80,091
 
Consumer
46
 
 
1,687
 
31
   
914
 
 
460
 
$
128,311
 
563
 
$
138,666
 

The table below presents by class, information regarding troubled debt restructured loans which had payment defaults during the three month periods ended June 30, 2012 and 2011 (dollars in thousands). Included are loans that became delinquent more than 90 days past due or transferred to nonaccrual within 12 months of restructuring.

 
Three Months Ended
June 30, 2012
 
Three Months Ended
June 30, 2011
 
 
 
Number of
Loans
 
Outstanding Recorded Balance
 
Number of
Loans
 
Outstanding Recorded Balance
 
 
 
 
 
 
     
 
Commercial and industrial
1
 
$
20
 
1
 
$
66
 
Commercial real estate
---
 
 
---
 
3
   
319
 
Consumer
---
 
 
---
 
---
   
---
 

The table below presents by class, information regarding troubled debt restructured loans which had payment defaults during the six month periods ended June 30, 2012 and 2011 (dollars in thousands). Included are loans that became delinquent more than 90 days past due or transferred to nonaccrual within 12 months of restructuring.

 
Six Months Ended
June 30, 2012
 
Six Months Ended
June 30, 2011
 
 
 
Number of
Loans
 
Outstanding Recorded Balance
 
Number of
Loans
 
Outstanding Recorded Balance
 
 
 
 
 
 
     
 
Commercial and industrial
3
 
$
112
 
4
 
$
830
 
Commercial real estate
1
 
 
76
 
4
   
546
 
Consumer
1
 
 
70
 
2
   
402
 
 
 
- 24 -

 
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 credit and the loan officer. All watch credits have an ALR completed monthly which analyzes the collateral position and cash flow of the borrower and its guarantors. The loan officer is required to complete both a short term and long term plan to rehabilitate or exit the credit and to provide monthly comments on the progress to these plans. Management meets quarterly with loan officers to discuss each of these credits in detail and to help attempt to 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 through the loan review process. The credit will stay on the ALR until either its grade has improved to a 4 or better 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 – Average 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. The ability to repay the entire loan is questionable. Loans in this category are normally characterized with less than adequate collateral, insolvent, or extremely weak financial condition. A loan classified doubtful has all the weaknesses inherent in one classified as 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 and should be charged off.

 
- 25 -


MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 3 – LOANS (Continued)
 
As of June 30, 2012, the risk grade category of commercial loans by class of loans was as follows (dollars in thousands):
 
      1       2       3       4       5       6       7       8  
                                                                 
Commercial and industrial
  $ 1,275     $ 11,275     $ 68,452     $ 115,912     $ 14,159     $ 4,384     $ 6,171     $ ---  
Commercial real estate:
                                                               
Residential developed
    ---       ---       763       7,381       8,995       5,864       5,461       ---  
Unsecured to residential developers
    ---       ---       ---       556       33       ---       ---       ---  
Vacant and unimproved
    ---       ---       14,608       24,981       17,349       3,059       118       ---  
Commercial development
    ---       ---       ---       2,420       1,104       826       422       ---  
Residential improved
    ---       119       8,704       42,294       15,331       10,572       2,149       ---  
Commercial improved
    ---       3,840       62,384       152,830       47,530       13,999       2,710       ---  
Manufacturing and industrial
    ---       2,101       17,096       35,816       11,450       8,811       257       ---  
                                                                 
    $ 1,275     $ 17,335     $ 172,007     $ 382,190     $ 115,951     $ 47,515     $ 17,288     $ ---  
 
As of December 31, 2011, the risk grade category of commercial loans by class of loans was as follows (dollars in thousands):
 
      1       2       3       4       5       6       7       8  
                                                                 
Commercial and industrial
  $ 595     $ 8,447     $ 56,457     $ 117,015     $ 27,674     $ 7,593     $ 9,270     $ ---  
Commercial real estate:
                                                               
Residential developed
    ---       ---       283       9,688       11,410       8,725       3,723       ---  
Unsecured to residential developers
    ---       ---       4,773       647       177       340       ---       ---  
Vacant and unimproved
    ---       ---       14,707       24,344       21,362       1,918       3,715       ---  
Commercial development
    ---       ---       60       2,261       1,109       1,107       49       ---  
Residential improved
    ---       121       2,650       45,813       18,642       9,968       5,143       ---  
Commercial improved
    ---       5       62,510       173,697       43,493       21,712       2,653       ---  
Manufacturing and industrial
    ---       2,242       12,209       38,533       11,344       7,000       134       ---  
                                                                 
    $ 595     $ 10,815     $ 153,649     $ 411,998     $ 135,211     $ 58,363     $ 24,687     $ ---  
 
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):
 
 
 
June 30,
 2012
 
 
December 31, 2011
 
 
 
 
 
 
 
 
Not classified as impaired
 
$
20,516
 
 
$
29,687
 
Classified as impaired
 
 
44,287
 
 
 
53,363
 
 
 
 
 
 
 
 
 
 
Total commercial loans classified substandard or worse
 
$
64,803
 
 
$
83,050
 
 
 
- 26 -


MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 3 – LOANS (Continued)
 
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):
 
   
Residential
   
Consumer
   
Home
   
Consumer
 
June 30, 2012
 
Mortgage
   
Unsecured
   
Equity
   
Other
 
Performing
  $ 170,297     $ 1,776     $ 95,980     $ 14,110  
Nonperforming
    686       ---       555       ---  
Total
  $ 170,983     $ 1,776     $ 96,535     $ 14,110  
 
   
Residential
   
Consumer
   
Home
   
Consumer
 
December 31, 2011
 
Mortgage
   
Unsecured
   
Equity
   
Other
 
Performing
  $ 155,374     $ 1,952     $ 100,576     $ 15,738  
Nonperforming
    1,517       ---       498       2  
Total
  $ 156,891     $ 1,952     $ 101,074     $ 15,740  
 
NOTE 4 – OTHER REAL ESTATE OWNED
 
Period-end other real estate owned was as follows (dollars in thousands):
 
 
 
Six
 
 
Year
 
 
Six
 
Months Ended
Ended
Months Ended
June 30,
December 31,
June 30,
2012
2011
2011
 
 
 
 
 
 
 
 
 
 
Beginning balance
 
$
83,663
 
 
$
68,388
 
 
$
68,388
 
Additions, transfers from loans and fixed assets
 
 
7,725
 
 
 
38,358
 
 
 
23,384
 
Proceeds from sales of other real estate owned
 
 
(8,587
)
 
 
(21,540
)
 
 
(11,330
)
Valuation allowance reversal upon sale
 
 
(1,998
)
 
 
(3,058
)
 
 
(1,730
)
Gain (loss) on sale of other real estate owned
 
 
20
 
 
 
1,515
 
 
 
745
 
 
 
 
80,823
 
 
 
83,663
 
 
 
79,457
 
Less: valuation allowance
 
 
(18,777
)
 
 
(17,225
)
 
 
(14,025
)
Ending balance
 
$
62,046
 
 
$
66,438
 
 
$
65,432
 
 
 
- 27 -


MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 4 – OTHER REAL ESTATE OWNED (Continued)

Activity in the valuation allowance for other real estate owned was as follows (dollars in thousands):

 
 
Three Months
   
Three Months
 
 
Six Months
 
 
Six Months
 
Ended
Ended
Ended
Ended
June 30,
June 30,
June 30,
June 30,
2012
2011
2012
2011
Beginning balance
 
$
17,452
   
$
12,020
 
 
$
17,225
 
 
$
10,404
 
Additions charged to expense
 
 
1,860
   
 
2,653
 
 
 
3,550
 
 
 
5,351
 
Reversals upon sale
 
 
(535
)
 
 
(648
)
 
 
(1,998
)
 
 
(1,730
)
Ending balance
 
$
18,777
   
$
14,025
   
$
18,777
   
$
14,025
 

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).
 
Loans Held for Sale: The fair value of loans held for sale is based upon binding quotes from 3rd party investors (Level 2 inputs)
 
Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses 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: Adjustments to commercial and residential real estate properties classified as other real estate owned (OREO) are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized through a valuation allowance.
 
 
- 28 -

 
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)
 
June 30, 2012
                       
U.S. Treasury and federal agency securities
  $ 30,525     $ ---     $ 30,525     $ ---  
U.S. Agency MBS and CMOs
    23,369       ---       23,369       ---  
Tax-exempt state and municipal bonds
    15,380       ---       15,380       ---  
Taxable state and municipal bonds
    21,448       ---       21,448       ---  
Corporate bonds and other debt securities
    4,234       ---       4,234       ---  
Other equity securities
    1,562       ---       1,562       ---  
Loans held for sale
    6,630       ---       6,630       ---  
                                 
December 31, 2011
                               
U.S. Treasury and federal agency securities
  $ 27,613     $ ---     $ 27,613     $ ---  
U.S. Agency MBS and CMOs
    3,886       ---       3,886       ---  
Tax-exempt state and municipal bonds
    4,408       ---       4,408       ---  
Taxable state and municipal bonds
    16,716       ---       16,716       ---  
Corporate bonds
    1,081       ---       1,081       ---  
Other equity securities
    1,042       ---       1,042       ---  
Loans held for sale
    1,026       ---       1,026       ---  
 
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)
 
June 30, 2012
 
 
   
 
   
 
   
 
 
Impaired loans
  $ 28,540     $ ---     $ ---     $ 28,540  
Other real estate owned
    43,263       ---       ---       43,263  
                                 
December 31, 2011
                               
Impaired loans
  $ 22,525     $ ---     $ ---     $ 22,525  
Other real estate owned
    39,730       ---       ---       39,730  
 
 
- 29 -

 
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 June 30, 2012 and December 31, 2011 (dollars in thousands).

