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

FORM 10-Q

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

For the quarterly period ended March 31, 2017

OR

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

For the transition period from _______ to _______

Commission file number: 000-25927

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

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

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

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


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

Indicate by check mark whether the registrant has submitted electronically 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 No

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

Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company
   
(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 No

The number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 33,944,789 shares of the Company's Common Stock (no par value) were outstanding as of April 27, 2017.
 


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”, “concern”, “going forward”, “focus”, “starting”, “initiative,” “trend” and variations of such words and similar expressions. Such statements are based upon current beliefs and expectations and involve substantial risks and uncertainties which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These statements include, among others, future levels of earning assets, statements related to stabilization of our loan portfolio, trends in credit quality metrics, future capital levels and capital needs, including the impact of Basel III, real estate valuation, future levels of repossessed and foreclosed properties and nonperforming assets, future levels of losses and costs associated with the administration and disposition of repossessed and foreclosed properties and nonperforming assets, future levels of loan charge-offs, future levels of other real estate owned, future levels of provisions for loan losses and reserve recoveries, the rate of asset dispositions, future dividends, future growth and funding sources, future cost of funds, future liquidity levels, future profitability levels, future FDIC assessment levels, future net interest margin levels, building and improving 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, future balances of short-term investments, future loan demand and loan growth, future levels of mortgage banking revenue and the future level of other revenue sources. Management's determination of the provision and allowance for loan losses, the appropriate carrying value of intangible assets (including deferred tax assets) and other real estate owned, and the fair value of investment securities (including whether any impairment on any investment security is temporary or other-than-temporary and the amount of any impairment) involves judgments that are inherently forward-looking. All statements with references to future time periods are forward-looking. All of the information concerning interest rate sensitivity is forward-looking. Our ability to sell other real estate owned at its carrying value or at all, successfully implement new programs and initiatives, increase efficiencies, 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, continue 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, 2016. 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.
 
 
Consolidated Financial Statements
4
     
 
Notes to Consolidated Financial Statements
10
     
 
Item 2.
 
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
37
     
 
Item 3.
 
 
Quantitative and Qualitative Disclosures About Market Risk
50
     
 
Item 4.
 
 
Controls and Procedures
51
     
Part II.
Other Information:
 
     
 
Item 6.
 
 
Exhibits
52
     
Signatures
53
 

Index
Part I Financial Information
Item 1.
 
MACATAWA BANK CORPORATION
CONSOLIDATED BALANCE SHEETS
As of March 31, 2017 (unaudited) and December 31, 2016
(Dollars in thousands, except per share data)

   
March 31,
2017
   
December 31,
2016
 
ASSETS
           
Cash and due from banks
 
$
30,631
   
$
27,690
 
Federal funds sold and other short-term investments
   
83,118
     
62,129
 
Cash and cash equivalents
   
113,749
     
89,819
 
Securities available for sale, at fair value
   
184,605
     
184,433
 
Securities held to maturity (fair value 2017 - $69,079 and 2016 - $69,849)
   
68,473
     
69,378
 
Federal Home Loan Bank (FHLB) stock
   
11,558
     
11,558
 
Loans held for sale, at fair value
   
2,767
     
2,181
 
Total loans
   
1,266,128
     
1,280,812
 
Allowance for loan losses
   
(16,696
)
   
(16,962
)
Net loans
   
1,249,432
     
1,263,850
 
Premises and equipment – net
   
49,832
     
50,026
 
Accrued interest receivable
   
4,204
     
4,092
 
Bank-owned life insurance
   
39,524
     
39,274
 
Other real estate owned - net
   
12,074
     
12,253
 
Net deferred tax asset
   
8,330
     
8,863
 
Other assets
   
4,305
     
5,286
 
Total assets
 
$
1,748,853
   
$
1,741,013
 
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
Deposits
               
Noninterest-bearing
 
$
466,415
   
$
501,478
 
Interest-bearing
   
966,731
     
947,246
 
Total deposits
   
1,433,146
     
1,448,724
 
Other borrowed funds
   
102,785
     
84,173
 
Long-term debt
   
41,238
     
41,238
 
Accrued expenses and other liabilities
   
5,539
     
4,639
 
Total liabilities
   
1,582,708
     
1,578,774
 
                 
Commitments and contingent liabilities
   
---
     
---
 
                 
Shareholders' equity
               
Common stock, no par value, 200,000,000 shares authorized;  33,944,788 and 33,940,788 shares issued and outstanding at March 31, 2017 and December 31, 2016
   
216,845
     
216,731
 
Retained deficit
   
(49,905
)
   
(53,008
)
Accumulated other comprehensive income (loss)
   
(795
)
   
(1,484
)
Total shareholders' equity
   
166,145
     
162,239
 
Total liabilities and shareholders' equity
 
$
1,748,853
   
$
1,741,013
 
 

See accompanying notes to consolidated financial statements.
 
- 4 -

MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Three Month Periods Ended March 31, 2017 and 2016
(unaudited)
(Dollars in thousands, except per share data)

   
Three Months
Ended
March 31,
2017
   
Three Months
Ended
March 31,
2016
 
Interest income
           
Loans, including fees
 
$
12,455
   
$
11,756
 
Securities
               
Taxable
   
639
     
550
 
Tax-exempt
   
538
     
433
 
FHLB Stock
   
124
     
124
 
Federal funds sold and other short-term investments
   
92
     
145
 
Total interest income
   
13,848
     
13,008
 
Interest expense
               
Deposits
   
481
     
463
 
Other borrowings
   
382
     
442
 
Long-term debt
   
402
     
365
 
Total interest expense
   
1,265
     
1,270
 
Net interest income
   
12,583
     
11,738
 
Provision for loan losses
   
(500
)
   
(100
)
Net interest income after provision for loan losses
   
13,083
     
11,838
 
Noninterest income
               
Service charges and fees
   
1,060
     
1,047
 
Net gains on mortgage loans
   
428
     
487
 
Trust fees
   
778
     
708
 
ATM and debit card fees
   
1,201
     
1,186
 
Gain on sales of securities
   
3
     
89
 
Bank owned life insurance ("BOLI") income
   
238
     
444
 
Other
   
523
     
647
 
Total noninterest income
   
4,231
     
4,608
 
Noninterest expense
               
Salaries and benefits
   
5,999
     
6,187
 
Occupancy of premises
   
1,026
     
982
 
Furniture and equipment
   
732
     
865
 
Legal and professional
   
225
     
159
 
Marketing and promotion
   
227
     
275
 
Data processing
   
682
     
659
 
FDIC assessment
   
136
     
251
 
Interchange and other card expense
   
313
     
286
 
Bond and D&O Insurance
   
117
     
132
 
Net losses (gains) on repossessed and foreclosed properties
   
(85
)
   
36
 
Administration and disposition of problem assets
   
180
     
375
 
Other
   
1,336
     
1,344
 
Total noninterest expenses
   
10,888
     
11,551
 
Income before income tax
   
6,426
     
4,895
 
Income tax expense
   
1,966
     
1,400
 
Net income
 
$
4,460
   
$
3,495
 
Basic earnings per common share
 
$
0.13
   
$
0.10
 
Diluted earnings per common share
 
$
0.13
   
$
0.10
 
Cash dividends per common share
 
$
0.04
   
$
0.03
 
 

See accompanying notes to consolidated financial statements.
 
- 5 -

MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Three Month Periods Ended March 31, 2017 and 2016
(unaudited)
(Dollars in thousands)
 
   
Three Months
Ended
March 31,
2017
   
Three Months
Ended
March 31,
2016
 
             
Net income
 
$
4,460
   
$
3,495
 
                 
Other comprehensive income:
               
                 
Unrealized gains (losses):
               
Net change in unrealized gains (losses) on securities available for sale
   
1,063
     
1,064
 
Tax effect
   
(372
)
   
(372
)
Net change in unrealized gains (losses) on securities available for sale, net of tax
   
691
     
692
 
                 
Less: reclassification adjustments:
               
Reclassification for gains included in net income
   
3
     
89
 
Tax effect
   
(1
)
   
(31
)
Reclassification for gains included in net income, net of tax
   
2
     
58
 
                 
Other comprehensive income (loss), net of tax
   
689
     
634
 
Comprehensive income
 
$
5,149
   
$
4,129
 
 

See accompanying notes to consolidated financial statements.
 
- 6 -

Index
MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Three Month Periods Ended March 31, 2017 and 2016
(unaudited)
(Dollars in thousands, except per share data)
 
   
Common
Stock
   
Retained
Deficit
   
Accumulated
Other
Comprehensive
Income (Loss)
   
Total
Shareholders'
Equity
 
Balance, January 1, 2016
 
$
216,540
   
$
(64,910
)
 
$
347
   
$
151,977
 
Net income for the three months ended March 31, 2016
   
---
     
3,495
     
---
     
3,495
 
Cash dividends at $.03 per share
   
---
     
(1,012
)
   
---
     
(1,012
)
Net change in unrealized gain on securities available for sale, net of tax
   
---
     
---
     
634
     
634
 
Stock compensation expense
   
147
     
---
     
---
     
147
 
Balance, March 31, 2016
 
$
216,687
   
$
(62,427
)
 
$
981
   
$
155,241
 
                                 
Balance, January 1, 2017
 
$
216,731
   
$
(53,008
)
 
$
(1,484
)
 
$
162,239
 
Net income for the three months ended March 31, 2017
   
---
     
4,460
     
---
     
4,460
 
Cash dividends at $.04 per share
   
---
     
(1,357
)
   
---
     
(1,357
)
Net change in unrealized loss on securities available for sale, net of tax
   
---
     
---
     
689
     
689
 
Stock compensation expense
   
114
     
---
     
---
     
114
 
Balance, March 31, 2017
 
$
216,845
   
$
(49,905
)
 
$
(795
)
 
$
166,145
 
 

See accompanying notes to consolidated financial statements.
 
- 7 -

Index
MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Three Month Periods Ended March 31, 2017 and 2016
(unaudited)
(Dollars in thousands)
 
   
Three Months
Ended
March 31,
2017
   
Three Months
Ended
March 31,
2016
 
Cash flows from operating activities
           
Net income
 
$
4,460
   
$
3,495
 
Adjustments to reconcile net income to net cash from operating activities:
               
Depreciation and amortization
   
537
     
659
 
Stock compensation expense
   
114
     
147
 
Provision for loan losses
   
(500
)
   
(100
)
Origination of loans for sale
   
(16,960
)
   
(18,883
)
Proceeds from sales of loans originated for sale
   
16,802
     
19,887
 
Net gains on mortgage loans
   
(428
)
   
(487
)
Gain on sales of securities
   
(3
)
   
(89
)
Write-down of other real estate
   
64
     
129
 
Net gain on sales of other real estate
   
(149
)
   
(92
)
Deferred income tax expense
   
162
     
(68
)
Change in accrued interest receivable and other assets
   
869
     
(1,124
)
Earnings in bank-owned life insurance
   
(238
)
   
(444
)
Change in accrued expenses and other liabilities
   
664
     
2,073
 
Net cash from operating activities
   
5,394
     
5,103
 
                 
Cash flows from investing activities
               
Loan originations and payments, net
   
14,862
     
(18,206
)
Change in interest-bearing deposits in other financial institutions
   
---
     
20,000
 
Purchases of securities available for sale
   
(8,867
)
   
(21,802
)
Proceeds from:
               
Maturities and calls of securities
   
6,457
     
12,883
 
Sales of securities available for sale
   
3,440
     
9,418
 
Principal paydowns on securities
   
1,109
     
911
 
Sales of other real estate
   
320
     
1,475
 
Death benefit from bank-owned life insurance
   
---
     
518
 
Additions to premises and equipment
   
(462
)
   
(154
)
Net cash from investing activities
   
16,859
     
5,043
 
                 
Cash flows from financing activities
               
Change in deposits
   
(15,578
)
   
(94,678
)
Repayments and maturities of other borrowed funds
   
(1,388
)
   
(1,329
)
Proceeds from other borrowed funds
   
20,000
     
---
 
Cash dividends paid
   
(1,357
)
   
(1,012
)
Net cash from financing activities
   
1,677
     
(97,019
)
Net change in cash and cash equivalents
   
23,930
     
(86,873
)
Cash and cash equivalents at beginning of period
   
89,819
     
181,476
 
Cash and cash equivalents at end of period
 
$
113,749
   
$
94,603
 
 

See accompanying notes to consolidated financial statements.
 
- 8 -

Index
MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Three Month Periods Ended March 31, 2017 and 2016
(unaudited)
(Dollars in thousands)
 
   
Three Months
Ended
March 31,
2017
   
Three Months
Ended
March 31,
2016
 
Supplemental cash flow information
           
Interest paid
 
$
1,272
   
$
1,270
 
Income taxes paid
   
---
     
---
 
Supplemental noncash disclosures:
               
Transfers from loans to other real estate
   
56
     
102
 
Security settlement
   
236
     
1,012
 
 

See accompanying notes to consolidated financial statements.
 
- 9 -

Index
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 month period ended March 31, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017. 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, 2016.

Use of Estimates:  To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ.  The allowance for loan losses, valuation of deferred tax assets, loss contingencies, fair value of other real estate owned and fair values of financial instruments are particularly subject to change.

Allowance for Loan Losses: The allowance for loan losses (allowance) is a valuation allowance for probable incurred credit losses inherent in our loan portfolio, increased by the provision for loan losses and recoveries, and decreased by charge-offs of loans. Management believes the allowance for loan losses balance to be adequate based on known and inherent risks in the portfolio, past loan loss experience, information about specific borrower situations and estimated collateral values, economic conditions and other relevant factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Management continues its collection efforts on previously charged-off balances and applies recoveries as additions to the allowance for loan losses.

The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-classified loans and is based on historical loss experience adjusted for current qualitative factors. The Company maintains a loss migration analysis that tracks loan losses and recoveries based on loan class and the loan risk grade assignment for commercial loans. At March 31, 2017, an 18 month annualized historical loss experience was used for commercial loans and a 12 month historical loss experience period was applied to residential mortgage loans and consumer loans. These historical loss percentages are adjusted (both upwards and downwards) for certain qualitative factors, including economic trends, credit quality trends, valuation trends, concentration risk, quality of loan review, changes in personnel, external factors and other considerations.

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 -

Index
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Commercial and commercial real estate loans with relationship balances exceeding $500,000 and an internal risk grading of 6 or worse are evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated and the loan is reported at the present value of estimated future cash flows using the loan’s existing interest rate or at the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment and they are not separately identified for impairment disclosures.

Troubled debt restructurings are also considered impaired with impairment generally measured at the present value of estimated future cash flows using the loan’s effective rate at inception or using the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral.

Foreclosed Assets: Assets acquired through or instead of loan foreclosure, primarily other real estate owned, are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Costs after acquisition are expensed unless they add value to the property.

Income Taxes: Income tax expense is the sum of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

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.