 
Level in
 
June 30, 2012
 
 
December 31, 2011
 
 
Fair Value
 
Carrying
 
 
Fair
 
 
Carrying
 
 
Fair
 
 
Hierarchy
 
Amount
 
 
Value
 
 
Amount
 
 
Value
 
Financial assets
   
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
Level 1
 
$
25,673
 
 
$
25,673
 
 
$
30,971
 
 
$
30,971
 
Cash equivalents
Level 2
   
218,721
     
218,721
     
212,071
     
212,071
 
Securities held to maturity
Level 2
 
 
300
 
 
 
300
 
 
 
300
 
 
 
300
 
FHLB stock
   
 
11,236
 
 
 
N/A
 
 
 
11,236
 
 
 
NA
 
Loans, net
Level 2
 
 
981,245
 
 
 
987,106
 
 
 
1,016,809
 
 
 
1,024,766
 
Bank owned life insurance
Level 3
   
26,404
     
26,404
     
25,957
     
25,957
 
Accrued interest receivable
Level 2
 
 
3,525
 
 
 
3,525
 
 
 
3,595
 
 
 
3,595
 
     
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Financial liabilities
   
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deposits
Level 2
 
 
(1,235,517
)
 
 
(1,235,896
)
 
 
(1,215,289
)
 
 
(1,216,452
)
Other borrowed funds
Level 2
 
 
(127,489
)
 
 
(130,922
)
 
 
(148,603
)
 
 
(151,566
)
Long-term debt
Level 2
 
 
(41,238
)
 
 
(34,861
)
 
 
(41,238
)
 
 
(34,820
)
Subordinated debt
Level 2
 
 
(1,650
)
 
 
(1,650
)
 
 
(1,650
)
 
 
(1,650
)
Accrued interest payable
Level 2
 
 
(4,186
)
 
 
(4,186
)
 
 
(3,517
)
 
 
(3,517
)
     
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
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 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.
 
NOTE 6 – DEPOSITS
 
Deposits are summarized as follows (in thousands):
 
    June 30,     December 31,  
    2012     2011  
Noninterest-bearing demand
  $
330,626
    $
324,253
 
Interest bearing demand
   
229,424
     
204,402
 
Savings and money market accounts
   
415,748
     
381,498
 
Certificates of deposit
 
 
259,719
   
 
305,136
 
    $
1,235,517
    $
1,215,289
 

Approximately $92.4 million and $106.3 million in certificates of deposit were in denominations of $100,000 or more at June 30, 2012 and December 31, 2011, respectively.
 
The Bank had no brokered deposits at June 30, 2012 and December 31, 2011.
 
 
- 30 -


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):
 
 
 
Advance
 
 
 
Weighted Average
 
Principal Terms
Amount
Range of Maturities
Interest Rate
 
 
 
 
 
 
 
 
June 30, 2012
 
 
 
 
 
 
 
Single maturity fixed rate advances
 
$
115,000
 
July 2012 to September 2016
 
 
1.69
%
Amortizable mortgage advances
 
 
12,489
 
March 2018 to July 2018
 
 
3.77
%
 
 
$
127,489
 
 
 
 
 
 
 
 
 
Advance
 
 
 
Weighted Average
 
Principal Terms
Amount
Range of Maturities
Interest Rate
 
 
 
 
 
 
 
 
December 31, 2011
 
 
 
 
 
 
 
Single maturity fixed rate advances
 
$
135,000
 
March 2012 to September 2016
 
 
1.79
%
Amortizable mortgage advances
 
 
13,603
 
March 2018 to July 2018
 
 
3.77
%
 
 
$
148,603
 
 
 
 
 
 
 
Each advance is subject to a prepayment penalty 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 $419.5 million under a blanket lien arrangement at June 30, 2012 and $389.8 million under a physical loan collateral delivery arrangement at December 31, 2011.
 
Scheduled repayments of FHLB advances as of June 30, 2012 were as follows (in thousands):
 
2012
 
$
15,667
 
2013
 
 
1,831
 
2014
 
 
21,884
 
2015
 
 
21,938
 
2016
 
 
61,996
 
Thereafter
 
 
4,173
 
 
 
$
127,489
 
 
 
- 31 -

 
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
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 six month periods ended June 30, 2012 and 2011 are as follows (dollars in thousands, except per share data):
 
 
 
Three Months
   
Three Months
 
 
Six Months
 
 
Six Months
 
Ended
Ended
Ended
Ended
June 30,
June 30,
June 30,
June 30,
2012
2011
2012
2011
 
 
 
   
 
 
 
 
 
 
 
 
Net income
 
$
3,186
   
$
2,401
 
 
$
7,671
 
 
$
3,692
 
Dividends declared on preferred shares
 
 
---
   
 
---
 
 
 
---
 
 
 
---
 
Net income available to common shares
 
$
3,186
   
$
2,401
 
 
$
7,671
 
 
$
3,692
 
 
 
 
     
 
 
 
 
 
 
 
 
 
 
 
Weighted average shares outstanding, including participating stock awards - Basic
 
 
27,082,825
   
 
18,964,150
 
 
 
27,082,825
 
 
 
18,325,434
 
 
 
 
     
 
 
 
 
 
 
 
 
 
 
 
Dilutive potential common shares:
 
 
     
 
 
 
 
 
 
 
 
 
 
 
Stock options
 
 
---
   
 
---
 
 
 
---
 
 
 
---
 
Conversion of preferred stock
 
 
---
   
 
---
 
 
 
---
 
 
 
---
 
Stock warrants
 
 
---
   
 
---
 
 
 
---
 
 
 
---
 
Weighted average shares outstanding - Diluted
 
 
27,082,825
   
 
18,964,150
 
 
 
27,082,825
 
 
 
18,325,434
 
 
 
 
     
 
 
 
 
 
 
 
 
 
 
 
Basic earnings per common share
 
$
0.12
   
$
0.13
 
 
$
0.28
 
 
$
0.20
 
Diluted earnings per common share
 
$
0.12
   
$
0.13
 
 
$
0.28
 
 
$
0.20
 
 
Stock options for 556,191 shares of common stock for both the three and six month periods ended June 30, 2012 were excluded from dilutive potential common shares because they were antidilutive.  Stock options for 705,390 and 710,522 shares of common stock for the three and six month periods ended June 30, 2011, respectively, were excluded from dilutive potential common shares because they were antidilutive. Common shares associated with convertible preferred stock and stock warrants were excluded from dilutive potential common shares in each period as they were antidilutive.
 
NOTE 9 - FEDERAL INCOME TAXES
 
Income tax expense (benefit) was as follows (dollars in thousands):
 
 
 
Three Months
 
 
Three Months
 
 
Six Months
 
 
Six Months
 
Ended
Ended
Ended
Ended
June 30,
June 30,
June 30,
June 30,
2012
2011
2012
2011
 
 
 
   
 
 
 
 
 
 
 
 
Current
 
$
(176
)
 
$
(80
)
 
$
(163
)
 
$
(82
)
Deferred (benefit) expense
 
 
176
   
 
80
 
 
 
163
 
 
 
82
 
 
 
$
---
   
$
---
 
 
$
---
 
 
$
---
 
 
 
- 32 -

 
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 9 - FEDERAL INCOME TAXES (Continued)
 
The difference between the financial statement tax expense (benefit) and amount computed by applying the statutory federal tax rate to pretax income was reconciled as follows (dollars in thousands):
 
 
 
Three Months
 
 
Three Months
   
Six Months
 
 
Six Months
 
Ended
Ended
Ended
Ended
June 30,
June 30,
June 30,
June 30,
2012
2011
2012
2011
 
 
 
   
 
   
 
 
 
 
 
Statutory rate
 
 
35
%
 
 
35
%
 
 
35
%
 
 
35
%
Statutory rate applied to income before taxes
 
$
1,115
 
 
$
840
   
$
2,685
 
 
$
1,292
 
Add (deduct)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Change in valuation allowance
 
 
(822
)
 
 
(654
)
 
 
(2,295
)
 
 
(1,009
)
Tax-exempt interest income
 
 
(20
)
 
 
(69
)
 
 
(32
)
 
 
(69
)
Bank-owned life insurance
 
 
(79
)
 
 
(88
)
 
 
(157
)
 
 
(163
)
Other, net
 
 
(194
)
 
 
(29
)
 
 
(201
)
 
 
(51
)
   
$
---
   
$
---
   
$
---
   
$
---
 

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.
 
We established an $18.0 million valuation allowance on deferred tax assets in 2009 based primarily on the Company’s net operating losses for 2009 and 2008. As a result of losses incurred in 2010, the Company increased the valuation allowance to $25.6 million at December 31, 2010. At December 31, 2011 and June 30, 2012, a valuation allowance of $24.0 million and $21.6 million, respectively, was maintained as the Company continued to face a challenging economic environment currently confronting banks that could negatively impact future operating results. The valuation allowance may be reversed to income in future periods to the extent that the related deferred tax assets are realized or when the Company returns to consistent, sustained profitability.
 
 
- 33 -


MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE 9 - FEDERAL INCOME TAXES (Continued)
 
The net deferred tax asset recorded included the following amounts of deferred tax assets and liabilities (dollars in thousands):
 
 
 
June 30,
 
 
December 31,
 
2012
2011
Deferred tax assets
 
 
 
 
 
 
Allowance for loan losses
 
$
9,513
 
 
$
11,074
 
Nonaccrual loan interest
 
 
953
 
 
 
839
 
Valuation allowance on other real estate owned
 
 
6,572
 
 
 
6,029
 
Net operating loss carryforward
 
 
5,982
 
 
 
7,673
 
Other
 
 
1,346
 
 
 
1,137
 
Gross deferred tax assets
 
 
24,366
 
 
 
26,752
 
Valuation allowance
 
 
(21,568
)
 
 
(24,026
)
Total net deferred tax assets
 
 
2,798
 
 
 
2,726
 
 
 
 
 
 
 
 
 
 
Deferred tax liabilities
 
 
 
 
 
 
 
 
Depreciation
 
 
(1,671
)
 
 
(1,758
)
Purchase accounting adjustments
 
 
---
 
 
 
(22
)
Unrealized gain on securities available for sale
 
 
(366
)
 
 
(204
)
Prepaid expenses
 
 
(407
)
 
 
(407
)
Other
 
 
(354
)
 
 
(335
)
Gross deferred tax liabilities
 
 
(2,798
)
 
 
(2,726
)
Net deferred tax asset
 
$
---
 
 
$
---
 
 
At June 30, 2012, we had federal net operating loss carry forwards of $17.1 million that expire through 2030.
 