Derivatives:  Certain of our commercial loan customers have entered into interest rate swap agreements directly with the Bank.  At the same time the Bank enters into a swap agreement with its customer, the Bank enters into a corresponding interest rate swap agreement with a correspondent bank at terms mirroring the Bank’s interest rate swap with its commercial loan customer.   This is known as a back-to-back swap agreement.  Under this arrangement the Bank has two freestanding interest rate swaps, both of which are carried at fair value.  As the terms mirror each other, there is no income statement impact to the Bank.  At March 31, 2017 and December 31, 2016, the total notional amount of such agreements was $43.5 million and $48.1 million and resulted in a derivative asset with a fair value of $383,000 and $494,000, respectively, which were included in other assets and a derivative liability of $383,000 and $494,000, respectively, which were included in other liabilities.

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

Adoption of New Accounting Standards:  The Financial Accounting Standards Board “FASB” issued Accounting Standards Update (“ASU”) ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting.  This ASU simplifies several aspects of the accounting for employee share-based payment transactions for both public and nonpublic entities, including the following: Accounting for income taxes, classification of excess tax benefits on the statement of cash flows, forfeitures, statutory tax withholding requirements, classification of awards as either equity or liabilities and classification of employee taxes paid on the statement of cash flows when an employer withholds shares for tax-withholding purposes.  The amendments are effective for annual periods beginning after December 15, 2016, and for interim periods within those annual periods.  The impact of adoption of this ASU by the Company was not material as no stock awards vested in the three months ended March 31, 2017, but could cause some volatility in income tax expense in future periods where stock awards vest.

FASB issued ASU No. 2017-08, Premium Amortization on Purchased Callable Debt Securities.  This ASU changes generally accepted accounting principles (“GAAP”) to require premiums on purchased callable debt securities to be amortized to the earliest call date.  Previous GAAP allowed entities to amortize to contractual maturity or to call date.  The amendments in this ASU are effective for annual periods beginning after December 15, 2018, with early adoption permitted.  As the Company has consistently amortized premiums on its purchased callable debt securities, the Company has elected to early adopt this ASU effective January 1, 2017.  There was no impact of adoption of this ASU by the Company.
 
- 11 -

Index
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Newly Issued Not Yet Effective Standards:  FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606).  The amendments in this Update create a new topic in the Codification, Topic 606. In addition to superseding and replacing nearly all existing U.S. GAAP revenue recognition guidance, including industry-specific guidance, ASC 606 establishes a new control-based revenue recognition model, changes the basis for deciding when revenue is recognized over time or at a point in time, provides new and more detailed guidance on specific topics and expands and improves disclosures about revenue.  In addition, ASU 2014-09 adds a new Subtopic to the Codification, ASC 340-40, Other Assets and Deferred Costs: Contracts with Customers, to provide guidance on costs related to obtaining a contract with a customer and costs incurred in fulfilling a contract with a customer that are not in the scope of another ASC Topic.   The new guidance does not apply to certain contracts within the scope of other ASC Topics, such as lease contracts, insurance contracts, financing arrangements, financial instruments, guarantees other than product or service warranties, and nonmonetary exchanges between entities in the same line of business to facilitate sales to customers. The amendments are effective for annual periods and interim periods within those annual periods beginning after December 15, 2017.  This ASU may require us to change how we recognize certain recurring revenue streams within trust and investment management fees, however, we do not expect these changes to have a significant effect on our financial statements.

FASB issued ASU 2016-02, Leases. The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement.  The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.  As the Company owns most of its branch locations, this ASU will apply primarily to operating leases and the impact of adoption of this ASU by the Company is not expected to be material.

FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.  This ASU provides financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date by replacing the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates.  The new guidance eliminates the probable initial recognition threshold and, instead, reflects an entity’s current estimate of all expected credit losses. The new guidance broadens the information that an entity must consider in developing its expected credit loss estimate for assets measured either collectively or individually to include forecasted information, as well as past events and current conditions. There is no specified method for measuring expected credit losses, and an entity is allowed to apply methods that reasonably reflect its expectations of the credit loss estimate. Although an entity may still use its current systems and methods for recording the allowance for credit losses, under the new rules, the inputs used to record the allowance for credit losses generally will need to change to appropriately reflect an estimate of all expected credit losses and the use of reasonable and supportable forecasts. Additionally, credit losses on available-for-sale debt securities will now have to be presented as an allowance rather than as a write-down. This ASU is effective for fiscal years beginning after December 15, 2019, and for interim periods within those years.  The Company is currently evaluating the impact of this new ASU on its consolidated financial statements.

FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (a consensus of the FASB Emerging Issues Task Force).  This ASU addresses concerns regarding diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows.  In particular, this ASU addresses eight specific cash flow issues in an effort to reduce this diversity in practice: (1) debt prepayment or debt extinguishment costs; (2) settlement of zero-coupon bonds; (3) contingent consideration payments made after a business combination; (4) proceeds from the settlement of insurance claims; (5) proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies; (6) distributions received from equity method investees; (7) beneficial interests in securitization transactions; and (8) separately identifiable cash flows and application of the predominance principle.  The amendments are effective for annual periods beginning after December 15, 2017, and for interim periods within those annual periods.  The impact of adoption of this ASU by the Company is not expected to be material.
 
- 12 -

Index
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 2 – SECURITIES

The amortized cost and fair value of securities at period-end were as follows (dollars in thousands):
 
   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
March 31, 2017
                       
Available for Sale:
                       
U.S. Treasury and federal agency securities
 
$
86,517
   
$
61
   
$
(900
)
 
$
85,678
 
U.S. Agency MBS and CMOs
   
11,306
     
16
     
(157
)
   
11,165
 
Tax-exempt state and municipal bonds
   
39,746
     
411
     
(348
)
   
39,809
 
Taxable state and municipal bonds
   
34,757
     
82
     
(342
)
   
34,497
 
Corporate bonds and other debt securities
   
12,002
     
16
     
(32
)
   
11,986
 
Other equity securities
   
1,500
     
---
     
(30
)
   
1,470
 
   
$
185,828
   
$
586
   
$
(1,809
)
 
$
184,605
 
                                 
Held to Maturity
                               
Tax-exempt state and municipal bonds
 
$
68,473
   
$
683
   
$
(77
)
 
$
69,079
 
                         
December 31, 2016
                       
Available for Sale:
                       
U.S. Treasury and federal agency securities
 
$
85,582
   
$
49
   
$
(1,281
)
 
$
84,350
 
U. S. Agency MBS and CMOs
   
12,037
     
11
     
(231
)
   
11,817
 
Tax-exempt state and municipal bonds
   
39,578
     
212
     
(603
)
   
39,187
 
Taxable state and municipal bonds
   
34,255
     
65
     
(437
)
   
33,883
 
Corporate bonds and other debt securities
   
13,765
     
16
     
(55
)
   
13,726
 
Other equity securities
   
1,500
     
---
     
(30
)
   
1,470
 
   
$
186,717
   
$
353
   
$
(2,637
)
 
$
184,433
 
                                 
Held to Maturity:
                               
Tax-exempt state and municipal bonds
 
$
69,378
   
$
573
   
$
(102
)
 
$
69,849
 

Proceeds from the sale of securities available for sale were $3.4 million and $9.4 million, respectively, in the three month periods ended March 31, 2017 and 2016 resulting in net gain on sale of $3,000 and $89,000, respectively, as reported in the Consolidated Statements of Income.  This resulted in a reclassification of $3,000 ($2,000 net of tax) for the three months ended March 31, 2017 and $89,000 ($58,000 net of tax) for the three months ended March 31, 2016 from accumulated other comprehensive income to gain on sale of securities in the Consolidated Statements of Income.

Contractual maturities of debt securities at March 31, 2017 were as follows (dollars in thousands):
 
   
Held–to-Maturity Securities
   
Available-for-Sale Securities
 
   
Amortized
Cost
   
Fair
Value
   
Amortized
Cost
   
Fair
Value
 
Due in one year or less
 
$
24,552
   
$
24,519
   
$
18,210
   
$
18,212
 
Due from one to five years
   
14,710
     
15,048
     
96,325
     
95,760
 
Due from five to ten years
   
8,279
     
8,471
     
54,895
     
54,526
 
Due after ten years
   
20,932
     
21,041
     
14,898
     
14,637
 
   
$
68,473
   
$
69,079
   
$
184,328
   
$
183,135
 
 
- 13 -

Index
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 2 – SECURITIES (Continued)

Securities with unrealized losses at March 31, 2017 and December 31, 2016, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (dollars in thousands):
 
   
Less than 12 Months
   
12 Months or More
   
Total
 
March 31, 2017
 
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
 
U.S. Treasury and federal agency securities
 
$
60,493
   
$
(890
)
 
$
3,039
   
$
(10
)
 
$
63,532
   
$
(900
)
U.S. Agency MBS and CMOs
   
10,114
     
(157
)
   
---
     
---
     
10,114
     
(157
)
Tax-exempt state and municipal bonds
   
37,802
     
(412
)
   
397
     
(8
)
   
38,199
     
(420
)
Taxable state and municipal bonds
   
19,139
     
(347
)
   
---
     
---
     
19,139
     
(347
)
Corporate bonds and other debt securities
   
5,628
     
(28
)
   
500
     
(4
)
   
6,128
     
(32
)
Other equity securities
   
1,470
     
(30
)
   
---
     
---
     
1,470
     
(30
)
Total temporarily impaired
 
$
134,646
   
$
(1,864
)
 
$
3,936
   
$
(22
)
 
$
138,582
   
$
(1,886
)
 
   
Less than 12 Months
   
12 Months or More
   
Total
 
December 31, 2016
 
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
 
U.S. Treasury and federal agency securities
 
$
59,129
   
$
(1,271
)
 
$
3,053
   
$
(10
)
 
$
62,182
   
$
(1,281
)
U.S. Agency MBS and CMOs
   
10,702
     
(231
)
   
---
     
---
     
10,702
     
(231
)
Tax-exempt state and municipal bonds
   
49,508
     
(698
)
   
1,672
     
(7
)
   
51,180
     
(705
)
Taxable state and municipal bonds
   
22,633
     
(437
)
   
---
     
---
     
22,633
     
(437
)
Corporate bonds and other debt securities
   
5,745
     
(50
)
   
500
     
(5
)
   
6,245
     
(55
)
Other equity securities
   
1,470
     
(30
)
   
---
     
---
     
1,470
     
(30
)
Total temporarily impaired
 
$
149,187
   
$
(2,717
)
 
$
5,225
   
$
(22
)
 
$
154,412
   
$
(2,739
)

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 the unrealized losses for each period were attributable to changes in interest rates and not due to credit quality.  As such, no OTTI charges were necessary during the three month periods ended March 31, 2017 and 2016.

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 at March 31, 2017 and December 31, 2016.
 
- 14 -

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

Portfolio loans were as follows (dollars in thousands):
  
   
March 31,
2017
   
December 31,
2016
 
Commercial and industrial
 
$
453,311
   
$
449,342
 
                 
Commercial real estate:
               
Residential developed
   
10,188
     
11,970
 
Unsecured to residential developers
   
4,785
     
4,734
 
Vacant and unimproved
   
44,950
     
40,286
 
Commercial development
   
499
     
378
 
Residential improved
   
73,064
     
75,348
 
Commercial improved
   
277,898
     
289,478
 
Manufacturing and industrial
   
97,424
     
95,787
 
Total commercial real estate
   
508,808
     
517,981
 
                 
Consumer
               
Residential mortgage
   
212,949
     
217,614
 
Unsecured
   
343
     
396
 
Home equity
   
83,666
     
88,113
 
Other secured
   
7,051
     
7,366
 
Total consumer
   
304,009
     
313,489
 
                 
Total loans
   
1,266,128
     
1,280,812
 
Allowance for loan losses
   
(16,696
)
   
(16,962
)
   
$
1,249,432
   
$
1,263,850
 

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

Three months ended March 31, 2017
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
 
$
6,345
   
$
6,703
   
$
3,871
   
$
43
   
$
16,962
 
Charge-offs
   
---
     
---
     
(26
)
   
---
     
(26
)
Recoveries
   
23
     
162
     
75
     
---
     
260
 
Provision for loan losses
   
101
     
(267
)
   
(329
)
   
(5
)
   
(500
)
Ending Balance
 
$
6,469
   
$
6,598
   
$
3,591
   
$
38
   
$
16,696
 
 
Three months ended March 31, 2016
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
 
$
4,826
   
$
8,457
   
$
3,761
   
$
37
   
$
17,081
 
Charge-offs
   
---
     
---
     
(76
)
   
---
     
(76
)
Recoveries
   
49
     
121
     
54
     
---
     
224
 
Provision for loan losses
   
70
     
(129
)
   
(40
)
   
(1
)
   
(100
)
Ending Balance
 
$
4,945
   
$
8,449
   
$
3,699
   
$
36
   
$
17,129
 
 
- 15 -

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

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method (dollars in thousands):
 
March 31, 2017
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
                             
Ending allowance attributable to loans:
                             
Individually reviewed for impairment
 
$
642
   
$
304
   
$
702
   
$
---
   
$
1,648
 
Collectively evaluated for impairment
   
5,827
     
6,294
     
2,889
     
38
     
15,048
 
Total ending allowance balance
 
$
6,469
   
$
6,598
   
$
3,591
   
$
38
   
$
16,696
 
                                         
Loans:
                                       
Individually reviewed for impairment
 
$
7,445
   
$
9,931
   
$
11,400
   
$
---
   
$
28,776
 
Collectively evaluated for impairment
   
445,866
     
498,877
     
292,609
     
---
     
1,237,352
 
Total ending loans balance
 
$
453,311
   
$
508,808
   
$
304,009
   
$
---
   
$
1,266,128
 
 
December 31, 2016
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
                             
Ending allowance attributable to loans:
                             
Individually reviewed for impairment
 
$
605
   
$
368
   
$
723
   
$
---
   
$
1,696
 
Collectively evaluated for impairment
   
5,740
     
6,335
     
3,148
     
43
     
15,266
 
Total ending allowance balance
 
$
6,345
   
$
6,703
   
$
3,871
   
$
43
   
$
16,962
 
                                         
Loans:
                                       
Individually reviewed for impairment
 
$
5,994
   
$
11,934
   
$
11,726
   
$
---
   
$
29,654
 
Collectively evaluated for impairment
   
443,348
     
506,047
     
301,763
     
---
     
1,251,158
 
Total ending loans balance
 
$
449,342
   
$
517,981
   
$
313,489
   
$
---
   
$
1,280,812
 
 
- 16 -

Index
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 March 31, 2017 (dollars in thousands):

March 31, 2017
 
Unpaid
Principal
Balance
   
Recorded
Investment
   
Allowance
Allocated
 
With no related allowance recorded:
                 
Commercial and industrial
 
$
3,921
   
$
3,921
   
$
---
 
                         
Commercial real estate:
                       
Residential developed
   
---
     
---
     
---
 
Unsecured to residential developers
   
---
     
---
     
---
 
Vacant and unimproved
   
---
     
---
     
---
 
Commercial development
   
---
     
---
     
---
 
Residential improved
   
27
     
27
     
---
 
Commercial improved
   
---
     
---
     
---
 
Manufacturing and industrial
   
---
     
---
     
---
 
     
27
     
27
     
---
 
Consumer:
                       
Residential mortgage
   
---
     
---
     
---
 
Unsecured
   
---
     
---
     
---
 
Home equity
   
---
     
---
     
---
 
Other secured
   
---
     
---
     
---
 
     
---
     
---
     
---
 
Total with no related allowance recorded
 
$
3,948
   
$
3,948
   
$
---
 
                         
With an allowance recorded:
                       
Commercial and industrial
 
$
3,524
   
$
3,524
   
$
642
 
                         
Commercial real estate:
                       
Residential developed
   
185
     
185
     
3
 
Unsecured to residential developers
   
---
     
---
     
---
 
Vacant and unimproved
   
375
     
375
     
10
 
Commercial development
   
189
     
189
     
6
 
Residential improved
   
2,815
     
2,815
     
149
 
Commercial improved
   
6,116
     
6,116
     
132
 
Manufacturing and industrial
   
224
     
224
     
4
 
     
9,904
     
9,904
     
304
 
Consumer:
                       
Residential mortgage
   
7,467
     
7,467
     
460
 
Unsecured
   
---
     
---
     
---
 
Home equity
   
3,933
     
3,933
     
242
 
Other secured
   
---
     
---
     
---
 
     
11,400
     
11,400
     
702
 
Total with an allowance recorded
 
$
24,828
   
$
24,828
   
$
1,648
 
Total
 
$
28,776
   
$
28,776
   
$
1,648
 
 
- 17 -

Index
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, 2016 (dollars in thousands):
 
December 31, 2016
 
Unpaid
Principal
Balance
   
Recorded
Investment
   
Allowance
Allocated
 
With no related allowance recorded:
                 
Commercial and industrial
 
$
2,298
   
$
2,298
   
$
---
 
                         
Commercial real estate:
                       
Residential developed
   
---
     
---
     
---
 
Unsecured to residential developers
   
---
     
---
     
---
 
Vacant and unimproved
   
---
     
---
     
---
 
Commercial development
   
---
     
---
     
---
 
Residential improved
   
27
     
27
     
---
 
Commercial improved
   
350
     
350
     
---
 
Manufacturing and industrial
   
---
     
---
     
---
 
     
377
     
377
     
---
 
Consumer:
                       
Residential mortgage
   
---
     
---
     
---
 
Unsecured
   
---
     
---
     
---
 
Home equity
   
---
     
---
     
---
 
Other secured
   
---
     
---
     
---
 
     
---
     
---
     
---
 
Total with no related allowance recorded
 
$
2,675
   
$
2,675
   
$
---
 
                         
With an allowance recorded:
                       
Commercial and industrial
 
$
3,696
   
$
3,696
   
$
605
 
                         
Commercial real estate:
                       
Residential developed
   
187
     
187
     
4
 
Unsecured to residential developers
   
---
     
---
     
---
 
Vacant and unimproved
   
387
     
387
     
9
 
Commercial development
   
189
     
189
     
6
 
Residential improved
   
4,687
     
4,687
     
216
 
Commercial improved
   
5,879
     
5,879
     
128
 
Manufacturing and industrial
   
228
     
228
     
5
 
     
11,557
     
11,557
     
368
 
Consumer:
                       
Residential mortgage
   
7,523
     
7,523
     
464
 
Unsecured
   
---
     
---
     
---
 
Home equity
   
4,203
     
4,203
     
259
 
Other secured
   
---
     
---
     
---
 
     
11,726
     
11,726
     
723
 
Total with an allowance recorded
 
$
26,979
   
$
26,979
   
$
1,696
 
Total
 
$
29,654
   
$
29,654
   
$
1,696
 
 
- 18 -

Index
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 month periods ended March 31, 2017 and 2016 (dollars in thousands):
 
   
Three
Months
Ended
March 31,
2017
   
Three
Months
Ended
March 31,
2016
 
Average of impaired loans during the period:
           
Commercial and industrial
 
$
6,843
   
$
8,265
 
                 
Commercial real estate:
               
Residential developed
   
185
     
---
 
Unsecured to residential developers
   
---
     
---
 
Vacant and unimproved
   
379
     
446
 
Commercial development
   
189
     
192
 
Residential improved
   
4,086
     
5,543
 
Commercial improved
   
6,158
     
9,537
 
Manufacturing and industrial
   
225
     
239
 
                 
Consumer
   
11,495
     
13,140
 
                 
Interest income recognized during impairment:
               
Commercial and industrial
   
278
     
298
 
Commercial real estate
   
126
     
201
 
Consumer
   
109
     
122
 
                 
Cash-basis interest income recognized
               
Commercial and industrial
   
265
     
288
 
Commercial real estate
   
123
     
200
 
Consumer
   
107
     
123
 
 
- 19 -

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

Nonaccrual loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.  The following tables present the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of March 31, 2017 and December 31, 2016:

 
March 31, 2017
 
Nonaccrual
   
Over 90
days
Accruing
 
             
Commercial and industrial
 
$
127
   
$
---
 
                 
Commercial real estate:
               
Residential developed
   
---
     
---
 
Unsecured to residential developers
   
---
     
---
 
Vacant and unimproved
   
---
     
---
 
Commercial development
   
49
     
---
 
Residential improved
   
79
     
---
 
Commercial improved
   
124
     
---
 
Manufacturing and industrial
   
---
     
---
 
     
252
     
---
 
Consumer:
               
Residential mortgage
   
2
     
---
 
Unsecured
   
13
     
---
 
Home equity
   
7
     
---
 
Other secured
   
---
     
---
 
     
22
     
---
 
Total
 
$
401
   
$
---
 
 
December 31, 2016
 
Nonaccrual
   
Over 90
days
Accruing
 
             
Commercial and industrial
 
$
36
   
$
---
 
                 
Commercial real estate:
               
Residential developed
   
---
     
---
 
Unsecured to residential developers
   
---
     
---
 
Vacant and unimproved
   
---
     
---
 
Commercial development
   
49
     
---
 
Residential improved
   
6
     
---
 
Commercial improved
   
128
     
---
 
Manufacturing and industrial
   
---
     
---
 
     
183
     
---
 
Consumer:
               
Residential mortgage
   
58
     
---
 
Unsecured
   
16
     
---
 
Home equity
   
7
     
---
 
Other secured
   
---
     
---
 
     
81
     
---
 
Total
 
$
300
   
$
---
 
 
- 20 -

Index
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 March 31, 2017 and December 31, 2016 by class of loans (dollars in thousands):
 
March 31, 2017
 
30-90
Days
   
Greater Than
90 Days
   
Total
Past Due
   
Loans Not
Past Due
   
Total
 
Commercial and industrial
 
$
30
   
$
121
   
$
151
   
$
453,160
   
$
453,311
 
                                         
Commercial real estate:
                                       
Residential developed
   
---
     
---
     
---
     
10,188
     
10,188
 
Unsecured to residential developers
   
---
     
---
     
---
     
4,785
     
4,785
 
Vacant and unimproved
   
---
     
---
     
---
     
44,950
     
44,950
 
Commercial development
   
189
     
49
     
238
     
261
     
499
 
Residential improved
   
92
     
79
     
171
     
72,893
     
73,064
 
Commercial improved
   
124
     
---
     
124
     
277,774
     
277,898
 
Manufacturing and industrial
   
---
     
---
     
---
     
97,424
     
97,424
 
     
405
     
128
     
533
     
508,275
     
508,808
 
Consumer:
                                       
Residential mortgage
   
204
     
---
     
204
     
212,745
     
212,949
 
Unsecured
   
12
     
---
     
12
     
331
     
343
 
Home equity
           
---
     
---
     
83,666
     
83,666
 
Other secured
   
15
     
---
     
15
     
7,036
     
7,051
 
     
231
     
---
     
231
     
303,778
     
304,009
 
Total
 
$
666
   
$
249
   
$
915
   
$
1,265,213
   
$
1,266,128
 
 
December 31, 2016
 
30-90
Days
   
Greater Than
90 Days
   
Total
Past Due
   
Loans Not
Past Due
   
Total
 
Commercial and industrial
 
$
425
   
$
28
   
$
453
   
$
448,889
   
$
449,342
 
                                         
Commercial real estate:
                                       
Residential developed
   
---
     
---
     
---
     
11,970
     
11,970
 
Unsecured to residential developers
   
---
     
---
     
---
     
4,734
     
4,734
 
Vacant and unimproved
   
---
     
---
     
---
     
40,286
     
40,286
 
Commercial development
   
---
     
49
     
49
     
329
     
378
 
Residential improved
   
74
     
5
     
79
     
75,269
     
75,348
 
Commercial improved
   
478
     
---
     
478
     
289,000
     
289,478
 
Manufacturing and industrial
   
---
     
---
     
---
     
95,787
     
95,787
 
     
552
     
54
     
606
     
517,375
     
517,981
 
Consumer:
                                       
Residential mortgage
   
64
     
56
     
120
     
217,494
     
217,614
 
Unsecured
   
---
     
---
     
---
     
396
     
396
 
Home equity
   
187
     
---
     
187
     
87,926
     
88,113
 
Other secured
   
81
     
---
     
81
     
7,285
     
7,366
 
     
332
     
56
     
388
     
313,101
     
313,489
 
Total
 
$
1,309
   
$
138
   
$
1,447
   
$
1,279,365
   
$
1,280,812
 
 
- 21 -

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

The Company had allocated $1,648,000 and $1,696,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings (“TDRs”) as of March 31, 2017 and December 31, 2016, respectively.  These loans may have involved the restructuring of terms to allow customers to mitigate the risk of foreclosure by meeting a lower loan payment requirement based upon their current cash flow.  These may also include loans that renewed at existing contractual rates, but below market rates for comparable credit.  The Company has been active at utilizing these programs and working with its customers to reduce the risk of foreclosure.  For commercial loans, these modifications typically include an interest only period and, in some cases, a lowering of the interest rate on the loan.  In some cases, the modification will include separating the note into two notes with the first note structured to be supported by current cash flows and collateral, and the second note made for the remaining unsecured debt.  The second note is charged off immediately and collected only after the first note is paid in full.  This modification type is commonly referred to as an A-B note structure.  For consumer mortgage loans, the restructuring typically includes a lowering of the interest rate to provide payment and cash flow relief.  For each restructuring, a comprehensive credit underwriting analysis of the borrower’s financial condition and prospects of repayment under the revised terms is performed to assess whether the structure can be successful and that cash flows will be sufficient to support the restructured debt.  An analysis is also performed to determine whether the restructured loan should be on accrual status.  Generally, if the loan is on accrual at the time of restructure, it will remain on accrual after the restructuring.  In some cases, a nonaccrual loan may be placed on accrual at restructuring if the loan’s actual payment history demonstrates it would have cash flowed under the restructured terms.  After six consecutive payments under the restructured terms, a nonaccrual restructured loan is reviewed for possible upgrade to accruing status.

In situations where there is a subsequent modification or renewal and the loan is brought to market terms, including a contractual interest rate not less than a market interest rate for new debt with similar credit risk characteristics, the TDR and impaired loan designations may be removed.  In addition, the TDR designation may also be removed from loans modified under an A-B note structure.  If the remaining “A” note is at a market rate at the time of restructuring (taking into account the borrower’s credit risk and prevailing market conditions), the loan can be removed from TDR designation in a subsequent calendar year after six months of performance in accordance with the new terms.  The market rate relative to the borrower’s credit risk is determined through analysis of market pricing information gathered from peers and use of a loan pricing model.  The general objective of the model is to achieve a consistent return on equity from one credit to the next, taking into consideration differences in credit risk.  In the model, credits with higher risk receive a higher potential loss allocation, and therefore require a higher interest rate to achieve the target return on equity.

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

The following table presents information regarding troubled debt restructurings as of March 31, 2017 and December 31, 2016 (dollars in thousands):
 
   
March 31, 2017
   
December 31, 2016
 
   
Number of
Loans
   
Outstanding
Recorded
Balance
   
Number of
Loans
   
Outstanding
Recorded
Balance
 
Commercial and industrial
   
24
   
$
7,444
     
25
   
$
5,994
 
Commercial real estate
   
43
     
9,931
     
49
     
11,933
 
Consumer
   
111
     
11,782
     
116
     
12,059
 
     
178
   
$
29,157
     
190
   
$
29,986
 
 
- 22 -

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

The following table presents information related to accruing troubled debt restructurings as of March 31, 2017 and December 31, 2016.  The table presents the amount of accruing troubled debt restructurings that were on nonaccrual status prior to the restructuring, accruing at the time of restructuring and those that were upgraded to accruing status after receiving six consecutive monthly payments in accordance with the restructured terms as of each period reported (dollars in thousands):
 
   
March 31,
2017
   
December 31,
2016
 
Accruing TDR - nonaccrual at restructuring
 
$
---
   
$
---
 
Accruing TDR - accruing at restructuring
   
23,215
     
25,665
 
Accruing TDR - upgraded to accruing after six consecutive payments
   
5,800
     
4,172
 
   
$
29,015
   
$
29,837
 
 
The following tables present information regarding troubled debt restructurings executed during the three month periods ended March 31, 2017 and 2016 (dollars in thousands):
 
   
Three Months Ended March 31,
2017
   
Three Months Ended March 31,
2016
 
   
# of
Loans
   
Pre-TDR
Balance
   
Writedown
Upon
TDR
   
# of
Loans
   
Pre-TDR
Balance
   
Writedown
Upon
TDR
 
Commercial and industrial
   
---
   
$
---
   
$
---
     
---
   
$
---
   
$
---
 
Commercial real estate
   
---
     
---
     
---
     
---
     
---
     
---
 
Consumer
   
---
     
---
     
---
     
4
     
238
     
---
 
     
---
     
---
   
$
---
     
4
   
$
238
   
$
---
 

According to the accounting standards, not all loan modifications are TDRs.  TDRs are modifications or renewals where the Company has granted a concession to a borrower in financial distress.  The Company reviews all modifications and renewals for determination of TDR status.  In some situations a borrower may be experiencing financial distress, but the Company does not provide a concession.  These modifications are not considered TDRs.  In other cases, the Company might provide a concession, such as a reduction in interest rate, but the borrower is not experiencing financial distress.  This could be the case if the Company is matching a competitor’s interest rate.  These modifications would also not be considered TDRs.  Finally, any renewals at existing terms for borrowers not experiencing financial distress would not be considered TDRs.  As with other loans not considered TDR or impaired, allowance allocations are based on the historical based allocation for the applicable loan grade and loan class.

Payment defaults on TDRs have been minimal and during the three months ended March 31, 2017 and 2016, the balance of loans that became delinquent by more than 90 days past due or that were transferred to nonaccrual within 12 months of restructuring were not material.
 