There were no unrecognized tax benefits at June 30, 2012 or December 31, 2011 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 2008.
 
NOTE 10 – CONTINGENCIES
 
We and our subsidiaries periodically become defendants in certain claims and legal actions arising in the ordinary course of business. As of June 30, 2012, there were no material pending legal proceedings to which we or any of our subsidiaries are a party or which any of our properties are the subject.
 
NOTE 11 – 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.
 
 
- 34 -

 
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 11 – SHAREHOLDERS' EQUITY (Continued)
 
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.
 
At June 30, 2012 and December 31, 2011, actual and minimum required capital levels were (in thousands):

   
Actual
   
Minimum Required
For Capital
Adequacy Purposes
   
To Be Well
Capitalized Under
Prompt Corrective
Action Regulations
   
Minimum Required
Under MOU/Consent
Order (1)
 
 
 
Amount
 
 
Ratio
 
 
Amount
 
 
Ratio
 
 
Amount
 
 
Ratio
 
 
Amount
 
 
Ratio
 
June 30, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total capital (to risk weighted assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
$
157,255
 
 
 
14.2
%
 
$
88,742
 
 
 
8.0
%
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
Bank
 
 
150,545
 
 
 
13.6
 
 
 
88,731
 
 
 
8.0
 
 
$
110,914
 
 
 
10.0
%
 
 
N/A
 
 
 
N/A
 
Tier 1 capital (to risk weighted assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
 
135,396
 
 
 
12.2
 
 
 
44,371
 
 
 
4.0
 
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
Bank
 
 
136,488
 
 
 
12.3
 
 
 
44,366
 
 
 
4.0
 
 
 
66,548
 
 
 
6.0
 
 
 
N/A
 
 
 
N/A
 
Tier 1 capital (to average assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
 
135,396
 
 
 
9.0
 
 
 
60,163
 
 
 
4.0
 
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
Bank
 
 
136,488
 
 
 
9.1
 
 
 
60,092
 
 
 
4.0
 
 
 
75,115
 
 
 
5.0
 
 
 $
120,184
 
 
 
8.0
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2011
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total capital (to risk weighted assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
$
149,905
 
 
 
13.2
%
 
$
91,201
 
 
 
8.0
%
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
Bank
 
 
142,059
 
 
 
12.5
 
 
 
91,193
 
 
 
8.0
 
 
$
113,991
 
 
 
10.0
%
 
$
125,390
 
 
 
11.0
%
Tier 1 capital (to risk weighted assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
 
125,028
 
 
 
11.0
 
 
 
45,601
 
 
 
4.0
 
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
Bank
 
 
127,576
 
 
 
11.2
 
 
 
45,596
 
 
 
4.0
 
 
 
68,394
 
 
 
6.0
 
 
 
N/A
 
 
 
N/A
 
Tier 1 capital (to average assets)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Consolidated
 
 
125,028
 
 
 
8.3
 
 
 
60,598
 
 
 
4.0
 
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
 
 
N/A
 
Bank
 
 
127,576
 
 
 
8.4
 
 
 
60,528
 
 
 
4.0
 
 
 
75,660
 
 
 
5.0
 
 
 
121,056
 
 
 
8.0
 
 
 
(1)
The MOU is applicable to the June 30, 2012 information presented in these columns, and the Consent Order is applicable to the December 31, 2011 information presented in these columns.

Approximately $33.8 million and $31.3 million of trust preferred securities outstanding at June 30, 2012 and December 31, 2011, respectively, qualified as Tier 1 capital. Refer to our 2011 Form 10-K for more information on the trust preferred securities.
 
The Bank was categorized as "well capitalized" at June 30, 2012 and “adequately capitalized” at December 31, 2011. The Bank’s regulatory capital ratios exceeded the levels ordinarily required to be categorized as "well capitalized" at December 31, 2011. However, because the Bank was subject to the Consent Order at the time, the Bank could not be categorized as "well capitalized" regardless of actual capital levels.  The Consent Order was terminated on March 2, 2012.
 
 
- 35 -

 
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 11 – SHAREHOLDERS' EQUITY (Continued)

The MOU prohibits the Bank from declaring or paying any cash dividend without the prior written consent of its regulators. The payment of future cash dividends by the Company is largely dependent upon dividends received from the Bank out of its earnings. Under Michigan law, the Bank is also restricted from paying dividends to the Company until its deficit retained earnings has been restored. The Bank had a retained deficit of approximately $22.9 million at June 30, 2012.
 
Additional information about the Consent Order and the MOU may be found in Note 1 under the heading "Regulatory Developments”.
 
 
- 36 -

 
Item 2.
 
Macatawa Bank Corporation is a Michigan corporation and a registered bank holding company. It wholly-owns Macatawa Bank, Macatawa Statutory Trust I 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 Trusts I and II are grantor trusts and issued $20.0 million each of pooled trust preferred securities. These trusts are not consolidated in our Consolidated Financial Statements. For further information regarding consolidation, see the Notes to the Consolidated Financial Statements.
 
At June 30, 2012, we had total assets of $1.52 billion, total loans of $1.04 billion, total deposits of $1.24 billion and shareholders' equity of $102.4 million. During the second quarter of 2012, we recognized net income of $3.2 million compared to net income of $2.4 million in the second quarter of 2011. This represented our ninth consecutive quarter of profitability. As described more fully below, continued reductions in net charge-offs and nonperforming loans led to a negative loan loss provision for the most recent quarter.

In response to our losses during 2008, 2009 and the first quarter of 2010, our Board of Directors implemented additional corporate governance practices and disciplined business and banking principles, including more conservative lending principles.   The focus of our management team turned from growth in our business to executing these disciplined business and banking procedures and policies designed to limit future losses, preserve capital and improve operational efficiencies.  In addition, the Board of Directors added experienced members to provide further oversight and guidance.  These and other efforts were reflected in our results of operations for the past two years with lower levels of charge-offs and provision for loan losses, reductions in operating expenses and reduction in balance sheet totals resulting in improvement in our regulatory capital and liquidity ratios.  We successfully completed our shareholder rights offering and public offering of common stock in June 2011 resulting in net proceeds of $20.3 million and contributed $10.0 million of the proceeds from the stock offering to the Bank retaining the remaining $10.3 million at the holding company.  As of June 30, 2012, the Company’s and the Bank’s regulatory capital ratios were the highest they have been since December 31, 1999.  The Bank was categorized as “well capitalized at June 30, 2012.

On February 22, 2010, Macatawa Bank entered into a Consent Order with the FDIC and OFIR, the primary banking regulators of the Bank. The Company also entered into a Written Agreement with the FRB with an effective date of July 23, 2010.   Upon completion of the Bank’s 2011 joint examination, the FDIC and OFIR terminated the Bank’s Consent Order effective March 2, 2012.
 
In connection with the termination of the Consent Order, the Bank reached an understanding with the regulators in the form of a Memorandum of Understanding (“MOU”).  As of June 30, 2012, we believe that the Bank was in compliance in all material respects with all of the provisions of the MOU. As of the same date, we believe that the Company was in compliance in all material respects with all of the provisions of the Written Agreement. See Note 1 to the Consolidated Financial Statements for more information.

Additional information further describing changes in our business, including those in response to the Consent Order, MOU and the Written Agreement, are described in detail in our 2011 Annual Report on Form 10-K.
 
RESULTS OF OPERATIONS
 
Summary: Net income available to common shares for the quarter ended June 30, 2012 was $3.2 million, compared to net income of $2.4 million in the second quarter of 2011.  Net income per common share on a diluted basis was $0.12 for the second quarter of 2012 and $0.13 for the second quarter of 2011.  For the six months ended June 30, 2012, net income was $7.7 million, compared to $3.7 million for the same period in 2011.  Net income per common share on a diluted basis for the six months ended June 30, 2012 was $0.28, compared to $0.20 for the same period in 2011.
 
The improvement in earnings in the second quarter and first six months of 2012 was a continuation of improvement in the past several quarters, led by a significantly lower level of net charge-offs from $2.9 million in the second quarter of 2011 to $521,000 in the second quarter of 2012. This, coupled with a decline in non-performing and impaired loan levels, resulted in a negative provision for loan losses for the most recent quarter. The provision for loan losses was a negative $1.75 million for the three month period ended June 30, 2012 compared to a negative $2.0 million for the same period in 2011.   For the year to date period ended June 30, 2012, we recognized a negative $5.35 million provision compared to a negative $3.45 million provision for the same period in 2011.  The increased negative provision in the six month period ended June 30, 2012 is largely attributable to a sizeable recovery recognized in the first quarter of 2012 as discussed in previous filings.
 
 
- 37 -

 
Operating results in recent periods have been significantly impacted by the expense associated with problem loans and nonperforming assets. Apart from the provision for loan losses, expenses associated with nonperforming assets (including administration costs and losses) were $3.2 million for the second quarter of 2012 compared to $3.7 million for the second quarter of 2011.  For the first half of 2012, such expenses totaled $6.2 million compared to $8.2 million for the same period in 2011. Significant valuation writedowns on other real estate owned and higher levels of legal costs associated with nonperforming assets in the first half of 2011 were the primary reasons for the change between periods.  Lost interest from elevated levels of nonperforming assets was approximately $970,000 and $2.1 million, respectively, for the three and six months ended June 30, 2012 compared to $1.8 million and $3.9 million, respectively, for the three and six months ended June 30, 2011.  Each of these items is discussed more fully below.
 
Net Interest Income: Net interest income totaled $11.3 million for the second quarter of 2012 compared to $11.8 million for the second quarter of 2011.  For the first half of 2012, net interest income was $22.6 million compared to $23.4 million for the same  period in 2011.
 
The decrease in net interest income in the second quarter of 2012 was due primarily to a $19.5 million reduction in our average interest earning assets as a result of our focus on reducing credit exposure within certain segments of our loan portfolio, liquidity improvement and capital preservation. The net interest margin was 3.32% for the second quarter of 2012 compared to 3.39% for the second quarter of 2011. Average interest earning assets decreased from $1.38 billion for the second quarter of 2011 to $1.36 billion for the same period in 2012. Our average yield on earning assets for the second quarter of 2012 decreased 39 basis points compared to the same period in 2011 from 4.47% to 4.08%. Average interest bearing liabilities decreased $66.1 million from $1.15 billion for the second quarter of 2011 to $1.09 billion for the same period in 2012. The cost of average interest bearing liabilities decreased 33 basis points compared to the same period in 2011 from 1.28% to 0.95%, which partially offset the effect of the decline in yield on earning assets.

Average interest earning assets decreased from $1.41 billion for the first six months of 2011 to $1.35 billion for the same period in 2012.  Our average yield on earning assets declined 32 basis points for the first half of 2012 in comparison with the same period in 2011. Our net interest margin was 3.32% for the six month period in 2012 compared to 3.31% for the same period in 2011 primarily due a 36 basis points decline in the average cost of interest bearing liabilities as we continued to payoff wholesale funding as the individual instruments matured.

The declines in yields on interest earning assets for the three and six month periods ended June 30, 2012 were from decreases in the yield on our commercial, residential and consumer loan portfolios, which have repriced in the generally lower rate environment during this period. Our margin has been negatively impacted by our decision to hold significant balances in liquid and short-term investments during the past two years. As we deploy these balances in building our investment portfolio and booking high quality loans, we expect our margin to be positively impacted.

The declines in cost of funds for the three and six month periods ended June 30, 2012 were due to a decrease in the rates paid on our deposit accounts in response to declining market rates and the rollover of time deposits and other borrowings at lower rates within the current rate environment. Also contributing to the reduction was a shift in our deposit mix from higher costing time deposits to lower costing demand and savings accounts.
 
 
- 38 -


The following table shows an analysis of net interest margin for the three month periods ended June 30, 2012 and 2011.
 
 
 
For the three months ended June 30,
 
 
 
2012
 
 
2011
 
 
 
 
 
 
Interest
 
Average
 
 
 
 
 
Interest
 
 
Average
 
 
 
Average
 
 
Earned
 
Yield
 
 
Average
 
 
Earned
 
 
Yield
 
 
 
Balance
 
 
or paid
 
or cost
 
 
Balance
 
 
or paid
 
 
or cost
 
 
 
(Dollars in thousands)
 
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Taxable securities
 
$
75,987
 
 
 
384
 
 
 
2.02
%
 
$
16,783
 
 
$
85
 
 
 
2.02
%
Tax-exempt securities (1)
 
 
9,955
 
 
 
65
 
 
 
4.47
%
 
 
22
 
 
 
---
 
 
 
5.59
%
Loans (2)
 
 
1,055,624
 
 
 
13,237
 
 
 
4.98
%
 
 
1,139,593
 
 
 
15,194
 
 
 
5.29
%
Federal Home Loan Bank stock
 
 
11,236
 
 
 
84
 
 
 
2.95
%
 
 
11,764
 
 
 
74
 
 
 
2.47
%
Federal funds sold and other short-term investments
 
 
203,251
 
 
 
130
 
 
 
0.25
%
 
 
207,351
 
 
 
137
 
 
 
0.26
%
Total interest earning assets (1)
 
 
1,356,053
 
 
 
13,900
 
 
 
4.08
%
 
 
1,375,513
 
 
 
15,490
 
 
 
4.47
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noninterest earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
 
 
22,140
 
 
 
 
 
 
 
 
 
 
 
22,569
 
 
 
 
 
 
 
 
 
Other
 
 
127,024
 
 
 
 
 
 
 
 
 
 
 
115,425
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total assets
 
$
1,505,217
 
 
 
 
 
 
 
 
 
 
$
1,513,507
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deposits:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing demand
 
$
223,439
 
 
 
86
 
 
 
0.15
%
 
$
184,989
 
 
 
108
 
 
 
0.23
%
Savings and money market accounts
 
 
419,097
 
 
 
505
 
 
 
0.48
%
 
 
373,104
 
 
 
527
 
 
 
0.57
%
Time deposits
 
 
272,149
 
 
 
935
 
 
 
1.38
%
 
 
380,743
 
 
 
1,781
 
 
 
1.88
%
Borrowings:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other borrowed funds
 
 
132,326
 
 
 
672
 
 
 
2.01
%
 
 
174,261
 
 
 
943
 
 
 
2.14
%
Long-term debt
 
 
41,238
 
 
 
380
 
 
 
3.65
%
 
 
41,238
 
 
 
349
 
 
 
3.35
%
Total interest bearing liabilities
 
 
1,088,249
 
 
 
2,578
 
 
 
0.95
%
 
 
1,154,335
 
 
 
3,708
 
 
 
1.28
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing demand accounts
 
 
308,152
 
 
 
 
 
 
 
 
 
 
 
278,417
 
 
 
 
 
 
 
 
 
Other noninterest bearing liabilities
 
 
7,580
 
 
 
 
 
 
 
 
 
 
 
8,202
 
 
 
 
 
 
 
 
 
Shareholders' equity
 
 
101,236
 
 
 
 
 
 
 
 
 
 
 
72,553
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total liabilities and shareholders' equity
 
$
1,505,217
 
 
 
 
 
 
 
 
 
 
$
1,513,507
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income
 
 
 
 
 
$
11,322
 
 
 
 
 
 
 
 
 
 
$
11,782
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest spread (1)
 
 
 
 
 
 
 
 
 
 
3.13
%
 
 
 
 
 
 
 
 
 
 
3.19
%
Net interest margin (1)
 
 
 
 
 
 
 
 
 
 
3.32
%
 
 
 
 
 
 
 
 
 
 
3.39
%
Ratio of average interest earning assets to average interest bearing liabilities
 
 
124.61
%
 
 
 
 
 
 
 
 
 
 
119.16
%
 
 
 
 
 
 
 
 
 
 
(1)
Yield adjusted to fully tax equivalent.
 
(2)
Includes non-accrual loans of approximately $24.9 million and $55.1 million for the three months ended June 30, 2012 and 2011.

 
- 39 -

 
The following table shows an analysis of net interest margin for the six month periods ended June 30, 2012 and 2011.
 
 
 
For the six months ended June 30,
 
 
 
2012
 
 
2011
 
 
 
 
 
 
Interest
 
Average
 
 
 
 
 
Interest
 
 
Average
 
 
 
Average
 
 
Earned
 
Yield
 
 
Average
 
 
Earned
 
 
Yield
 
 
 
Balance
 
 
or paid
 
or cost
 
 
Balance
 
 
or paid
 
 
or cost
 
 
 
(Dollars in thousands)
 
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Taxable securities
 
$
67,941
 
 
 
701
 
 
 
2.06
%
 
$
14,222
 
 
$
111
 
 
 
1.56
%
Tax-exempt securities (1)
 
 
8,075
 
 
 
108
 
 
 
4.61
%
 
 
49
 
 
 
1
 
 
 
6.66
%
Loans (2)
 
 
1,062,338
 
 
 
26,763
 
 
 
5.01
%
 
 
1,161,887
 
 
 
30,776
 
 
 
5.28
%
Federal Home Loan Bank stock
 
 
11,236
 
 
 
169
 
 
 
2.97
%
 
 
11,847
 
 
 
150
 
 
 
2.52
%
Federal funds sold and other short-term investments
 
 
203,578
 
 
 
257
 
 
 
0.25
%
 
 
218,399
 
 
 
305
 
 
 
0.25
%
Total interest earning assets (1)
 
 
1,353,168
 
 
 
27,998
 
 
 
4.12
%
 
 
1,406,404
 
 
 
31,343
 
 
 
4.44
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noninterest earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
 
 
21,751
 
 
 
 
 
 
 
 
 
 
 
22,221
 
 
 
 
 
 
 
 
 
Other
 
 
126,697
 
 
 
 
 
 
 
 
 
 
 
110,875
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total assets
 
$
1,501,616
 
 
 
 
 
 
 
 
 
 
$
1,539,500
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deposits:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing demand
 
$
216,973
 
 
 
182
 
 
 
0.17
%
 
$
181,982
 
 
 
211
 
 
 
0.23
%
Savings and money market accounts
 
 
407,196
 
 
 
1,014
 
 
 
0.50
%
 
 
371,879
 
 
 
1,070
 
 
 
0.58
%
Time deposits
 
 
284,150
 
 
 
1,979
 
 
 
1.40
%
 
 
407,490
 
 
 
4,047
 
 
 
2.00
%
Borrowings:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other borrowed funds
 
 
140,855
 
 
 
1,451
 
 
 
2.04
%
 
 
180,267
 
 
 
1,942
 
 
 
2.14
%
Long-term debt
 
 
41,238
 
 
 
770
 
 
 
3.70
%
 
 
41,238
 
 
 
693
 
 
 
3.35
%
Total interest bearing liabilities
 
 
1,090,412
 
 
 
5,396
 
 
 
0.99
%
 
 
1,182,856
 
 
 
7,963
 
 
 
1.35
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Noninterest bearing demand accounts
 
 
305,742
 
 
 
 
 
 
 
 
 
 
 
278,706
 
 
 
 
 
 
 
 
 
Other noninterest bearing liabilities
 
 
7,082
 
 
 
 
 
 
 
 
 
 
 
7,189
 
 
 
 
 
 
 
 
 
Shareholders' equity
 
 
98,380
 
 
 
 
 
 
 
 
 
 
 
70,749
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total liabilities and shareholders' equity
 
$
1,501,616
 
 
 
 
 
 
 
 
 
 
$
1,539,500
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest income
 
 
 
 
 
$
22,602
 
 
 
 
 
 
 
 
 
 
$
23,380
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net interest spread (1)
 
 
 
 
 
 
 
 
 
 
3.13
%
 
 
 
 
 
 
 
 
 
 
3.09
%
Net interest margin (1)
 
 
 
 
 
 
 
 
 
 
3.32
%
 
 
 
 
 
 
 
 
 
 
3.31
%
Ratio of average interest earning assets to average interest bearing liabilities
 
 
124.10
%
 
 
 
 
 
 
 
 
 
 
118.90
%
 
 
 
 
 
 
 
 
 
(1)
Yield adjusted to fully tax equivalent.
(2)
Includes non-accrual loans of approximately $28.1 million and $64.2 million for the six months ended June 30, 2012 and 2011.
 