- 23 -

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

Credit Quality Indicators: The Company categorizes loans into risk categories based on relevant information about the ability of the borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors.  The Company analyzes commercial loans individually and classifies these relationships by credit risk grading.  The Company uses an eight point grading system, with grades 5 through 8 being considered classified, or watch, credits.  All commercial loans are assigned a grade at origination, at each renewal or any amendment.  When a credit is first downgraded to a watch credit (either through renewal, amendment, loan officer identification or the loan review process), an Administrative Loan Review (“ALR”) is generated by the credit department and the loan officer.  All watch credits have an ALR completed 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 give 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 formulate solutions where progress has stalled.  When necessary, the loan officer proposes changes to the assigned loan grade as part of the ALR.  Additionally, Loan Review reviews all loan grades upon origination, renewal or amendment and again as loans are selected though the loan review process.  The credit will stay on the ALR until either its grade has improved to a 4 or the credit relationship is at a zero balance.  The Company uses the following definitions for the risk grades:

1. Excellent - Loans supported by extremely strong financial condition or secured by the Bank’s own deposits. Minimal risk to the Bank and the probability of serious rapid financial deterioration is extremely small.

2. Above Average - Loans supported by sound financial statements that indicate the ability to repay or borrowings secured (and margined properly) with marketable securities. Nominal risk to the Bank and probability of serious financial deterioration is highly unlikely. The overall quality of these credits is very high.

3. Good Quality - Loans supported by satisfactory asset quality and liquidity, good debt capacity coverage, and good management in all critical positions. Loans are secured by acceptable collateral with adequate margins. There is a slight risk of deterioration if adverse market conditions prevail.

4. Acceptable Risk - Loans carrying an acceptable risk to the Bank, which may be slightly below average quality. The borrower has limited financial strength with considerable leverage. There is some probability of deterioration if adverse market conditions prevail. These credits should be monitored closely by the Relationship Manager.

5. Marginally Acceptable - Loans are of marginal quality with above normal risk to the Bank. The borrower shows acceptable asset quality but very little liquidity with high leverage. There is inconsistent earning performance without the ability to sustain adverse market conditions. The primary source of repayment is questionable, but the secondary source of repayment still remains an option. Very close attention by the Relationship Manager and management is needed.

6. Substandard - Loans are inadequately protected by the net worth and paying capacity of the borrower or the collateral pledged. The primary and secondary sources of repayment are questionable. Heavy debt condition may be evident and volume and earnings deterioration may be underway. It is possible that the Bank will sustain some loss if the deficiencies are not immediately addressed and corrected.

7. Doubtful - Loans supported by weak or no financial statements, as well as the ability to repay the entire loan, are questionable. Loans in this category are normally characterized less than adequate collateral, insolvent, or extremely weak financial condition. A loan classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses makes collection or liquidation in full highly questionable. The possibility of loss is extremely high, however, activity may be underway to minimize the loss or maximize the recovery.

8. Loss - Loans are considered uncollectible and of little or no value as a bank asset.
 
- 24 -

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

As of March 31, 2017 and December 31, 2016, the risk grade category of commercial loans by class of loans were as follows (dollars in thousands):
 
March 31, 2017
   
1
     
2
     
3
     
4
     
5
     
6
     
7
     
8
   
Total
 
Commercial and industrial
 
$
---
   
$
24,690
   
$
111,044
   
$
297,713
   
$
12,063
   
$
7,674
   
$
127
   
$
---
   
$
453,311
 
                                                                         
Commercial real estate:
                                                                       
Residential developed
   
---
     
---
     
1,703
     
7,640
     
845
     
---
     
---
     
---
     
10,188
 
Unsecured to residential developers
   
---
     
---
     
---
     
4,785
     
---
     
---
     
---
     
---
     
4,785
 
Vacant and unimproved
   
---
     
---
     
21,257
     
20,157
     
3,536
     
---
     
---
     
---
     
44,950
 
Commercial development
   
---
     
---
     
121
     
139
     
---
     
190
     
49
     
---
     
499
 
Residential improved
   
---
     
---
     
6,132
     
62,688
     
2,572
     
1,593
     
79
     
---
     
73,064
 
Commercial improved
   
---
     
3,656
     
58,960
     
206,827
     
7,233
     
1,098
     
124
     
---
     
277,898
 
Manufacturing & industrial
   
---
     
1,587
     
37,797
     
55,153
     
2,308
     
579
     
---
     
---
     
97,424
 
   
$
---
   
$
29,933
   
$
237,014
   
$
655,102
   
$
28,557
   
$
11,134
   
$
379
   
$
---
   
$
962,119
 
 
December 31, 2016
   
1
     
2
     
3
     
4
     
5
     
6
     
7
     
8
   
Total
 
Commercial and industrial
 
$
---
   
$
27,619
   
$
118,243
   
$
282,527
   
$
14,610
   
$
6,307
   
$
36
   
$
---
   
$
449,342
 
                                                                         
Commercial real estate:
                                                                       
Residential developed
   
---
     
---
     
2,328
     
8,786
     
856
     
---
     
---
     
---
     
11,970
 
Unsecured to residential developers
   
---
     
---
     
---
     
4,734
     
---
     
---
     
---
     
---
     
4,734
 
Vacant and unimproved
   
---
     
---
     
17,672
     
19,028
     
3,586
     
---
     
---
     
---
     
40,286
 
Commercial development
   
---
     
---
     
---
     
140
     
---
     
189
     
49
     
---
     
378
 
Residential improved
   
---
     
---
     
7,100
     
63,957
     
2,628
     
1,657
     
6
     
---
     
75,348
 
Commercial improved
   
---
     
2,433
     
66,259
     
210,449
     
9,084
     
1,125
     
128
     
---
     
289,478
 
Manufacturing & industrial
   
---
     
1,665
     
38,719
     
51,718
     
3,076
     
609
     
---
     
---
     
95,787
 
   
$
---
   
$
31,717
   
$
250,321
   
$
641,339
   
$
33,840
   
$
9,887
   
$
219
   
$
---
   
$
967,323
 
 
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):
 
   
March 31,
2017
   
December 31,
2016
 
Not classified as impaired
 
$
2,434
   
$
2,608
 
Classified as impaired
   
9,079
     
7,498
 
Total commercial loans classified substandard or worse
 
$
11,513
   
$
10,106
 
 
- 25 -

Index
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):


March 31, 2017
 
Residential
Mortgage
   
Consumer
Unsecured
   
Home
Equity
   
Consumer
Other
 
Performing
 
$
212,949
   
$
343
   
$
83,666
   
$
7,051
 
Nonperforming
   
---
     
---
     
---
     
---
 
Total
 
$
212,949
   
$
343
   
$
83,666
   
$
7,051
 
 
December 31, 2016
 
Residential
Mortgage
   
Consumer
Unsecured
   
Home
Equity
   
Consumer
Other
 
Performing
 
$
217,558
   
$
396
   
$
88,113
   
$
7,366
 
Nonperforming
   
56
     
---
     
---
     
---
 
Total
 
$
217,614
   
$
396
   
$
88,113
   
$
7,366
 
 
NOTE 4 – OTHER REAL ESTATE OWNED

Other real estate owned was as follows (dollars in thousands):
 
   
Three
Months Ended
March 31,
2017
   
Year
Ended
December 31,
2016
   
Three
Months Ended
March 31,
2016
 
Beginning balance
 
$
22,864
   
$
28,377
   
$
28,377
 
Additions, transfers from loans
   
56
     
339
     
102
 
Proceeds from sales of other real estate owned
   
(320
)
   
(5,339
)
   
(1,475
)
Valuation allowance reversal upon sale
   
(250
)
   
(1,158
)
   
(251
)
Gain on sales of other real estate owned
   
149
     
645
     
92
 
     
22,499
     
22,864
     
26,845
 
Less: valuation allowance
   
(10,425
)
   
(10,611
)
   
(10,683
)
Ending balance
 
$
12,074
   
$
12,253
   
$
16,162
 

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

   
Three
Months Ended
March 31,
2017
   
Three
Months Ended
March 31,
2016
 
Beginning balance
 
$
10,611
   
$
10,805
 
Additions charged to expense
   
64
     
129
 
Reversals upon sale
   
(250
)
   
(251
)
Ending balance
 
$
10,425
   
$
10,683
 
 
- 26 -

Index
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 5 – FAIR VALUE

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

Level 1:
Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2:
Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3:
Significant unobservable inputs that reflect a reporting entity's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Investment Securities: The fair values of investment securities are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities' relationship to other benchmark quoted securities (Level 2 inputs).  The fair values of certain securities held to maturity are determined by computing discounted cash flows using observable and unobservable market inputs (Level 3 inputs).

Loans Held for Sale: The fair value of loans held for sale is based upon binding quotes from third party investors (Level 2 inputs).

Impaired Loans: Loans identified as impaired are measured using one of three methods: the loan’s observable market price, the fair value of collateral or the present value of expected future cash flows.  For each period presented, no impaired loans were measured using the loan’s observable market price.  If an impaired loan has had a chargeoff or if the fair value of the collateral is less than the recorded investment in the loan, we establish a specific reserve and report the loan as nonrecurring Level 3.  The fair value of collateral of impaired loans is generally based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Other Real Estate Owned: Other real estate owned (OREO) properties are initially recorded at fair value, less estimated costs to sell when acquired, establishing a new cost basis.  Adjustments to OREO are measured at fair value, less costs to sell. Fair values are generally based on third party appraisals or realtor evaluations of the property. These appraisals and evaluations may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.  Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available.  Such adjustments are usually significant and typically result in a Level 3 classification.  In cases where the carrying amount exceeds the fair value, less estimated costs to sell, an impairment loss is recognized through a valuation allowance, and the property is reported as nonrecurring Level 3.

Interest Rate Swaps:   For interest rate swap agreements, we measure fair value utilizing pricing provided by a third-party pricing source that that uses market observable inputs, such as forecasted yield curves, and other unobservable inputs and accordingly, interest rate swap agreements are classified as Level 3.
 
- 27 -

Index
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)
 
March 31, 2017
                       
U.S. Treasury and federal agency securities
 
$
85,678
   
$
---
   
$
85,678
   
$
---
 
U.S. Agency MBS and CMOs
   
11,165
     
---
     
11,165
     
---
 
Tax-exempt state and municipal bonds
   
39,809
     
---
     
39,809
     
---
 
Taxable state and municipal bonds
   
34,497
     
---
     
34,497
     
---
 
Corporate bonds and other debt securities
   
11,986
     
---
     
11,986
     
---
 
Other equity securities
   
1,470
     
---
     
1,470
     
---
 
Loans held for sale
   
2,767
     
---
     
2,767
     
---
 
Interest rate swaps
   
383
     
---
     
---
     
383
 
Interest rate swaps
   
(383
)
   
---
     
---
     
(383
)
                         
December 31, 2016
                       
U.S. Treasury and federal agency securities
 
$
84,350
   
$
---
   
$
84,350
   
$
---
 
U.S. Agency MBS and CMOs
   
11,817
     
---
     
11,817
     
---
 
Tax-exempt state and municipal bonds
   
39,187
     
---
     
39,187
     
---
 
Taxable state and municipal bonds
   
33,883
     
---
     
33,883
     
---
 
Corporate bonds and other debt securities
   
13,726
     
---
     
13,726
     
---
 
Other equity securities
   
1,470
     
---
     
1,470
     
---
 
Loans held for sale
   
2,181
     
---
     
2,181
     
---
 
Interest rate swaps
   
494
     
---
     
---
     
494
 
Interest rate swaps
   
(494
)
   
---
     
---
     
(494
)

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)
 
March 31, 2017
                       
Impaired loans
 
$
3,282
   
$
---
   
$
---
   
$
3,282
 
Other real estate owned
   
9,400
     
---
      ---      
9,400
 
                                  
December 31, 2016
                      
Impaired loans
 
$
3,436
   
$
---
   
$
---
   
$
3,436
 
Other real estate owned
   
9,542
     
---
      ---      
9,542
 
 
- 28 -

Index
MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
NOTE 5 – FAIR VALUE (Continued)

Quantitative information about Level 3 fair value measurements measured on a non-recurring basis was as follows at period end (dollars in thousands):
 
   
Asset
Fair
Value
 
Valuation
Technique
 
Unobservable
Inputs
   
Range (%)
 
March 31, 2017
                     
Impaired Loans
 
$
3,282
 
Sales comparison approach
 
Adjustment for differences between comparable sales
   
1.0 to 35.0
 
         
Income approach
 
Capitalization rate
   
9.5 to 11.0
 
                         
Other real estate owned
   
9,400
 
Sales comparison approach
 
Adjustment for differences between comparable sales
   
2.0 to 42.0
 
         
Income approach
 
Capitalization rate
   
9.5 to 11.5
 
 
 
Asset
Fair
Value
 
Valuation
Technique
 
Unobservable
Inputs
 
Range (%)
 
December 31, 2016
                     
Impaired Loans
 
$
3,436
 
Sales comparison approach
 
Adjustment for differences between comparable sales
   
1.0 to35.0
 
         
Income approach
 
Capitalization rate
   
9.5 to 11.5
 
                            
Other real estate owned
   
9,542
 
Sales comparison approach
 
Adjustment for differences between comparable sales
   
2.0 to 32.5
 
         
Income approach
 
Capitalization rate
   
9.5 to 11.5
 
 
- 29 -

Index
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 March 31, 2017 and December 31, 2016 (dollars in thousands):

 
Financial assets
Level in
Fair Value
Hierarchy 
  
March 31, 2017
   
December 31, 2016
 
Carrying
Amount
Fair
Value
Carrying
Amount
Fair
Value
 
                         
Cash and due from banks
Level 1
 
$
30,631
   
$
30,631
   
$
27,690
   
$
27,690
 
Cash equivalents
Level 2
   
83,118
     
83,118
     
62,129
     
62,129
 
Securities held to maturity
Level 3
   
68,473
     
69,079
     
69,378
     
69,849
 
FHLB stock
     
11,558
   
NA
     
11,558
   
NA
 
Loans, net
Level 2
   
1,245,996
     
1,234,716
     
1,260,414
     
1,247,842
 
Bank owned life insurance
Level 3
   
39,524
     
39,524
     
39,274
     
39,274
 
Accrued interest receivable
Level 2
   
4,204
     
4,204
     
4,092
     
4,092
 
                                   
Financial liabilities
                                 
Deposits
Level 2
   
(1,433,146
)
   
(1,433,068
)
   
(1,448,724
)
   
(1,448,692
)
Other borrowed funds
Level 2
   
(102,785
)
   
(102,595
)
   
(84,173
)
   
(84,051
)
Long-term debt
Level 2
   
(41,238
)
   
(36,277
)
   
(41,238
)
   
(36,112
)
Accrued interest payable
Level 2
   
(275
)
   
(275
)
   
(282
)
   
(282
)
                                   
Off-balance sheet credit-related items
                                 
Loan commitments
     
---
     
---
     
---
     
---
 

The methods and assumptions used to estimate fair value are described as follows.