 
- 40 -

 
Provision for Loan Losses: The provision for loan losses for the second quarter of 2012 was a negative $1.75 million compared to a negative $2.0 million for the second quarter of 2011. The negative provisions in both periods were the result of continued significant declines in the level of net charge-offs, reduction in the balances and required reserves on nonperforming loans, and stabilizing real estate values on problem credits.  The provision for loan losses for the first half of 2012 was a negative $5.4 million, compared to a negative $3.45 million for the same period in 2011.  The larger negative provision in the first half of 2012 was primarily associated with a $4.4 million recovery on a previously charged-off loan in the first quarter of 2012.
 
Net charge-offs were $521,000 for the second quarter of 2012 compared to $2.9 million for the second quarter of 2011.  The charge-offs for each period have largely been driven by declines in the value of real estate securing our loans. The pace of the decline in real estate value, however, has been slowing, translating into a decline in charge-offs. We are also experiencing positive results from our collection efforts with recoveries increasing as evidenced by the $4.4 million recovery collected in the first quarter of 2012.  For the second quarter of 2012, recoveries were $378,000 compared to $1.6 million for the same period in 2011.  For the six months ended June 30, 2012 we experienced net recoveries of $889,000 compared to net charge-offs of $6.5 million for the same period in 2011 due to the large recovery collected in the first quarter of 2012.  For the six months ended June 30, 2012, recoveries totaled $5.3 million, compared to $2.1 million for the same period in 2011.  While we expect our collection efforts to produce further recoveries, the amount achieved in the first quarter of 2012 was unusually high and may not recur at this level in future quarters.
 
We have also experienced a decline in the pace of commercial loans migrating to a worse loan grade, which receive higher allocations in our loan loss reserve, as more fully discussed under the heading "Allowance for Loan Losses" below. In addition to experiencing fewer downgrades of credits, we continue to see an increase in the quality of some credits resulting in an improved loan grade. Over the past six quarters, we have experienced improvements in our weighted average loan grade. We believe efforts that began in late 2009 and in early 2010 to improve loan administration and loan risk management practices have had a significant impact, ultimately allowing for the reduction in the level of the provision for loan losses in 2012.
 
The amounts of loan loss provision in all periods presented 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. The sustained lower level of quarterly net charge-offs over the past several quarters had a significant effect on the historical loss component of our methodology. 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.
 
Noninterest Income: Noninterest income for the three and six month periods ended June 30, 2012 increased to $4.0 million and $7.7 million, respectively, from $3.6 million and $7.3 million, respectively, for the same periods in 2011.  The components of noninterest income are shown in the table below (in thousands):
 
 
 
Three Months
Ended
June 30,
2012
 
 
Three Months
Ended
June 30,
2011
 
 
Six Months
Ended
June 30,
2012
 
 
Six Months
Ended
June 30,
2011
 
 
 
 
 
 
 
 
 
       
 
Service charges and fees on deposit accounts
 
$
776
 
 
$
969
 
 
$
1,571
   
$
1,917
 
Net gains on mortgage loans
 
 
780
 
 
 
262
 
 
 
1,251
     
697
 
Trust fees
 
 
598
 
 
 
620
 
 
 
1,207
     
1,270
 
ATM and debit card fees
 
 
1,064
 
 
 
1,027
 
 
 
2,045
     
1,946
 
Bank owned life insurance income
 
 
224
 
 
 
251
 
 
 
447
     
466
 
Investment services fees
 
 
160
 
 
 
254
 
 
 
389
     
487
 
Other income
 
 
398
 
 
 
233
 
 
 
801
     
512
 
Total noninterest income
 
$
4,000
   
$
3,616
   
$
7,711
   
$
7,295
 

Service charges on deposit accounts decreased for the three and six month periods ended June 30, 2012 as a result of declines in overdraft fee income, consistent with banking industry-wide trends. We recognized increases in gains on sales of mortgage loans for the second quarter of 2012 and for the first half of 2012, due in part to increased focus on growth in our residential mortgage loan origination volume. The low interest rate environment has also contributed significantly to this increase in sales volume. Trust income is down slightly for the three and six month periods ended June 30, 2012 compared to the same periods in 2011 due primarily to a decline in trust asset balances and market conditions. Income from ATM and debit card fees was up for the most recent quarter and the first half of 2012 compared to the same periods in 2011 due to increased volume of activity during 2012.  The increase in other income in the three and six month periods ended June 30, 2012 compared to the same periods in 2011 was primarily attributable to rental income on other real estate owned.  Rental income from these properties increased $123,000 and $237,000, respectively, for the three and six month periods ended June 30, 2012 compared to the same periods in 2011.
 
 
- 41 -

 
Noninterest Expense: Noninterest expense decreased to $13.9 million for the three month period and decreased to $28.0 million for the six month period ended June 30, 2012, respectively, from $15.0 million and $30.4 million, respectively, for the same periods in 2011. The components of noninterest expense are shown in the table below (in thousands):
 
 
 
Three Months
Ended
June 30,
2012
 
 
Three Months
Ended
June 30,
2011
 
 
Six Months
Ended
June 30,
2012
 
 
Six Months
Ended
June 30,
2011
 
 
 
 
 
 
 
 
 
       
 
Salaries and benefits
 
$
5,723
 
 
$
5,600
 
 
 
11,443
     
10,947
 
Occupancy of premises
 
 
941
 
 
 
989
 
 
 
1,912
     
2,001
 
Furniture and equipment
 
 
858
 
 
 
829
 
 
 
1,685
     
1,646
 
Legal and professional
 
 
180
 
 
 
322
 
 
 
392
     
591
 
Marketing and promotion
 
 
210
 
 
 
224
 
 
 
420
     
448
 
Data processing
 
 
368
 
 
 
334
 
 
 
719
     
638
 
FDIC assessment
 
 
479
 
 
 
841
 
 
 
1,188
     
1,819
 
ATM and debit card processing
 
 
308
 
 
 
311
 
 
 
596
     
581
 
Bond and D&O insurance
 
 
215
 
 
 
378
 
 
 
483
     
757
 
Administration and disposition of problem assets
 
 
3,190
 
 
 
3,741
 
 
 
6,249
     
8,175
 
Outside services
 
 
381
 
 
 
405
 
 
 
759
     
826
 
Other noninterest expense
 
 
1,033
 
 
 
1,023
 
 
 
2,146
     
2,004
 
Total noninterest expense
 
$
13,886
   
$
14,997
   
$
27,992
   
$
30,433
 

Several components of noninterest expense experienced a decline due to our ongoing efforts to manage expenses and scale our operations in response to prolonged economic weakness. However, our largest component of noninterest expense, salaries and benefits, increased in the second quarter of 2012 by $123,000 from the second quarter of 2011. We had 373 full-time equivalent employees at June 30, 2012 compared to 402 at June 30, 2011. The increased expense for the second quarter of 2012 was primarily attributable to increased commissions paid for mortgage origination activity, which was nearly two times greater in the second quarter of 2012 compared to the second quarter of 2011.   Also, in March 2012, our board authorized a cost of living increase for the first time in several years, which resulted in an increase in compensation expense beginning in the second quarter of 2012.  For the first six month period, salaries and benefits increased by $496,000 from $10.9 million in 2011 to $11.4 million in 2012.  The increase for the first half of 2012 compared to the first half of 2011 is also due to the cost of living adjustments made in the second quarter of 2012 and the increased mortgage commissions from higher loan origination volume.
 
The next largest noninterest expense was the cost related to administration and disposition of problem assets. Costs associated with administration and disposition of problem assets include legal costs, repossessed and foreclosed property administration expense and losses on repossessed and foreclosed properties. Repossessed and foreclosed property administration expense includes survey and appraisal, property maintenance and management and other disposition and carrying costs. Losses on repossessed and foreclosed properties include both net 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
June 30,
2012
 
 
Three Months
Ended
June 30,
2011
 
 
Six Months
Ended
June 30,
2012
 
 
Six Months
Ended
June 30,
2011
 
 
 
 
 
 
 
 
 
       
 
Legal and professional – nonperforming assets
 
$
266
 
 
$
543
 
 
$
707
   
$
1,368
 
Repossessed and foreclosed property administration
 
 
990
 
 
 
1,077
 
 
 
2,011
     
2,194
 
Losses on repossessed and foreclosed properties
 
 
1,934
 
 
 
2,121
 
 
 
3,531
     
4,613
 
Total
 
$
3,190
   
$
3,741
   
$
6,249
   
$
8,175
 

Costs associated with administration and disposition of problem assets remained elevated, but has decreased in both the three and six month periods ended June 30, 2012 as compared to the same periods in 2011. For the three and six month periods ended June 30, 2012, we recognized reductions from the same periods in 2011 in each category of these costs for both the three and six month periods as we have had fewer properties moving into the problem asset category and as property values have begun to stabilize.  Losses on repossessed and foreclosed properties declined by $1.1 million for the six month period ended June 30, 2012 compared to the same period in 2011.  As our level of problem loans and other real estate owned continues to decrease, we believe we will experience meaningful reductions in these costs.
 