Carrying amount is the estimated fair value for cash and cash equivalents, bank owned life insurance, accrued interest receivable and payable, demand deposits, short-term borrowings and variable rate loans or deposits that reprice frequently and fully. Security fair values are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities as discussed above. For fixed rate loans, interest-bearing time deposits in other financial institutions, or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk (including consideration of widening credit spreads). Fair value of debt is based on current rates for similar financing. It was not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability. The fair value of off-balance sheet credit-related items is not significant.
 
- 30 -

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

 
NOTE 6 – DEPOSITS

Deposits are summarized as follows (in thousands):

   
March 31,
2017
   
December 31,
2016
 
Noninterest-bearing demand
 
$
466,415
   
$
501,478
 
Interest bearing demand
   
342,812
     
340,715
 
Savings and money market accounts
   
548,761
     
532,853
 
Certificates of deposit
   
75,158
     
73,678
 
   
$
1,433,146
   
$
1,448,724
 

Time deposits that exceed the FDIC insurance limit of $250,000 were approximately $18.1 million at March 31, 2017 and $17.4 million at December 31, 2016.

NOTE 7 - OTHER BORROWED FUNDS

Other borrowed funds include advances from the Federal Home Loan Bank and borrowings from the Federal Reserve Bank.

Federal Home Loan Bank Advances

At period-end, advances from the Federal Home Loan Bank were as follows (dollars in thousands):

 
Principal Terms
Advance
Amount
 
Range of Maturities
 Weighted
Average
Interest Rate
 
March 31, 2017
                 
Single maturity fixed rate advances
 
$
100,000
 
April 2017 to April 2021
   
1.41
%
Amortizable mortgage advances
   
2,785
 
March 2018 to July 2018
   
3.75
%
   
$
102,785
           

 
Principal Terms
 
Advance
Amount
 
 
Range of Maturities
 Weighted
Average
Interest Rate
 
December 31, 2016
                 
Single maturity fixed rate advances
 
$
80,000
 
February 2018 to April 2021
   
1.60
%
Amortizable mortgage advances
   
4,173
 
March 2018 to July 2018
   
3.78
%
   
$
84,173
           

Each advance is subject to a prepayment fee if paid prior to its maturity date.  Fixed rate advances are payable at maturity.   Amortizable mortgage advances are fixed rate advances with scheduled repayments based upon amortization to maturity.  These advances were collateralized by residential and commercial real estate loans totaling $464,498,000 and $424,951,000 under a blanket lien arrangement at March 31, 2017 and December 31, 2016, respectively.
 
- 31 -

MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 7 - OTHER BORROWED FUNDS

Scheduled repayments of FHLB advances as of March 31, 2017 were as follows (in thousands):

2017
 
$
20,667
 
2018
   
52,118
 
2019
   
10,000
 
2020
   
10,000
 
2021
   
10,000
 
Thereafter
   
---
 
   
$
102,785
 

Federal Reserve Bank borrowings

The Company has a financing arrangement with the Federal Reserve Bank.  There were no borrowings outstanding at March 31, 2017 and December 31, 2016, and the Company had approximately $16.3 million and $18.1 million in unused borrowing capacity based on commercial and mortgage loans pledged to the Federal Reserve Bank totaling $20.4 million and $20.7 million at March 31, 2017 and December 31, 2016, respectively.

NOTE 8 - EARNINGS PER COMMON SHARE

A reconciliation of the numerators and denominators of basic and diluted earnings per common share for the three month periods ended March 31, 2017 and 2016 are as follows (dollars in thousands, except per share data):
 
   
Three Months
Ended
March 31,
2017
   
Three Months
Ended
March 31,
2016
 
Net income available to common shares
 
$
4,460
   
$
3,495
 
                 
Weighted average shares outstanding, including participating stock awards - Basic
   
33,941,010
     
33,925,113
 
                 
Dilutive potential common shares:
               
Stock options
   
7,574
     
---
 
Stock warrants
   
---
     
---
 
Weighted average shares outstanding - Diluted
   
33,948,584
     
33,925,113
 
Basic earnings per common share
 
$
0.13
   
$
0.10
 
Diluted earnings per common share
 
$
0.13
   
$
0.10
 

Stock options for 101,473 shares of common stock for the three month period ended March 31, 2016, were not considered in computing diluted earnings per share because they were antidilutive. There were no antidilutive shares of common stock at March 31, 2017.
 
- 32 -

MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 9 - FEDERAL INCOME TAXES

Income tax expense was as follows (dollars in thousands):

   
Three Months
Ended
March 31,
2017
   
Three Months
Ended
March 31,
2016
 
Current
 
$
1,804
   
$
1,468
 
Deferred
   
162
     
(68
)
   
$
1,966
   
$
1,400
 

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

   
Three Months
Ended
March 31,
2017
   
Three Months
Ended
March 31,
2016
 
Statutory rate
   
35
%
   
35
%
Statutory rate applied to income before taxes
 
$
2,249
   
$
1,713
 
Deduct
               
Tax-exempt interest income
   
(183
)
   
(148
)
Bank-owned life insurance
   
(83
)
   
(155
)
Other, net
   
(17
)
   
(10
)
   
$
1,966
   
$
1,400
 

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.  No valuation allowance was necessary at March 31, 2017 or December 31, 2016.
 
- 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):
  
 
March 31,
2017
   
December 31,
2016
 
Deferred tax assets
           
Allowance for loan losses
 
$
5,844
   
$
5,937
 
Nonaccrual loan interest
   
642
     
718
 
Valuation allowance on other real estate owned
   
3,649
     
3,714
 
Unrealized loss on securities available for sale
   
428
     
799
 
Other
   
216
     
176
 
Gross deferred tax assets
   
10,779
     
11,344
 
Valuation allowance
   
---
     
---
 
Total net deferred tax assets
   
10,779
     
11,344
 
                 
Deferred tax liabilities
               
Depreciation
   
(1,655
)
   
(1,705
)
Prepaid expenses
   
(399
)
   
(399
)
Unrealized gain on securities available for sale
   
---
     
---
 
Other
   
(395
)
   
(377
)
Gross deferred tax liabilities
   
(2,449
)
   
(2,481
)
Net deferred tax asset
 
$
8,330
   
$
8,863
 

There were no unrecognized tax benefits at March 31, 2017 or December 31, 2016 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 2013.

NOTE 10 – COMMITMENTS AND OFF BALANCE-SHEET RISK

Some financial instruments are used to meet customer financing needs and to reduce exposure to interest rate changes.  These financial instruments include commitments to extend credit and standby letters of credit.  These involve, to varying degrees, credit and interest rate risk in excess of the amount reported in the financial statements.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment, and generally have fixed expiration dates.  Standby letters of credit are conditional commitments to guarantee a customer’s performance to a third party.  Exposure to credit loss if the other party does not perform is represented by the contractual amount for commitments to extend credit and standby letters of credit.  Collateral or other security is normally not obtained for these financial instruments prior to their use and many of the commitments are expected to expire without being used.

A summary of the contractual amounts of financial instruments with off‑balance‑sheet risk was as follows at period-end (dollars in thousands):

 
March 31,
2017
   
December 31,
2016
 
Commitments to make loans
 
$
95,653
   
$
90,293
 
Letters of credit
   
13,598
     
13,823
 
Unused lines of credit
   
446,346
     
437,435
 

The notional amount of commitments to fund mortgage loans to be sold into the secondary market was approximately $16.8 million and $19.8 million at March 31, 2017 and December 31, 2016, respectively.
 
- 34 -

MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 10 – COMMITMENTS AND OFF BALANCE-SHEET RISK (Continued)

At March 31, 2017, approximately 37.5% of the Bank’s commitments to make loans were at fixed rates, offered at current market rates.  The remainder of the commitments to make loans were at variable rates tied to prime or one month LIBOR and generally expire within 30 days.  The majority of the unused lines of credit were at variable rates tied to prime.

NOTE 11 – CONTINGENCIES

The Company and its subsidiaries periodically become defendants in certain claims and legal actions arising in the ordinary course of business. As of March 31, 2017, there were no material pending legal proceedings to which the Company or any of its subsidiaries are a party or which any of its properties are the subject.
 
NOTE 12 – SHAREHOLDERS' EQUITY

Regulatory Capital

The Company and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements.

The prompt corrective action regulations provide five categories, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If a bank is only adequately capitalized, regulatory approval is required to, among other things, accept, renew or roll-over brokered deposits. If a bank is undercapitalized, capital distributions and growth and expansion are limited, and plans for capital restoration are required.

In July 2013, the Board of Governors of the Federal Reserve Board and the FDIC approved the final rules implementing the Basel Committee on Banking Supervision's capital guidelines for U.S. banks (commonly known as Basel III). Under the final rules, which began for the Company and the Bank on January 1, 2015 and are subject to a phase-in period through January 1, 2019, minimum requirements will increase for both the quantity and quality of capital held by the Company and the Bank. The rules include a new common equity Tier 1 capital to risk-weighted assets ratio (CET1 ratio) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, which when fully phased-in, effectively results in a minimum CET1 ratio of 7.0%.  Basel III raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5% when fully phased-in), which effectively results in a minimum total capital to risk-weighted assets ratio of 10.5% (with the capital conservation buffer fully phased-in), and requires a minimum leverage ratio of 4.0%. Basel III also makes changes to risk weights for certain assets and off-balance-sheet exposures.
 
- 35 -

MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

 
NOTE 12 – SHAREHOLDERS' EQUITY (Continued)

At March 31, 2017 and December 31, 2016, actual capital levels and minimum required levels were (dollars in thousands):

   
Actual
   
Minimum
Capital
Adequacy
   
Minimum Capital
Adequacy With
Capital Buffer
   
To Be Well
Capitalized Under
Prompt Corrective
Action Regulations
 
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
March 31, 2017
                                               
CET1 capital (to risk weighted assets)
                                               
Consolidated
 
$
166,880
     
11.3
%
 
$
66,557
     
4.5
%
 
$
85,045
     
5.8
%
   
N/A
     
N/A
 
Bank
   
201,129
     
13.6
     
66,552
     
4.5
     
85,038
     
5.8
   
$
96,130
     
6.5
%
Tier 1 capital (to risk weighted assets)
                                                               
Consolidated
   
206,880
     
14.0
     
88,742
     
6.0
     
107,230
     
7.3
     
N/A
     
N/A
 
Bank
   
201,129
     
13.6
     
88,736
     
6.0
     
107,222
     
7.3
     
118,314
     
8.0
 
Total capital (to risk weighted assets)
                                                               
Consolidated
   
223,575
     
15.1
     
118,323
     
8.0
     
136,811
     
9.3
     
N/A
     
N/A
 
Bank
   
217,825
     
14.7
     
118,314
     
8.0
     
136,801
     
9.3
     
147,893
     
10.0
 
Tier 1 capital (to average assets)
                                                               
Consolidated
   
206,880
     
12.1
     
68,329
     
4.0
     
N/A
     
N/A
     
N/A
     
N/A
 
Bank
   
201,129
     
11.8
     
68,264
     
4.0
     
N/A
     
N/A
     
85,330
     
5.0
 
                                                                 
December 31, 2016
                                                               
CET1 capital (to risk weighted assets)
                                                               
Consolidated
 
$
163,663
     
11.0
%
 
$
66,743
     
4.5
%
 
$
76,013
     
5.1
%
   
N/A
     
N/A
 
Bank
   
197,972
     
13.4
     
66,737
     
4.5
     
76,006
     
5.1
   
$
96,398
     
6.5
%
Tier 1 capital (to risk weighted assets)
                                                               
Consolidated
   
203,663
     
13.7
     
88,991
     
6.0
     
98,261
     
6.6
     
N/A
     
N/A
 
Bank
   
197,972
     
13.4
     
88,983
     
6.0
     
98,252
     
6.6
     
118,644
     
8.0
 
Total capital (to risk weighted assets)
                                                               
Consolidated
   
220,625
     
14.9
     
118,655
     
8.0
     
127,925
     
8.6
     
N/A
     
N/A
 
Bank
   
214,934
     
14.5
     
118,644
     
8.0
     
127,913
     
8.6
     
148,305
     
10.0
 
Tier 1 capital (to average assets)
                                                               
Consolidated
   
203,663
     
12.0
     
67,810
     
4.0
     
N/A
     
N/A
     
N/A
     
N/A
 
Bank
   
197,972
     
11.7
     
67,742
     
4.0
     
N/A
     
N/A
     
84,677
     
5.0
 

Approximately $40.0 million of trust preferred securities outstanding at March 31, 2017 and December 31, 2016, respectively, qualified as Tier 1 capital. Refer to our 2016 Form 10-K for more information on the trust preferred securities.

The Bank was categorized as "well capitalized" at March 31, 2017 and December 31, 2016.
 
- 36 -

Item 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Macatawa Bank Corporation is a Michigan corporation and a registered bank holding company. It wholly-owns Macatawa Bank, 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 Consolidated Financial Statements.

At March 31, 2017, we had total assets of $1.75 billion, total loans of $1.27 billion, total deposits of $1.43 billion and shareholders' equity of $166.1 million.  During the first quarter of 2017, we recognized net income of $4.5 million compared to net income of $3.5 million in the first quarter of 2016.  The Bank was categorized as “well capitalized” under regulatory capital standards at March 31, 2017.

We paid a dividend of $0.02 per share in each quarter in 2014 and in the first quarter of 2015, increasing to $0.03 per share in the second through fourth quarters of 2015 and each quarter of 2016.  We increased the dividend to $0.04 per share in the first quarter of 2017.

RESULTS OF OPERATIONS

Summary: Net income for the quarter ended March 31, 2017 was $4.5 million, compared to net income of $3.5 million in the first quarter of 2016. Net income per common share on a diluted basis was $0.13 for the first quarter of 2017 and $0.10 for the first quarter of 2016.

The increase in earnings in the first quarter of 2017 compared to the first quarter of 2016 was due primarily to increased net interest income, a larger negative provision for loan losses and reduced nonperforming asset expenses, partially offset by lower earnings on bank owned life insurance.  Net interest income increased to $12.6 million in the first quarter of 2017 compared to $11.7 million in the same period in 2016.  The provision for loan losses was a negative $500,000 for the first quarter of 2017, compared to a negative $100,000 for the first quarter of 2016.  Bank owned life insurance income decreased to $238,000 in the first quarter of 2017 compared to $444,000 in the first quarter of 2016.  Nonperforming asset expenses (including administration costs and losses) were $95,000 for the first quarter of 2017 compared to $411,000 for the first quarter of 2016, primarily as a result of a decrease of $4.1 million in other real estate owned.  We again were in a net loan recovery position for the first quarter of 2017, with $234,000 in net loan recoveries, compared to $148,000 in net loan recoveries in the first quarter of 2016.  Each of these items is discussed more fully below.