 
- 42 -

 
FDIC assessments decreased by $362,000 to $479,000 for the second quarter of 2012 compared to $841,000 for the second quarter of 2011 as a result of our reduced level of deposits, changes to the assessment base implemented by the FDIC and due to a change in our assessment category resulting from the termination of our Consent Order effective March 2, 2012.  We estimate an annual FDIC assessment cost savings of $1.2 million related to the Consent Order termination.  Because the Consent Order was not terminated until March 2, 2012, we will not realize the full amount of estimated annual savings in 2012.   For the six months ended June 30, 2012, our FDIC assessments were $1.2 million, compared to $1.8 million for the same period in 2011.
 
We realized a reduction in our bond and D&O insurance costs in the three and six month periods ended June 30, 2012 compared to the same periods of 2011 as a result of our improving financial condition and the decreased risk perceived by our insurance carriers.
 
Federal Income Tax Expense/Benefit: We recorded no federal income tax expense for the three and six month periods ended June 30, 2012 and 2011. Since June 30, 2009, we have concluded that a full valuation allowance must be maintained for all of our net deferred tax assets based primarily on our net operating losses in 2008, 2009 and the first quarter of 2010 and the continued challenging environment confronting banks that could negatively impact future operating results. At June 30, 2012, the valuation allowance on our net deferred tax assets totaled $21.6 million.  Under certain conditions according to accounting standards, the valuation allowance may be reversed to income in future periods to the extent that the related deferred tax assets are realized or when we return to consistent, sustained profitability.
 
 
- 43 -

 
FINANCIAL CONDITION
 
Summary: Due to the continuing soft economic conditions and having been under the Consent Order, in recent periods we had been focused on reducing our loan portfolio, including reducing exposure in higher loan concentration types, to improve our financial condition through increased liquidity, diversification of credit risk, improved capital ratios, and reduced reliance on non-core funding.   With the successful capital raise in the second quarter of 2011, our improving financial condition and the termination of the Consent Order, we are beginning to focus on high quality, measured growth in our investment and loan portfolios.
 
Total assets were $1.52 billion at June 30, 2012, an increase of $12.7 million from $1.51 billion at December 31, 2011. This change reflected increases of $6.7 million in short-term investments and $41.8 million in securities available for sale, partially offset by a decline of $34.0 million in our loan portfolio. Total deposits increased $20.2 million and other borrowed funds were paid down by $21.1 million during the first half of 2012.
 
Federal Funds Sold and Other Short Term Investments: The $6.7 million increase in federal funds sold and other short-term investments to $218.7 million at June 30, 2012 resulted from increased levels of deposits and net repayments in our loan portfolio.  We expect these balances to decrease in the second half of 2012 as we focus on loan growth and continue to rebuild our investment portfolio.
 
Securities Available for Sale: Securities available for sale were $96.5 million at June 30, 2012 compared to $54.7 million at December 31, 2011. We began rebuilding our investment portfolio during the second quarter of 2011. The balance at June 30, 2012 primarily consisted of U.S. agency securities, agency mortgage backed securities and various municipal investments. We expect to continue to reinvest excess liquidity and selectively rebuild our investment portfolio to continue our diversification of asset quality throughout the remainder of 2012.
 
Portfolio Loans and Asset Quality: Total portfolio loans declined by $34.0 million to $1.04 billion at June 30, 2012 compared to $1.07 billion at December 31, 2011. During the first six months of 2012, our commercial and consumer loan portfolios (excluding residential mortgages) decreased by $41.8 million and $6.3 million, respectively, while our residential mortgage portfolio increased by $14.1 million as a result of our initiative to increase this portfolio segment to further diversify our credit risk.
 
We also had a significant increase in the volume of residential mortgage loans originated for sale in the first six months of 2012 compared to the same period in 2011. Residential mortgage loans originated for sale more than doubled at $59.4 million in the first half of 2012 compared to $28.9 million for the same period in 2011. This increase was primarily due to market conditions and our focus on increasing our residential mortgage lending volume.
 
The decline in the commercial loan portfolio balances in recent quarters reflected the continuing weak economic conditions in West Michigan and our interest in improving the quality of our loan portfolio through reducing our exposure to these generally higher credit risk assets. We have focused our efforts on reducing our exposure to residential land development loans, diversifying our commercial loan portfolio and improving asset quality. As discussed earlier, we believe our loan portfolio has stabilized and we expect to begin measured high quality loan portfolio growth.
 
Commercial and commercial real estate loans still remained our largest loan segment and accounted for approximately 73% of the total loan portfolio at June 30, 2012 and 74% at December 31, 2011. Residential mortgage and consumer loans comprised approximately 27% and 26% of total loans at June 30, 2012 and December 31, 2011, respectively.
 
 
- 44 -

 
A further breakdown of the composition of the commercial loan portfolio is shown in the table below (in thousands):
 
 
 
 
June 30,
 2012
 
 
Percent of Total Loans
 
 
 
December 31, 2011
 
 
Percent of Total Loans
 
Commercial real estate:(1)
 
 
 
 
 
   
 
 
 
 
 
 
   
 
Residential developed
 
$
28,464
 
 
 
2.7
%
 
$
33,829
 
 
 
3.2
%
Unsecured to residential developers
 
 
589
 
 
 
0.1
 
 
 
5,937
 
 
 
0.5
 
Vacant and unimproved
   
60,115
     
5.8
     
66,046
     
6.2
 
Commercial development
   
4,772
     
0.5
     
4,586
     
0.4
 
Residential improved
   
79,169
     
7.6
     
82,337
     
7.7
 
Commercial improved
   
283,293
     
27.3
     
304,070
     
28.4
 
Manufacturing and industrial
   
75,531
     
7.3
     
71,462
     
6.7
 
Total commercial real estate loans
   
531,933
     
51.3
     
568,267
     
53.1
 
Commercial and industrial
   
221,628
     
21.4
     
227,051
     
21.2
 
Total commercial loans
 
$
753,561
     
72.7
%
 
$
795,318
     
74.3
%
 
 
(1)
Includes both owner occupied and non-owner occupied commercial real estate.
 
Commercial real estate accounted for approximately 51% of the total loan portfolio at June 30, 2012 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 land loans are secured by raw land for which development has not yet begun and agricultural land.
 
Total commercial real estate loans declined $36.3 million since December 31, 2011 as we continued to focus on reducing our real estate loan concentrations and balances. Commercial loans secured by residential real estate, the portfolio that had created the majority of stress within our loan portfolio, declined $13.9 million. The balance of loans secured by nonresidential real estate declined $22.4 million since December 31, 2011.

The following table shows our loan origination activity for portfolio loans during the first six months of 2012, broken out by loan type and also shows average originated loan size (dollars in thousands):

 
 
Portfolio
Originations
Six Months Ended
June 30,
2012
 
 
Percent of
Total
Originations
 
 
Average
Loan
Size
 
Commercial real estate:
 
 
 
 
 
 
 
 
 
Residential developed
 
$
510
     
0.2
%
 
$
170
 
Unsecured to residential developers
 
 
---
 
 
 
---
 
 
 
---
 
Vacant and unimproved
 
 
7,791
 
 
 
3.5
 
 
 
519
 
Commercial development
 
 
---
 
 
 
---
 
 
 
---
 
Residential improved
 
 
23,964
 
 
 
10.9
 
 
 
212
 
Commercial improved
 
 
15,667
 
 
 
7.1
 
 
 
412
 
Manufacturing and industrial
 
 
11,974
 
 
 
5.4
 
 
 
599
 
Total commercial real estate
 
 
59,906
 
 
 
27.1
 
 
 
317
 
Commercial and industrial
 
 
118,779
 
 
 
53.7
 
 
 
35
 
Total commercial
 
 
178,685
 
 
 
80.8
 
 
 
50
 
                         
Consumer:
 
 
 
 
 
 
 
 
 
 
 
 
Residential mortgage
 
 
31,349
 
 
 
14.2
 
 
 
158
 
Unsecured
 
 
184
 
 
 
0.1
 
 
 
18
 
Home equity
 
 
8,961
 
 
 
4.0
 
 
 
65
 
Other secured
 
 
1,974
 
 
 
0.9
 
 
 
13
 
Total consumer
 
 
42,468
 
 
 
19.2
 
 
 
84
 
Total portfolio loan originations
 
$
221,153
 
 
 
100
 %
   
54
 

 
- 45 -


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 monthly 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, that loan is placed in non-accrual 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 June 30, 2012, nonperforming assets totaled $80.9 million compared to $95.4 million at December 31, 2011. Significant progress has been made to accelerate workout strategies with problem assets, leading to several properties moving to other real estate owned.  Additions to other real estate owned in the first six months of 2012 were $7.7 million compared to $23.4 million of additions in the first six months of 2011.  Based on the loans currently in their redemption period, we expect reduced levels of loans moving into other real estate owned in the remaining quarters of 2012.  Proceeds from sales of foreclosed properties were $8.6 million in the first half of 2012 resulting in a net gain of $20,000. The volume of sales in the first half of 2011 generated proceeds of $11.3 million and a net gain of $745,000.
 
Nonperforming loans include loans on non-accrual status and loans delinquent more than 90 days but still accruing. As of June 30, 2012, nonperforming loans totaled $18.9 million, or 1.82% of total portfolio loans, compared to $28.9 million, or 2.70% of total portfolio loans, at December 31, 2011.
 
Loans for development or sale of 1-4 family residential properties comprised a large portion of nonperforming loans. They were approximately $5.8 million, or 30.7% of total nonperforming loans, at June 30, 2012 compared to $8.5 million, or 29.4% of total nonperforming loans, at December 31, 2011. The remaining balance of nonperforming loans at June 30, 2012 consisted of $5.3 million of commercial real estate loans secured by various types of non-residential real estate, $6.2 million of commercial and industrial loans, and $1.6 million of consumer and residential mortgage loans.
 