Net Interest Income: Net interest income totaled $12.6 million for the first quarter of 2017 and $11.7 million for the first quarter of 2016.

Net interest income was positively impacted in the first quarter of 2017 by an increase in average earning assets of $40.6 million compared to the first quarter of 2016.  Our average yield on earning assets for the first quarter of 2017 increased 17 basis points compared to the same period in 2016 from 3.42% to 3.59%.  Average interest earning assets totaled $1.58 billion for the first quarter of 2017 compared to $1.54 billion for the first quarter of 2016. The net interest margin was 3.26% for the first quarter of 2017 compared to 3.09% for the first quarter of 2016.  An increase of $42.1 million in average securities between periods and an increase of $62.8 million in loans were the primary drivers of the increase.  Yield on commercial loans increased from 3.95% for the first quarter of 2016 to 4.04% for the first quarter of 2017.  The commercial loan yield in the first quarter of 2017 was positively impacted by the complete payoff of a loan that had been on nonaccrual, resulting in the realization of $267,000 in interest income that had been deferred.  Yield on residential mortgage loans decreased from 3.54% for the first quarter of 2016 to 3.46% for the first quarter of 2017, while yields on consumer loans increased from 3.95% for the first quarter of 2016 to 3.98% for the first quarter of 2017.  The December 2016 increase in federal funds rate had a net positive impact on our net interest margin position as more loans repriced at the higher rate than our funding sources.  The March 2017 increase also had a limited positive impact on our net interest margin.
 
- 37 -

The cost of funds was 0.47% in both the first quarter of 2017 and the first quarter of 2016.  An increase in average other borrowed funds offset the decrease due to a continued shift in our deposit mix from higher costing time deposits to lower costing demand and savings accounts.

The following table shows an analysis of net interest margin for the three month periods ended March 31, 2017 and 2016 (dollars in thousands):
 
   
For the three months ended March 31,
 
   
2017
   
2016
 
   
Average
Balance
   
Interest
Earned
or Paid
   
Average
Yield
or Cost
   
Average
Balance
   
Interest
Earned
or Paid
     
Average
Yield
or Cost
 
 
 
Assets
                                   
Taxable securities
 
$
147,639
   
$
639
     
1.72
%
 
$
129,541
   
$
550
     
1.69
%
Tax-exempt securities (1)
   
108,608
     
538
     
3.07
     
84,635
     
433
     
3.20
 
Commercial loans (2)
   
956,151
     
9,657
     
4.04
     
891,238
     
8,892
     
3.95
 
Residential mortgage loans
   
217,256
     
1,881
     
3.46
     
213,063
     
1,884
     
3.54
 
Consumer loans
   
93,381
     
917
     
3.98
     
99,667
     
980
     
3.95
 
Federal Home Loan Bank stock
   
11,558
     
124
     
4.27
     
11,558
     
124
     
4.24
 
Federal funds sold and other short-term investments
   
45,165
     
92
     
0.81
     
109,464
     
145
     
0.53
 
Total interest earning assets (1)
   
1,579,758
     
13,848
     
3.59
     
1,539,166
     
13,008
     
3.42
 
                                                 
Noninterest earning assets:
                                               
Cash and due from banks
   
26,252
                     
25,031
                 
Other
   
100,633
                     
99,393
                 
Total assets
 
$
1,706,643
                   
$
1,663,590
                 
                                                 
Liabilities
                                               
Deposits:
                                               
Interest bearing demand
 
$
321,008
   
$
70
     
0.09
%
 
$
334,726
   
$
85
     
0.10
%
Savings and money market accounts
   
549,693
     
291
     
0.21
     
513,243
     
238
     
0.19
 
Time deposits
   
77,967
     
120
     
0.62
     
90,278
     
140
     
0.62
 
Borrowings:
                                               
Other borrowed funds
   
99,022
     
382
     
1.54
     
95,921
     
442
     
1.83
 
Long-term debt
   
41,238
     
402
     
3.91
     
41,238
     
365
     
3.51
 
Total interest bearing liabilities
   
1,088,928
     
1,265
     
0.47
     
1,075,406
     
1,270
     
0.47
 
                                                 
Noninterest bearing liabilities:
                                               
Noninterest bearing demand accounts
   
448,928
                     
427,634
                 
Other noninterest bearing liabilities
   
4,470
                     
6,306
                 
Shareholders' equity
   
164,317
                     
154,244
                 
Total liabilities and shareholders' equity
 
$
1,706,643
                   
$
1,663,590
                 
                                                 
Net interest income
         
$
12,583
                   
$
11,738
         
                                                 
Net interest spread (1)
                   
3.12
%
                   
2.95
%
Net interest margin (1)
                   
3.26
%
                   
3.09
%
Ratio of average interest earning assets to average interest bearing liabilities
   
145.07
%
                   
143.12
%
               

(1)
Yields are presented on a tax equivalent basis using a 35% tax rate.
(2)
Includes loan fees of $209,000 and $244,000 for the three months ended March 31, 2017 and 2016.  Includes average nonaccrual loans of approximately $384,000 and $584,000 for the three months ended March 31, 2017 and 2016.
 
- 38 -

Provision for Loan Losses: The provision for loan losses for the first quarter of 2017 was a negative $500,000 compared to a negative $100,000 for the first quarter of 2016.  The negative provisions for loan losses for each period were the result of continued stabilization of real estate values on problem credits, continued improvement in asset quality metrics and net loan recoveries of $234,000 in the first quarter of 2017 and $148,000 in the first quarter of 2016.  At March 31, 2017, we had experienced net loan recoveries in eleven of the past twelve quarters, and in each of the past nine quarters.

Gross loan recoveries were $260,000 for the first quarter of 2017 and $224,000 for the same period in 2016.  In the first quarter of 2017, we had $26,000 in charge-offs, compared to $76,000 in the first quarter of 2016.  We continue to experience positive results from our collection efforts as evidenced by our net loan recoveries.  While we expect our collection efforts to produce further recoveries, they may not continue at the same level we have experienced the past several quarters.

The amounts of loan loss provision in both the most recent quarter and comparable prior year period were the result of establishing our allowance for loan losses at levels believed necessary based upon our methodology for determining the adequacy of the allowance. 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 month period ended March 31, 2017 decreased to $4.2 million compared to $4.6 million for the same period in 2016. The components of noninterest income are shown in the table below (in thousands):

   
Three Months
Ended
March 31,
2017
   
Three Months
Ended
March 31,
2016
 
Service charges and fees on deposit accounts
 
$
1,060
   
$
1,047
 
Net gains on mortgage loans
   
428
     
487
 
Trust fees
   
778
     
708
 
Gain as sales of securities
   
3
     
89
 
ATM and debit card fees
   
1,201
     
1,186
 
Bank owned life insurance (“BOLI”) income
   
238
     
444
 
Investment services fees
   
216
     
304
 
Other income
   
307
     
343
 
Total noninterest income
 
$
4,231
   
$
4,608
 

Net gains on mortgage loans were down $59,000 in the first quarter of 2017 compared to the first quarter of 2016 as a result of an overall lower level of volume.  Mortgage loans originated for sale in the first quarter of 2017 were $17.0 million, compared to $18.9 million in the first quarter of 2016.  Mortgage loans originated for portfolio in the first quarter of 2017 were $8.9 million, compared to $14.1 million in the first quarter of 2016.  BOLI income in the first quarter of 2016 included $290,000 in net benefits from the distribution of a death claim on a covered former employee.  Trust fees and investment service fees were down in the first quarter of 2017 due to investment market volatility in the quarter, particularly at the beginning of the year.
 
- 39 -

Noninterest Expense: Noninterest expense decreased to $10.9 million for the three month period ended March 31, 2017, down $663,000 from $11.6 million for the same period in 2016. The components of noninterest expense are shown in the table below (in thousands):

 
Three Months
Ended
March 31,
2017
   
Three Months
Ended
March 31,
2016
 
Salaries and benefits
 
$
5,999
   
$
6,187
 
Occupancy of premises
   
1,026
     
982
 
Furniture and equipment
   
732
     
865
 
Legal and professional
   
225
     
159
 
Marketing and promotion
   
227
     
275
 
Data processing
   
682
     
659
 
FDIC assessment
   
136
     
251
 
Interchange and other card expense
   
313
     
286
 
Bond and D&O insurance
   
117
     
132
 
Net (gains) losses on repossessed and foreclosed properties
   
(85
)
   
36
 
Administration and disposition of problem assets
   
180
     
375
 
Outside services
   
448
     
370
 
Other noninterest expense
   
888
     
974
 
Total noninterest expense
 
$
10,888
   
$
11,551
 

Many categories of noninterest expense had reductions compared to the first quarter of 2016 due to our ongoing efforts to manage expenses and scale our operations. Our largest component of noninterest expense, salaries and benefits, decreased by $188,000 in the first quarter of 2017 from the first quarter of 2016. This decrease is largely due to a lower level of costs associated with employee benefits, particularly medical insurance, which was down $75,000 compared to the first quarter of 2016 due to a lower level of claims.  Variable based compensation was down $75,000 compared to the first quarter of 2016 due to lower mortgage production and brokerage volume.  We had 338 full-time equivalent employees at March 31, 2017 and 2016.

Our FDIC assessment costs decreased by $115,000 in the first quarter of 2017 compared to the same period in 2016 due primarily to positive changes in our assessment rates.   These costs have been trending down for the past few years and we believe the rate has stabilized and future expense fluctuations will likely be dependent on changes in our asset size.

Costs associated with administration and disposition of problem assets remain elevated, but have decreased significantly over the past several years.  These expenses 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 gains and losses on the sale of properties and unrealized losses from value declines for outstanding properties.  We experienced decreases in each of these three expense categories in the first quarter of 2017 compared to the same period in the prior year.

These costs are itemized in the following table (in thousands):

   
Three Months
Ended
March 31,
2017
   
Three Months
Ended
March 31,
2016
 
Legal and professional – nonperforming assets
 
$
17
   
$
71
 
Repossessed and foreclosed property administration
   
163
     
304
 
Net (gains) losses on repossessed and foreclosed properties
   
(85
)
   
36
 
Total
 
$
95
   
$
411
 

As problem loans move through the collection process, the costs associated with nonperforming assets remained elevated, but have decreased significantly over the past several years.  Other real estate owned decreased from $16.2 million at March 31, 2016 to $12.1 million at March 31, 2017.  As our level of problem loans and other real estate owned decreases, we believe we will experience more reductions in these costs going forward.
 
- 40 -

Losses on repossessed assets and foreclosed properties for the three month period ended March 31, 2017 decreased $121,000 from the same period in 2016.  This decrease was primarily due to a lower level of writedowns of other real estate properties in the first quarter of 2017.  In the first quarter of 2016, such writedowns totaled $128,000, compared to $64,000 in the first quarter of 2017.  Also contributing to the decrease was an increase of $57,000 in net gains on sales of other real estate owned.  In the first quarter of 2016, we recognized net gains totaling $92,000 on such sales, compared to $148,000 in the first quarter of 2017.

Federal Income Tax Expense: We recorded $1,966,000 in federal income tax expense for the three month period ended March 31, 2017 compared to $1,400,000 in the same period in 2016.  Our effective tax rate was 30.59% for the first quarter of 2017 compared to 28.61% for first quarter of 2016.  The effective tax rate was lower in the first quarter of 2016 due to the level of earnings on bank owned life insurance resulting from payment of a death benefit.

FINANCIAL CONDITION

Summary:  Over the past several years, we focused on improving our financial position through diversification of credit risk, improved capital ratios, and reduced reliance on non-core funding.   We experienced positive results in each of these areas over the past several years. With the success in strengthening our financial condition, we also turned our focus in 2014 to achieving high quality loan portfolio growth, and have experienced this growth since then.

Total assets were $1.75 billion at March 31, 2017, an increase of $7.8 million from $1.74 billion at December 31, 2016. This change reflected increases of $23.9 million in cash and cash equivalents offset by decreases of $14.7 million in our loan portfolio and $1.4 million in other assets.  Total deposits decreased by $15.6 million and other borrowed funds increased by $18.6 million at March 31, 2017 compared to December 31, 2016.

Cash and Cash Equivalents: Our cash and cash equivalents, which include federal funds sold and short-term investments, were $113.7 million at March 31, 2017 compared to $89.8 million at December 31, 2016. Since total loans and total deposits decreased by approximately the same amount during the first quarter, the $23.9 million increase was primarily the result of an additional short-term borrowing of $20 million obtained early in the quarter.  We expect declines in our balances of short term investments as loan demand continues to increase and seasonal deposits return to more normal levels.

Securities: Securities available for sale were $184.6 million at March 31, 2017 compared to $184.4 million at December 31, 2016. The balance at March 31, 2017 primarily consisted of U.S. agency securities, agency mortgage backed securities and various municipal investments. Our held to maturity portfolio decreased from $69.4 million at December 31, 2016 to $68.5 million at March 31, 2017.  Our held to maturity portfolio is comprised of state and municipal bonds.

Portfolio Loans and Asset Quality: Total portfolio loans decreased by $14.7 million in the first quarter of 2017 and were $1.27 billion at March 31, 2017 compared to $1.28 billion at December 31, 2016. During the first quarter of 2017, our commercial portfolio decreased by $5.2 million, while our consumer portfolio decreased by $4.8 million and our residential mortgage portfolio decreased by $4.7 million.  These decreases are seasonal and we expect balances to increase throughout the remainder of 2017.  We have been focusing efforts to increase our consumer and residential mortgage portfolio segments to further diversify our credit risk.

The volume of residential mortgage loans originated for sale in the first quarter of 2017 decreased $1.9 million compared to the same period in 2016 due to a higher interest rate environment. Residential mortgage loans originated for sale were $17.0 million in the first quarter of 2017 compared to $18.9 million in the first quarter of 2016.  Mortgage loans originated for portfolio in the first quarter of 2017 were $8.9 million, compared to $14.1 million in the first quarter of 2016.  Mortgage loans originated for portfolio are typically loans that conform to secondary market requirements and have a term of fifteen years or less.

We experienced year over year growth in commercial loan balances for the first time in many years in 2014, increasing $71.8 million in 2014, $67.8 million in 2015 and $81.4 million in 2016.  We experienced a slight decrease in the first quarter of 2017 due to the payoff of a couple of large commercial credits at the end of the quarter.  Overall, the commercial loan portfolio decreased $5.2 million in the first quarter of 2017.  Our commercial and industrial portfolio increased by $4.0 million and our commercial real estate loans decreased by $9.2 million.  Considering our pipeline of commercial credits at March 31, 2017, we expect to return to continued, measured, high quality loan portfolio growth throughout the remainder of 2017.

Commercial and commercial real estate loans remained our largest loan segment and accounted for approximately 76% of the total loan portfolio at March 31, 2017 and December 31, 2016. Residential mortgage and consumer loans comprised approximately 24% of total loans at March 31, 2017 and December 31, 2016.
 
- 41 -

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

   
March 31, 2017
   
December 31, 2016
 
   
Balance
   
Percent of
Total Loans
   
Balance
   
Percent of
Total Loans
 
Commercial real estate: (1)
                       
Residential developed
 
$
10,188
     
0.8
%
 
$
11,970
     
0.9
%
Unsecured to residential developers
   
4,785
     
0.4
     
4,734
     
0.4
 
Vacant and unimproved
   
44,950
     
3.5
     
40,286
     
3.1
 
Commercial development
   
499
     
---
     
378
     
---
 
Residential improved
   
73,064
     
5.8
     
75,348
     
5.9
 
Commercial improved
   
277,898
     
22.0
     
289,478
     
22.6
 
Manufacturing and industrial
   
97,424
     
7.7
     
95,787
     
7.5
 
Total commercial real estate
   
508,808
     
40.2
     
517,981
     
40.4
 
Commercial and industrial
   
453,311
     
35.8
     
449,342
     
35.1
 
Total commercial
   
962,119
     
76.0
     
967,323
     
75.5
 
                                 
Consumer
                               
Residential mortgage
   
212,949
     
16.8
     
217,614
     
17.0
 
Unsecured
   
343
     
---
     
396
     
---
 
Home equity
   
83,666
     
6.6
     
88,113
     
6.9
 
Other secured
   
7,051
     
0.6
     
7,366
     
0.6
 
Total consumer
   
304,009
     
24.0
     
313,489
     
24.5
 
Total loans
 
$
1,266,128
     
100.0
%
 
$
1,280,812
     
100.0
%

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

Commercial real estate loans accounted for approximately 40% of the total loan portfolio at March 31, 2017 and consisted primarily of loans to business owners and developers of owner and non-owner occupied commercial properties and loans to developers of single and multi-family residential properties. In the table above, we show our commercial real estate portfolio by loans secured by residential and commercial real estate, and by stage of development. Improved loans are generally secured by properties that are under construction or completed and placed in use. Development loans are secured by properties that are in the process of development or fully developed. Vacant and unimproved loans are secured by raw land for which development has not yet begun and agricultural land.

Our consumer residential mortgage loan portfolio, which also includes residential construction loans made to individual homeowners, comprised approximately 17% of portfolio loans at March 31, 2017 and December 31, 2016.  We expect to continue to retain in our loan portfolio certain types of residential mortgage loans (primarily high quality, low loan-to-value loans) in an effort to continue to diversify our credit risk and deploy our excess liquidity. A large portion of our residential mortgage loan production continues to be sold on the secondary market with servicing released.

The volume of residential mortgage loans originated for sale during the first quarter of 2017 decreased from the first quarter of 2016 as a result of interest rate conditions.  We are also experiencing a shift in production to financing new home purchases versus refinancings.

Our portfolio of other consumer loans includes loans secured by personal property and home equity fixed term and line of credit loans. Consumer loans decreased by $4.8 million to $91.1 million at March 31, 2017 from $95.9 million at December 31, 2016, due primarily to a decrease in home equity loans.  Consumer loans comprised approximately 7% of our portfolio loans at March 31, 2017 and 8% at December 31, 2016.
 
- 42 -

The following table shows our loan origination activity for portfolio loans during the first three months of 2017 and 2016, broken out by loan type and also shows average originated loan size (dollars in thousands):

 
Three months ended March 31, 2017
   
Three months ended March 31, 2016
 
   
Portfolio
Originations
   
Percent of
Total
Originations
   
Average
Loan Size
   
Portfolio
Originations
   
Percent of
Total
Originations
   
Average
Loan Size
 
Commercial real estate:
                                   
Residential developed
 
$
969
     
1.3
%
 
$
323
   
$
5,227
     
6.8
%
 
$
871
 
Unsecured to residential developers
   
---
     
---
     
---
     
---
     
---
     
---
 
Vacant and unimproved
   
491
     
0.6
     
123
     
---
     
---
     
---
 
Commercial development
   
---
     
---
     
---
     
2,200
     
2.9
     
2,200
 
Residential improved
   
10,289
     
13.2
     
264
     
28,113
     
36.8
     
541
 
Commercial improved
   
8,043
     
10.3
     
1,005
     
9,802
     
12.8
     
700
 
Manufacturing and industrial
   
2,406
     
3.1
     
401
     
778
     
1.0
     
389
 
Total commercial real estate
   
22,198
     
28.5
     
370
     
46,120
     
60.3
     
615
 
Commercial and industrial
   
38,158
     
48.9
     
1,004
     
8,553
     
11.2
     
231
 
Total commercial
   
60,356
     
77.4
     
616
     
54,673
     
71.5
     
488
 
                                                 
Consumer
                                               
Residential mortgage
   
9,141
     
11.7
     
229
     
14,086
     
18.4
     
181
 
Unsecured
   
---
     
---
     
---
     
12
     
---
     
12
 
Home equity
   
8,037
     
10.3
     
77
     
7,155
     
9.4
     
86
 
Other secured
   
452
     
0.6
     
13
     
525
     
0.7
     
21
 
Total consumer
   
17,630
     
22.6
     
99
     
21,778
     
28.5
     
116
 
Total loans
 
$
77,986
     
100.0
%
   
283
   
$
76,451
     
100.0
%
   
255
 

The following table shows a breakout of our commercial loan activity during the first three months of 2017 and 2016 (dollars in thousands):

   
Three Months
Ended
March 31,
2017
   
Three Months
Ended
March 31,
2016
 
Commercial loans originated
 
$
60,356
   
$
54,673
 
Repayments of commercial loans
   
(58,600
)
   
(43,347
)
Change in undistributed - available credit
   
(6,960
)
   
8,045
 
Net increase/(decrease) in total commercial loans
 
$
(5,204
)
 
$
19,371
 

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, the loan is placed in nonaccrual status. Any interest previously accrued but not collected is reversed and charged against current earnings.

Nonperforming assets are comprised of nonperforming loans, foreclosed assets and repossessed assets. At March 31, 2017, nonperforming assets totaled $12.5 million compared to $12.6 million at December 31, 2016. Additions to other real estate owned in the first quarter of 2017 were $56,000, compared to $102,000 in the first quarter of 2016.  At March 31, 2017, there were no loans in redemption, so we expect there to be few additions to other real estate owned in 2017.  Proceeds from sales of foreclosed properties were $320,000 in the first quarter of 2017, resulting in a net realized gain on sale of $149,000.  Proceeds from sales of foreclosed properties were $1.5 million in the first quarter of 2016 resulting in a net realized gain on sale of $92,000.    Based upon purchase agreements in place at March 31, 2017, we expect the level of sales of foreclosed properties to be higher in the second quarter of 2017 than experienced in the first quarter of 2017.
 
- 43 -

Nonperforming loans include loans on nonaccrual status and loans delinquent more than 90 days but still accruing. As of March 31, 2017, nonperforming loans totaled $401,000, or 0.03% of total portfolio loans, compared to $300,000, or 0.02% of total portfolio loans, at December 31, 2016.

Nonperforming loans at March 31, 2017 consisted of $252,000 of commercial real estate loans, $127,000 of commercial and industrial loans, and $22,000 of consumer and residential mortgage loans.

Foreclosed and repossessed assets include assets acquired in settlement of loans. Foreclosed assets totaled $12.1 million at March 31, 2017 and $12.3 million at December 31, 2016. Of this balance at March 31, 2017, there were 32 commercial real estate properties totaling approximately $11.5 million. The remaining balance was comprised of 7 residential properties totaling approximately $574,000.  One commercial real estate property comprised $3.4 million, or 28% of total other real estate owned at March 31, 2017.  All properties acquired through or in lieu of foreclosure are initially transferred at their fair value less estimated costs to sell and then evaluated monthly for impairment after transfer using a lower of cost or market approach. Updated property valuations are obtained at least annually on all foreclosed assets.

At March 31, 2017, our foreclosed asset portfolio had a weighted average age held in portfolio of 5.55 years. Below is a breakout of our foreclosed asset portfolio at March 31, 2017 and December 31, 2016 by property type and the percentages the property has been written down since taken into our possession and the combined writedown percentage, including losses taken when the property was loan collateral (dollars in thousands):
  
 
March 31, 2017
   
December 31, 2016
 
Foreclosed Asset Property Type
 
Carrying
Value
   
Foreclosed
Asset
Writedown
   
Combined
Writedown
(Loan and
Foreclosed
Asset)
   
Carrying
Value at
Carrying
Value
   
Foreclosed
Asset
Writedown
   
Combined
Writedown
(Loan and
Foreclosed
Asset)
 
Single Family
 
$
190
     
1.0
%
   
16.0
%
 
$
136
     
---
%
   
20.3
%
Residential Lot
   
384
     
26.8
     
48.1
     
438
     
30.1
     
48.0
 
Multi-Family
   
---
     
---
     
---
     
---
     
---
     
---
 
Vacant Land
   
2,969
     
48.2
     
57.7
     
3,096
     
47.2
     
58.3
 
Residential Development
   
2,498
     
34.8
     
74.4
     
2,570
     
36.2
     
74.2
 
Commercial Office
   
240
     
49.3
     
51.1
     
240
     
49.3
     
51.1
 
Commercial Industrial
   
---
     
---
     
---
     
---
     
---
     
---
 
Commercial Improved
   
5,793
     
48.6
     
51.1
     
5,773
     
48.7
     
51.2
 
   
$
12,074
     
45.2
     
59.9
   
$
12,253
     
45.2
     
60.1
 

The following table shows the composition and amount of our nonperforming assets (dollars in thousands):

 
March 31,
2017
   
December 31,
2016
 
Nonaccrual loans
 
$
401
   
$
300
 
Loans 90 days or more delinquent and still accruing
   
---
     
---
 
Total nonperforming loans (NPLs)
   
401
     
300
 
Foreclosed assets
   
12,074
     
12,253
 
Repossessed assets
   
---
     
---
 
Total nonperforming assets (NPAs)
 
$
12,475
   
$
12,553
 
                 
NPLs to total loans
   
0.03
%
   
0.02
%
NPAs to total assets
   
0.71
%
   
0.73
%
 
- 44 -

The following table shows the composition and amount of our troubled debt restructurings (TDRs) at March 31, 2017 and December 31, 2016 (dollars in thousands):

   March 31, 2017          December 31, 2016  
   
Commercial
   
Consumer
 
 
 
Total
   
Commercial
   
Consumer
   
Total
 
Performing TDRs
 
$
17,240
   
$
11,775
   
$
29,015
   
$
17,786
   
$
12,051
   
$
29,837
 
Nonperforming TDRs (1)
   
135
     
7
     
142
     
141
     
8
     
149
 
Total TDRs
 
$
17,375
   
$
11,782
   
$
29,157
   
$
17,927
   
$
12,059
   
$
29,986
 
 
 
(1)
Included in nonperforming asset table above
 
We had a total of $29.2 million and $30.0 million of loans whose terms have been modified in troubled debt restructurings (“TDRs”) as of March 31, 2017 and December 31, 2016, respectively.  These loans may have involved the restructuring of terms to allow customers to mitigate the risk of foreclosure by meeting a lower loan payment requirement based upon their current cash flow.  These may also include loans that renewed at existing contractual rates, but below market rates for comparable credit.  For each restructuring, a comprehensive credit underwriting analysis of the borrower’s financial condition and prospects of repayment under the revised terms is performed to assess whether the structure can be successful and that cash flows will be sufficient to support the restructured debt.  An analysis is also performed to determine whether the restructured loan should be on accrual status.  Generally, if the loan is on accrual at the time of restructure, it will remain on accrual after the restructuring.  In some cases, a nonaccrual loan may be placed on accrual at restructuring if the loan’s actual payment history demonstrates it would have cash flowed under the restructured terms.  After six consecutive payments under the restructured terms, a nonaccrual restructured loan is reviewed for possible upgrade to accruing status.  In situations where there is a subsequent modification or renewal and the loan is brought to market terms, including a contractual interest rate not less than a market interest rate for new debt with similar credit risk characteristics, the TDR and impaired designations may be removed.

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

Allowance for loan losses: The allowance for loan losses at March 31, 2017 was $16.7 million, a decrease of $266,000 from $17.0 million at December 31, 2016.  The balance of the allowance for loan losses represented 1.32% of total portfolio loans at March 31, 2017 and at December 31, 2016.  The allowance for loan losses to nonperforming loan coverage ratio decreased from 5,654% at December 31, 2016 to 4,163% at March 31, 2017.

The table below shows the changes in these metrics over the past five quarters:

(Dollars in millions)
 
Quarter Ended
March 31,
2017
   
Quarter Ended
December 31,
2016
   
Quarter Ended
September 30,
2016
   
Quarter Ended
June 30,
2016
   
Quarter Ended
March 31
2016
 
Commercial loans
 
$
962.1
   
$
967.3
   
$
923.2
   
$
894.4
   
$
905.3
 
Nonperforming loans
   
0.4
     
0.3
     
0.2
     
0.3
     
0.4
 
Other real estate owned and repo assets
   
12.1
     
12.3
     
13.1
     
14.1
     
16.2
 
Total nonperforming assets
   
12.5
     
12.6
     
13.3
     
14.4
     
16.6
 
Net charge-offs (recoveries)
   
(0.2
)
   
(1.2
)
   
(0.1
)
   
(0.6
)
   
(0.1
)
Total delinquencies
   
0.9
     
1.4
     
0.3
     
1.0
     
0.8
 

Nonperforming loans continually declined since 2012 to $401,000 at March 31, 2017.  As discussed earlier, we have had net loan recoveries in eleven of the last twelve quarters and in each of the last nine quarters.  Our total delinquencies have continued to be negligible and were $915,000 at March 31, 2017 and $1.4 million at December 31, 2016.  Our delinquency percentage at March 31, 2017 was just 0.07%, well below the Bank’s peers.
 
- 45 -

These factors all impact our necessary level of allowance for loan losses and our provision for loan losses. The allowance for loan losses decreased $266,000 in the first quarter of 2017.  We recorded a negative provision for loan losses of $500,000 for the three months ended March 31, 2017 compared to a negative $100,000 for the same period of 2016.  Net loan recoveries were $234,000 for the three months ended March 31, 2017, compared to net recoveries of $148,000 for the same period in 2016. The ratio of net charge-offs to average loans was (0.07)% on an annualized basis for the first quarter of 2017, compared to (0.12)% for the fourth quarter of 2016 and (0.05)% for the first quarter of 2016.

We are encouraged by the reduced level of charge-offs over recent quarters. We do, however, recognize that future charge-offs and resulting provisions for loan losses are expected to be impacted by the timing and extent of changes in the overall economy and the real estate markets. We believe we have seen some stabilization 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 to further reduce our impaired loans.