Foreclosed and repossessed assets include assets acquired in settlement of loans. Foreclosed assets totaled $62.0 million at June 30, 2012 compared to $66.4 million at December 31, 2011. Of this balance, there were 134 commercial real estate properties totaling approximately $56.7 million. The remaining balance was comprised of 65 residential properties totaling approximately $5.3 million. All properties acquired through or in lieu of foreclosure are initially transferred at their fair value less estimated costs to sell and then evaluated for impairment after transfer using a lower of cost or market approach. Updated property valuations are obtained at least annually on all foreclosed assets to ensure proper carrying values are maintained.
 
At June 30, 2012, our foreclosed asset portfolio had a weighted average age held in portfolio of 1.6 years. Below is a breakout of our foreclosed asset portfolio at June 30, 2012 by property type and the percentages by which 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):
 
Foreclosed Asset Property type
 
Carrying
Value at
June 30,
2012
 
 
Foreclosed Asset
Writedown
 
 
Combined Writedown
(Loan and Foreclosed Asset)
 
 
 
 
 
 
 
 
 
 
 
Single Family
 
$
4,013
 
 
 
10.0
%
 
 
45.7
%
Residential Lot
 
 
1,326
 
 
 
34.9
%
 
 
60.4
%
Multi-Family
 
 
462
 
 
 
13.8
%
 
 
40.1
%
Vacant Land
 
 
7,788
 
 
 
29.1
%
 
 
49.1
%
Residential Development
 
 
18,553
 
 
 
30.9
%
 
 
62.4
%
Commercial Office
 
 
6,002
 
 
 
21.0
%
 
 
51.6
%
Commercial Industrial
 
 
1,817
 
 
 
14.5
%
 
 
33.1
%
Commercial Improved
 
 
22,085
 
 
 
15.6
%
 
 
31.4
%
 
 
$
62,046
 
 
 
23.2
%
 
 
49.7
%
 
 
- 46 -


The following table shows the composition and amount of our nonperforming assets (dollars in thousands):
 
 
 
June 30,
2012
 
 
December 31,
2011
 
Nonaccrual loans
 
$
18,852
 
 
$
26,876
 
Loans 90 days past due and still accruing
 
 
27
 
 
 
2,070
 
Total nonperforming loans (NPLs)
 
 
18,879
 
 
 
28,946
 
Foreclosed assets
 
 
62,046
 
 
 
66,438
 
Repossessed assets
 
 
---
 
 
 
---
 
Total nonperforming assets (NPAs)
 
 
80,925
 
 
 
95,384
 
Accruing restructured loans (ARLs) (1)
 
 
61,197
 
 
 
55,679
 
Total NPAs and ARLs
 
$
142,122
 
 
$
151,063
 
 
 
 
 
 
 
 
 
 
NPLs to total loans
 
 
1.82
%
 
 
2.70
%
NPAs to total assets
 
 
5.33
%
 
 
6.33
%
 
 
(1)
Comprised of approximately $45.4 million and $40.9 million of commercial loans and $15.8 million and $14.8 million of consumer loans whose terms have been restructured at June 30, 2012 and December 31, 2011, respectively. Interest is being accrued on these loans under their restructured terms as they are less than 90 days past due.
 
Allowance for loan losses: The allowance for loan losses at June 30, 2012 was $27.2 million, a decrease of $4.5 million, compared to $31.6 million at December 31, 2011. The balance of the allowance for loan losses represented 2.62% of total portfolio loans compared to 2.95% of total portfolio loans at December 31, 2011. While this ratio decreased, the allowance for loan losses to nonperforming loan coverage ratio continued to increase, from 109.31% at December 31, 2011 to 143.97% at June 30, 2012.
 
The continued reduction in net charge-offs over the past several quarters had a significant effect on the historical loss component of our allowance for loan loss computation as did the improvements in our credit quality metrics. The table below shows the changes in these metrics over the past five quarters:
 
 
 
(in millions)
 
Quarter Ended
June 30,
2012
 
 
Quarter Ended
March 31,
2012
 
 
Quarter Ended
December 31,
2011
 
 
Quarter Ended
September 30,
2011
 
 
Quarter Ended
June 30,
2011
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial loans
 
$
753.6
 
 
$
773.1
 
 
$
795.3
 
 
$
819.6
 
 
$
836.6
 
Nonperforming loans
 
 
18.9
 
 
 
23.5
 
 
 
28.9
 
 
 
35.0
 
 
 
40.4
 
Other real estate owned and repo assets
 
 
62.0
 
 
 
66.2
 
 
 
66.4
 
 
 
66.5
 
 
 
65.4
 
Total nonperforming assets
 
 
80.9
 
 
 
89.7
 
 
 
95.4
 
 
 
101.5
 
 
 
105.9
 
Net charge-offs (recoveries)
 
 
0.5
 
 
 
(1.4
)
 
 
3.2
 
 
 
1.4
 
 
 
2.9
 
Total delinquencies
 
 
6.9
 
 
 
8.9
 
 
 
13.1
 
 
 
20.7
 
 
 
30.4
 
 
Nonperforming loans have continually declined since the first quarter of 2010 to $18.9 million at June 30, 2012, which was our lowest level of nonperforming loans since the second quarter of 2007. As discussed earlier, we had net charge-offs of $521,000 for the second quarter of 2012, compared to the second quarter of 2011 when we incurred $2.9 million in net charge-offs.  Our total delinquencies have continued to decline, from $30.4 million at June 30, 2011 to just $6.9 million at June 30, 2012.
 
As discussed earlier, the sustained reduced level of quarterly net charge-offs has had a significant effect on our 18 month historical loss ratios, which are the base for our allowance for loan loss computation. The change in the 18 month historical loss ratios from December 31, 2011 to June 30, 2012 reduced the historical loss allocations in our allowance computation by $1.0 million for the quarter ended June 30, 2012 and by $1.6 million for the six months ended June 30, 2012.
 
These factors all provide for a reduction in our provision for loan losses. The provision for loan losses increased $250,000 to a negative $1.75 million for the three months ended June 30, 2012 compared to a negative $2.0 million for the same period of 2011. For the first six month periods, the provision decreased $1.9 million from a negative $3.45 million in 2011 to a negative $5.35 million in 2012.  Net charge-offs were $521,000 for the three months ended June 30, 2012 compared to $2.9 million for the same period in 2011. For the first half of 2012, we had net recoveries of $889,000 compared to net charge-offs of $6.5 million for the same period in 2011.  The ratio of net charge-offs to average loans was 0.20% on an annualized basis for the second quarter of 2012, compared to 1.19% for the fourth quarter of 2011 and 1.01% for the second quarter of 2011.
 
 
- 47 -


We are encouraged by the continued reduced level of charge-offs over recent quarters. We do, however, recognize that future chargeoffs 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. We believe we have seen some stabilization in the pace of decline in economic conditions and real estate markets. However, we expect it to take additional time for sustained improvement in the economy and real estate markets in order for us to reduce our non-performing and impaired loans to acceptable levels.
 
Our allowance for loan losses is maintained at a level believed appropriate based upon our monthly 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 decreased to $80.9 million at June 30, 2012, from $84.6 million at December 31, 2011. The specific allowance for impaired loans increased $870,000 to $10.5 million, or 12.9% of total impaired loans, at June 30, 2012 compared to $9.6 million, or 11.3% of total impaired loans, at December 31, 2011. The decrease in impaired loans was primarily attributable to loans migrating to other real estate owned, loan payoffs and upgrades more than offsetting loans moving into an impaired status.  Charge-offs totaling $2.3 million had previously been taken on these impaired loans, bringing the balance to $80.9 million as of June 30, 2012. Combined with the $10.5 million of specific reserves at June 30, 2012, these loans have been written down 15.8%.
 
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 chargeoff history as the base for our computation. The 18 month period ended June 30, 2012 reflected a sizeable decrease in net chargeoff experience. We addressed this volatility in the qualitative factor considerations applied in our allowance computation. Adjustments to the qualitative factors also involved consideration of different loss periods for the Bank, including 12 and 24 month periods. Considering the change in our qualitative factors and the decrease in our commercial loan portfolio balances, the general commercial loan allowance decreased to $13.9 million at June 30, 2012 compared to $18.9 million at December 31, 2011. This resulted in a general reserve percentage allocated at June 30, 2012 of 2.02% of commercial loans, a decrease from 2.61% at December 31, 2011. The qualitative component of our allowance allocated to commercial loans decreased from $14.3 million at December 31, 2011 to $11.7 million at June 30, 2012.
 
Groups of homogeneous loans, such as residential real estate and open- and closed-end consumer loans, receive allowance allocations based on loan type. 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 $2.7 million at June 30, 2012 compared to $3.1 million at December 31, 2011. The decrease was related to significant improvements in delinquencies in both residential mortgage and consumer loan portfolios.
 
The allowance allocations are not intended to imply limitations on usage of the allowance. The entire allowance is available for any loan losses without regard to loan type.
 
 
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Deposits and Other Borrowings: Total deposits increased $20.2 million to $1.24 billion at June 30, 2012 compared to $1.22 billion at December 31, 2011.  During the first six months of 2012, we had increases in lower cost product types including a $6.4 million increase in noninterest checking, a $25.0 million increase in interest bearing checking, and a $34.3 million increase in savings and money market deposits.  Partially offsetting this was a $45.4 million decrease in certificates of deposit which is our most rate sensitive category of deposits.  Much of this decline in certificates of deposit was intentional and encouraged through our rate setting process in response to our high on-balance sheet liquidity.
 
The overall stability of in-market deposits is particularly noteworthy considering the financial challenges we have experienced, the lack of economic expansion in western Michigan and the competition for core deposit growth in our markets. We believe the stability in 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 maturing branch network and the breadth and depth of our product line. A provision of the Dodd-Frank Act went into effect on July 21, 2011 eliminating the prohibition of payment of interest on commercial checking accounts. This change may impact the shift of noninterest bearing checking accounts in future periods.
 