Our allowance for loan losses is maintained at a level believed appropriate based upon our assessment of the probable estimated losses inherent in the loan portfolio. Our methodology for measuring the appropriate level of allowance and related provision for loan losses relies on several key elements, which include specific allowances for loans considered impaired, general allowance for commercial loans not considered impaired based upon applying our loan rating system, and general allocations based on historical trends for homogeneous loan groups with similar risk characteristics.

Overall, impaired loans were stable at $28.8 million at March 31, 2017 compared to $29.7 million at December 31, 2016.  The specific allowance for impaired loans decreased $48,000 to $1.6 million, compared to $1.7 million at December 31, 2016.  The specific allowance for impaired loans represented 5.7% of total impaired loans at March 31, 2017 and December 31, 2016.  The overall balance of impaired loans remained elevated partially due to an accounting rule (ASU 2011-02) adopted in 2011 that requires us to identify classified loans that renew at existing contractual rates as troubled debt restructurings (“TDRs”) if the contractual rate is less than market rates for similar loans at the time of renewal.

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.  Over the past few years, the 18 month period computations have reflected sizeable decreases in net chargeoff experience.  We addressed this volatility in the qualitative factor considerations applied in our allowance for loan losses computation. Adjustments to the qualitative factors also involved consideration of different loss periods for the Bank, including 12, 24, 36, 48 and 60 month periods. We also considered the extended period of improved asset quality in assessing the overall qualitative component.  Considering the change in our qualitative factors and our commercial loan portfolio balances, the general allowance allocated to commercial loans was unchanged at $12.1 million at March 31, 2017 and December 31, 2016.  This resulted in a general reserve percentage allocated at March 31, 2017 of 1.28% of commercial loans, an increase from 1.27% at December 31, 2016.  The qualitative component of our allowance allocated to commercial loans was $12.3 million at March 31, 2017 (down from $12.4 million at December 31, 2016).

Groups of homogeneous loans, such as residential real estate and open- and closed-end consumer loans, receive allowance allocations based on loan type.  A rolling 12 month (four quarter) historical loss experience period was applied to residential mortgage and consumer loan portfolios.  As with commercial loans that are not considered impaired, the determination of the allowance allocation percentage is based principally on our historical loss experience.  These allocations are adjusted for consideration of general economic and business conditions, credit quality and delinquency trends, collateral values, and recent loss experience for these similar pools of loans.  The homogeneous loan allowance was $2.9 million at March 31, 2017 and $3.1 million at December 31, 2016.

The allowance allocations are not intended to imply limitations on usage of the allowance for loan losses.  The entire allowance for loan losses is available for any loan losses without regard to loan type.

Premises and Equipment:  Premises and equipment totaled $49.8 million at March 31, 2017, down $194,000 from $50.0 million at December 31, 2016 as depreciation more than offset capital additions of current facilities and equipment during the first quarter of 2017.

Deposits and Other Borrowings: Total deposits decreased $15.6 million to $1.43 billion at March 31, 2017, as compared to $1.45 billion at December 31, 2016.  Non-interest checking account balances decreased $35.1 million during the first quarter of 2017.  Interest bearing demand account balances increased $2.1 million and savings and money market account balances increased $15.9 million in the first quarter of 2017.  Certificates of deposits increased by $1.5 million in the first quarter of 2017.  We believe our success in maintaining the balances of personal and business checking and savings accounts was primarily attributable to our focus on quality customer service, the desire of customers to deal with a local bank, the convenience of our branch network and the breadth and depth of our sophisticated product line.
 
- 46 -

Noninterest bearing demand accounts comprised 33% of total deposits at March 31, 2017 and 35% at December 31, 2016.  These balances typically increase at year end for many of our commercial customers, then decline in the first quarter.  Because of the generally low rates paid on interest bearing account alternatives, many of our business customers chose to keep their balances in these more liquid noninterest bearing demand account types.  Interest bearing demand, including money market and savings accounts, comprised 62% of total deposits at March 31, 2017 and 60% at December 31, 2016. Time accounts as a percentage of total deposits were 5% at March 31, 2017 and December 31, 2016.

Borrowed funds totaled $144.0 million at March 31, 2017, including $102.8 million of Federal Home Loan Bank (“FHLB”) advances and $41.2 million in long-term debt associated with trust preferred securities.  Borrowed funds totaled $125.4 million at December 31, 2016, including $84.2 million of FHLB advances and $41.2 million in long-term debt associated with trust preferred securities.  Borrowed funds increased by $18.6 million in the first quarter of 2017 due to obtaining a new short-term $20 million FHLB advance early in the quarter partially offset by an annual payment on an amortizing FHLB advance.

CAPITAL RESOURCES

Total shareholders' equity of $166.1 million at March 31, 2017 increased $3.9 million from $162.2 million at December 31, 2016. The increase was primarily a result of net income of $4.5 million earned in the first quarter of 2017 and an increase of $689,000 in accumulated other comprehensive income, partially offset by the payment of $1.4 million in cash dividends to shareholders on February 28, 2017.  The Bank was categorized as “well capitalized” at March 31, 2017.

In July 2013, the Board of Governors of the Federal Reserve Board and the FDIC approved the final rules implementing the Basel Committee on Banking Supervision's capital guidelines for U.S. banks (commonly known as Basel III). Under the final rules, which began for the Company and the Bank on January 1, 2015 and are subject to a phase-in period through January 1, 2019, minimum requirements will increase for both the quantity and quality of capital held by the Company and the Bank. The rules include a new common equity Tier 1 capital to risk-weighted assets ratio (CET1 ratio) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, which when fully phased-in, effectively results in a minimum CET1 ratio of 7.0%. Basel III raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5% when fully phased-in), effectively results in a minimum total capital to risk-weighted assets ratio of 10.5% (with the capital conservation buffer fully phased-in), and requires a minimum leverage ratio of 4.0%. Basel III also makes changes to risk weights for certain assets and off-balance-sheet exposures. We expect that the capital ratios for the Company and the Bank under Basel III will continue to exceed the well capitalized minimum capital requirements.

The following table shows our regulatory capital ratios (on a consolidated basis) for the past several quarters:

Macatawa Bank Corporation
 
March 31,
2017
   
Dec 31,
2016
   
Sept 30,
2016
   
June 30,
2016
   
March 31,
2016
 
Total capital to risk weighted assets
   
15.1
%
   
14.9
%
   
15.2
%
   
15.2
%
   
15.0
%
Common Equity Tier 1 to risk weighted assets
   
11.3
     
11.0
     
11.3
     
11.1
     
11.1
 
Tier 1 capital to risk weighted assets
   
14.0
     
13.7
     
14.1
     
14.0
     
13.8
 
Tier 1 capital to average assets
   
12.1
     
12.0
     
12.0
     
11.9
     
11.7
 

Approximately $40.0 million of trust preferred securities outstanding at March 31, 2017 qualified as Tier 1 capital.

LIQUIDITY

Liquidity of Macatawa Bank: The liquidity of a financial institution reflects its ability to manage a variety of sources and uses of funds. Our Consolidated Statements of Cash Flows categorize these sources and uses into operating, investing and financing activities. We primarily focus on developing access to a variety of borrowing sources to supplement our deposit gathering activities and provide funds for our investment and loan portfolios. Our sources of liquidity include our borrowing capacity with the FRB's discount window, the Federal Home Loan Bank, federal funds purchased lines of credit and other secured borrowing sources with our correspondent banks, loan payments by our borrowers, maturity and sales of our securities available for sale, growth of our deposits, federal funds sold and other short-term investments, and the various capital resources discussed above.
 
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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.

We have actively pursued initiatives to maintain a strong liquidity position.  The Bank reduced its reliance on non-core funding sources, including brokered deposits, and focused on achieving a non-core funding dependency ratio below its peer group average.  We have had no brokered deposits on our balance sheet since December 2011.  We continue to maintain significant on-balance sheet liquidity.  At March 31, 2017, the Bank held $83.1 million of federal funds sold and other short-term investments.  In addition, the Bank has available borrowing capacity from correspondent banks of approximately $288.6 million as of March 31, 2017.

In the normal course of business, we enter into certain contractual obligations, including obligations which are considered in our overall liquidity management.  The table below summarizes our significant contractual obligations at March 31, 2017 (dollars in thousands):

 
Less than
1 year
   
1-3 years
   
3-5 years
   
More than
5 years
 
Long term debt
 
$
---
   
$
---
   
$
---
   
$
41,238
 
Time deposit maturities
   
39,701
     
33,236
     
2,221
     
---
 
Other borrowed funds
   
32,118
     
60,667
     
10,000
     
---
 
Operating lease obligations
   
234
     
458
     
81
     
---
 
Total
 
$
72,053
   
$
94,361
   
$
12,302
   
$
41,238
 

In addition to normal loan funding, we also maintain liquidity to meet customer financing needs through unused lines of credit, unfunded loan commitments and standby letters of credit.  The level and fluctuation of these commitments is also considered in our overall liquidity management.  At March 31, 2017, we had a total of $446.3 million in unused lines of credit, $95.7 million in unfunded loan commitments and $13.4 million in standby letters of credit.

Liquidity of Holding Company: The primary sources of liquidity for the Company are dividends from the Bank, existing cash resources and the capital markets if the need to raise additional capital arises.  Banking regulations and the laws of the State of Michigan in which our Bank is chartered limit the amount of dividends the Bank may declare and pay to the Company in any calendar year.  Under the state law limitations, the Bank is restricted from paying dividends to the Company in excess of retained earnings.  In 2016, the Bank paid dividends to the Company totaling $6.2 million.  In the same period, the Company paid dividends to its shareholders totaling $4.0 million.  On February 27, 2017, the Bank paid a dividend totaling $1.8 million to the Company in anticipation of the common share cash dividend of $0.04 per share paid on February 28, 2017 to shareholders of record on February 13, 2017.  The Company retained the remaining balance in each period for general corporate purposes.  At March 31, 2017, the Bank had a retained earnings balance of $40.2 million.
 
During 2016, the Company received payments from the Bank totaling $7.1 million, representing the Bank’s intercompany tax liability for the 2016 tax year, in accordance with the Company’s tax allocation agreement.
 
The Company has the right to defer interest payments for 20 consecutive quarters on its trust preferred securities if necessary for liquidity purposes.  During the deferral period, the Company may not declare or pay any dividends on its common stock or make any payment on any outstanding debt obligations that rank equally with or junior to the trust preferred securities.

The Company’s cash balance at March 31, 2017 was $5.4 million.  The Company believes that it has sufficient liquidity to meet its cash flow obligations.
 
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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 first quarter of 2017.

Assets acquired through or instead of foreclosure, primarily other real estate owned, are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis.  New real estate appraisals are generally obtained at the time of foreclosure and are used to establish fair value.  If fair value declines, a valuation allowance is recorded through expense.  Estimating the initial and ongoing fair value of these properties involves a number of factors and judgments including holding time, costs to complete, holding costs, discount rate, absorption and other factors.

Loss contingencies are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated.  This, too, is an accounting area that involves significant judgment.  Although, based upon our judgment, internal analysis, and consultations with legal counsel we believe that we have properly accounted for loss contingencies, future changes in the status of such contingencies could result in a significant change in the level of contingent liabilities and a related impact to operating earnings.

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 March 31, 2017, we had gross deferred tax assets of $10.8 million, gross deferred tax liabilities of $2.4 million resulting in a net deferred tax asset of $8.3 million.  Accounting standards require that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a "more likely than not" standard.  Each reporting period we consider all reasonably available positive and negative evidence and determine whether it is “more likely than not” that we would be able to realize our deferred tax assets.  With the positive results in the first quarter of 2017, we concluded at March 31, 2017 that no valuation allowance on our net deferred tax asset was required.  Changes in tax laws, changes in tax rates, changes in ownership and our future level of earnings can impact the ultimate realization of our net deferred tax asset.
 
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Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of our transactions are denominated in U.S. dollars with no specific foreign exchange exposure. Macatawa Bank has only limited agricultural-related loan assets, and therefore has no significant exposure to changes in commodity prices.

Our balance sheet has sensitivity, in various categories of assets and liabilities, to changes in prevailing rates in the U.S. for prime rate, mortgage rates, U.S. Treasury rates and various money market indexes. Our asset/liability management process aids us in providing liquidity while maintaining a balance between interest earning assets and interest bearing liabilities.

We utilize a simulation model as our primary tool to assess the direction and magnitude of variations in net interest income and the economic value of equity (“EVE”) resulting from potential changes in market interest rates. Key assumptions in the model include contractual cash flows and maturities of interest-sensitive assets and interest-sensitive liabilities, prepayment speeds on certain assets, and changes in market conditions impacting loan and deposit pricing. We also include pricing floors on discretionary priced liability products which limit how low various checking and savings products could go under declining interest rates. These floors reflect our pricing philosophy in response to changing interest rates.

We forecast the next twelve months of net interest income under an assumed environment of gradual changes in market interest rates under various scenarios. The resulting change in net interest income is an indication of the sensitivity of our earnings to directional changes in market interest rates. The simulation also measures the change in EVE, or the net present value of our assets and liabilities, under an immediate shift, or shock, in interest rates under various scenarios, as calculated by discounting the estimated future cash flows using market-based discount rates.

The following table shows the impact of changes in interest rates on net interest income over the next twelve months and EVE based on our balance sheet as of March 31, 2017 (dollars in thousands):

Interest Rate Scenario
 
Economic
Value of
Equity
   
Percent
Change
   
Net Interest
Income
   
Percent
Change
 
Interest rates up 200 basis points
 
$
212,093
     
(2.59
)%
 
$
54,363
     
4.33
%
Interest rates up 100 basis points
   
215,815
     
(0.88
)
   
53,208
     
2.11
 
No change
   
217,722
     
---
     
52,107
     
---
 
Interest rates down 100 basis points
   
202,314
     
(7.08
)
   
49,976
     
(4.09
)

If interest rates were to increase, this analysis suggests that we are positioned for an improvement in net interest income over the next twelve months.

We also forecast the impact of immediate and parallel interest rate shocks on net interest income under various scenarios to measure the sensitivity of our earnings under extreme conditions.

The quarterly simulation analysis is monitored against acceptable interest rate risk parameters by the Asset/Liability Committee and reported to the Board of Directors.

In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including: the growth, composition and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; economic and competitive conditions; potential changes in lending, investing and deposit gathering strategies; and client preferences.
 
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Item 4:
CONTROLS AND PROCEDURES

(a)
Evaluation of Disclosure Controls and Procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Exchange Act Rules 13a-15(e) as of March 31, 2017, 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)) 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.
 
- 51 -

PART II – OTHER INFORMATION

Item 6.
EXHIBITS.

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 February 19, 2015 in Macatawa Bank Corporation's Annual Report on Form 10-K for the year ended December 31, 2014, Exhibit 3.1. 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
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.
10.1
Change in control agreements between Macatawa Bank Corporation and its Chief Operating Officer.  Previously filed with the Commission on Form 8-K on February 1, 2017, Exhibit 10.1.  Here incorporated by reference.
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
 
- 52 -

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: April 27, 2017
 
 
- 53 -