Other borrowed funds, consisting of Federal Home Loan Bank advances, decreased $21.1 million during the first six months of 2012 as a result of scheduled maturities.

Accrued expenses and other liabilities:  Accrued expenses and other liabilities increased $5.6 million to $12.0 million at June 30, 2012 compared to $6.5 million at December 31, 2011.  The primary reason for the increase was a liability of $4.7 million created at June 30, 2012 to account for securities purchased at June 30, 2012 that settled in early July 2012.

CAPITAL RESOURCES
 
Total shareholders' equity of $102.4 million at June 30, 2012 increased $8.0 million from $94.4 million at December 31, 2011. The increase was primarily from net income of $7.7 million earned in the first six months of 2012.
 
Our regulatory capital ratios improved again in the second quarter of 2012 and the Bank was categorized as “well capitalized” at June 30, 2012. The following table shows our regulatory capital ratios (on a consolidated basis) for the past several quarters:
 
 
 
June 30,
2012
 
 
March 31,
2012
 
 
Dec 31,
2011
 
 
Sept 30,
2011
 
 
June 30,
2011
 
 
March 31,
2011
 
 
Dec 31,
2010
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total capital to risk weighted assets
 
 
14.2
%
 
 
13.7
%
 
 
13.2
%
 
 
12.9
%
 
 
12.7
%
 
 
10.3
%
 
 
9.7
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Tier 1 capital to average assets
 
 
9.0
%
 
 
8.8
%
 
 
8.3
%
 
 
8.1
%
 
 
8.1
%
 
 
5.8
%
 
 
5.8
%
 
Approximately $33.8 million of the $40.0 million of trust preferred securities outstanding at June 30, 2012 qualified as Tier 1 capital. The remaining $6.2 million qualified as Tier II capital, a component of total risk-based capital. The ratios have increased each quarter since March 31, 2010 due to declines in risk weighted assets, positive earnings for each quarter and the stock offering completed in the second quarter of 2011.

We continued to suspend payments of cash dividends on our preferred stock during the quarter and until further action by the Board of Directors. During any period that we do not declare and pay cash dividends on our preferred stock, we may not declare and pay cash dividends on our common stock. During the quarter, we also continued to exercise our right to defer interest payments on our trust preferred securities for 20 consecutive quarters or until such earlier time as is determined by further action of the Board of Directors. During any deferral period, we may not declare or pay any dividends on our common stock or preferred stock or make any payment on any outstanding debt obligations that rank equally with or junior to the trust preferred securities.
 
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 and deposit equivalents, federal funds sold, and the various capital resources discussed above.
 
 
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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.
 
The Bank made significant progress during 2010 and 2011 to intentionally reduce its reliance on non-core funding sources, including brokered deposits, and remains focused on maintaining a non-core funding dependency ratio below its peer group average. During 2010, we reduced our brokered deposits by $158.4 million and other borrowed funds by $92.7 million. During 2011, we paid off $48.2 million in brokered deposits and had no such deposits outstanding at December 31, 2011 or at June 30, 2012.  Since December 31, 2008, we reduced our brokered deposits by $337.8 million. We also reduced other borrowed funds by $36.7 million in 2011 and an additional $21.1 million in the first six months of 2012.
 
The Bank also held $218.7 million of short-term investments and had available borrowing capacity from correspondent banks of approximately $149.3 million as of June 30, 2012 to provide additional liquidity as needed.

Liquidity of Holding Company: The primary sources of liquidity for the Company are dividends from the Bank, existing cash resources and the various capital resources discussed above. 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 to the Company in any calendar year. Under Michigan law limitations, the Bank is restricted from paying dividends to the Company until its deficit retained earnings has been restored. At June 30, 2012, the retained deficit of the Bank was approximately $22.9 million, down from its peak of $41.8 million at March 31, 2010. Throughout 2009, 2010, 2011 and the first six months of 2012, the Company has not received dividends from the Bank and we have not paid any dividends to our common shareholders. Under the MOU and the Written Agreement, the Bank and the Company may not pay any dividends without prior regulatory approval.
 
The Company continued to suspend payments of cash dividends on its preferred stock during 2010, 2011 and the first six months of 2012 until further action is taken by the Board of Directors. During the period that the Company does not declare and pay cash dividends on its preferred stock, it may not declare and pay cash dividends on its common stock.
 
During 2010, 2011 and the first six months of 2012, the Company also continued to exercise its right to defer interest payments on its trust preferred securities for 20 consecutive quarters or until such earlier time as is determined by further action of the Board of Directors. During the deferral period, the Company may not declare or pay any dividends on its common stock or preferred stock or make any payment on any outstanding debt obligations that rank equally with or junior to the trust preferred securities.
 
In June 2011, the Company closed its shareholder rights and public offerings and conversion of our 2% Subordinated Note due 2018, resulting in the issuance of 9,404,202 shares of common stock and net proceeds of $20.3 million.  The Company contributed $10.0 million of the proceeds to the Bank in 2011 and retained the remaining $10.3 million at the holding company level. The Company’s cash balance at June 30, 2012 was $10.1 million.  The Company believes it has sufficient liquidity to meet its cash flow requirements for the remainder of 2012.
 
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 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 periods presented in the consolidated financial statements that are a part of this report.
 
 
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Assets acquired through or instead of foreclosure, primarily other real estate owned, are initially recorded at fair value less 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.

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 June 30, 2012, we had gross deferred tax assets of $24.4 million, gross deferred tax liabilities of $2.8 million and a valuation allowance of $21.6 million for the entire amount of net deferred tax assets. 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. Based upon a number of factors, including our net operating losses in recent years and the challenging environment currently confronting banks that could negatively impact future operating results, we concluded that we needed to continue to maintain a valuation allowance during the second quarter of 2012 for our net deferred tax assets. 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 as well as the valuation allowance that we established.
 
 
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Item 4:
 
(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 Rules 13a-15(e) and 15d-15(e), as of June 30, 2012, 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 Rules 13a-15(e) and 15d-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.

 
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Item 6.
 
3.1                    
Restated Articles of Incorporation. Previously filed with the Commission on April 28, 2011 in Macatawa Bank Corporation’s Quarterly Report on Form 10-Q, Exhibit 3.1. Here incorporated by reference.
 
 
3.2                    
Bylaws. Previously filed with the Commission on November 24, 2009 in Macatawa Bank Corporation's Current Report on Form 8-K, Exhibit 3.1. Here incorporated by reference.
 
 
3.3                    
Certificate of Designation of Series A Noncumulative Convertible Perpetual Preferred Stock. Previously filed with the Commission on November 5, 2008 in Macatawa Bank Corporation's Current Report on Form 8-K, Exhibit 4.1. Here incorporated by reference.
 
 
3.4                    
Certificate of Designation of Series B Noncumulative Convertible Perpetual Preferred Stock. Previously filed with the Commission on July 2, 2009 in Macatawa Bank Corporation's Current Report on Form 8-K, Exhibit 4.1. Here incorporated by reference.
 
 
4.1                    
Restated Articles of Incorporation. Exhibit 3.1 is here incorporated by reference.
 
 
4.2                    
Bylaws. Exhibit 3.2 is here incorporated by reference.
 
 
4.3                    
Certificate of Designation of Series A Noncumulative Convertible Perpetual Preferred Stock. Exhibit 3.3 is here incorporated by reference.
 
 
4.4                    
Certificate of Designation of Series B Noncumulative Convertible Perpetual Preferred Stock. Exhibit 3.4 is here incorporated by reference.
 
 
4.5                    
First Amended Settlement and Release and Warrant Issuance Agreement dated January 30, 2009. Previously filed with the Commission on January 30, 2009 in Macatawa Bank Corporation's Current Report on Form 8-K, Exhibit 10.1. Here incorporated by reference.
 
 
4.6                    
Second Amendment to Settlement and Release and Warrant Issuance Agreement dated April 30, 2009. Previously filed with the Commission on May 8, 2009 in Macatawa Bank Corporation's Quarterly Report on Form 10-Q, Exhibit 10. Here incorporated by reference.
 
 
4.7                    
Warrant Agreement between the Company and Registrar and Transfer Company dated June 16, 2009. Previously filed with the Commission on June 19, 2009 in Macatawa Bank Corporation's Current Report on Form 8-K, Exhibit 4.1. Here incorporated by reference.
 
 
4.8                    
Warrant Agreement Addendum between the Company and Registrar and Transfer Company dated July 27, 2009. Previously filed with the Commission on July 31, 2009 in Macatawa Bank Corporation's Current Report on Form 8-K, Exhibit 4.1. Here incorporated by reference.
 
 
4.9                    
Form of Warrant Certificate (first series). Previously filed with the Commission on June 19, 2009 in Macatawa Bank Corporation's Current Report on Form 8-K, Exhibit 4.2. Here incorporated by reference.
 
 
4.10                    
Form of Warrant Certificate (second series). Previously filed with the Commission on July 31, 2009 in Macatawa Bank Corporation's Current Report on Form 8-K, Exhibit 4.2. Here incorporated by reference.

 
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4.11                    
Form of 11% Subordinated Note Due 2017. Previously filed with the Commission on July 2, 2009 in Macatawa Bank Corporation's Current Report on Form 8-K, Exhibit 4.2. Here incorporated by reference.
 
 
4.12 
Form of Subscription Rights Certificate. Previously filed with the Commission on May 11, 2011 in Macatawa Bank Corporation's Amendment No. 2 to Form S-1 registration statement, Exhibit 4.13. Here incorporated by reference.
 
 
4.13
Form of 2% Subordinated Note Due 2018. Previously filed with the Commission on April 22, 2011 in Macatawa Bank Corporation's Current Report on Form 8-K, Exhibit 4.1. Here incorporated by reference.
 
 
4.14
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
 
 
- 54 -

 
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: July 26, 2012

 
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