CHEMICAL

FINANCIAL CORPORATIONSM

 

2006

Annual Report

to Shareholders

 

      

 

CHEMICAL FINANCIAL CORPORATION

 

 

2006 ANNUAL REPORT TO SHAREHOLDERS

 

FORWARD-LOOKING STATEMENTS

 

This report contains forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and Chemical Financial Corporation itself. Words such as “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “judgment,” “plans,” “predicts,” “projects,” “should,” “will,” variations of such words and similar expressions are intended to identify such forward-looking statements. In addition, certain statements under the subheadings “Liquidity Risk” and “Market Risk” in “Management’s Discussion and Analysis” are forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“risk factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. Chemical Financial Corporation undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise.

 

Risk factors include, but are not limited to, the risk factors described on pages 87-88; changes in banking laws and regulations; changes in tax laws; changes in prices, levies and assessments; the impact of technological advances and issues; governmental and regulatory policy changes; opportunities for acquisitions and the effective completion of acquisitions and integration of acquired entities; and the local and global effects of the ongoing war on terrorism and other military actions, including actions in Iraq. These are representative of the risk factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.

 

 

 

 

 

BUSINESS OF THE CORPORATION

 

Chemical Financial Corporation (the Corporation) is a financial holding company with its business concentrated in a single industry segment — commercial banking. The Corporation, through its subsidiary bank, offers a full range of commercial banking services. These banking services include deposits, business and personal checking accounts, savings and individual retirement accounts, time deposit instruments, electronically accessed banking products, residential and commercial real estate financing, commercial lending, consumer financing, debit cards, safe deposit box services, money transfer services, automated teller machines, access to insurance products and corporate and personal trust and investment management services.

 

The principal markets for the Corporation’s commercial banking services are communities within Michigan in which the Corporation’s subsidiary bank branches are located and the areas immediately surrounding those communities. As of December 31, 2006, the Corporation operated through one subsidiary bank, Chemical Bank, headquartered in Midland, Michigan, serving 89 communities through 127 banking offices and 1 loan production office located in 31 counties across Michigan’s lower peninsula. In addition to its banking offices, the Corporation operated 137 automated teller machines, both on- and off-bank premises. On December 31, 2005, a corporate internal consolidation was completed resulting in the consolidation of the Corporation’s three commercial bank charters into one commercial subsidiary bank, Chemical Bank. The Corporation’s sole subsidiary bank continues to operate through an organizational structure of community banks.

 

The principal source of revenue for the Corporation is interest and fees on loans, which accounted for 72% of total revenues in 2006, 69% of total revenues in 2005 and 67% of total revenues in 2004. Interest on investment securities is also a significant source of revenue, accounting for 10% of total revenues in 2006, 13% of total revenues in 2005 and 15% of total revenues in 2004. Business volumes tend to be influenced by overall economic factors including market interest rates, business and consumer spending, and consumer confidence, as well as competitive conditions in the marketplace.

 

FINANCIAL HIGHLIGHTS

 

The following discussion and analysis is intended to cover the significant factors affecting the Corporation’s consolidated statements of financial position and income included in this report. It is designed to provide shareholders with a more comprehensive review of the consolidated operating results and financial position of the Corporation than could be obtained from an examination of the financial statements alone.

 

CRITICAL ACCOUNTING POLICIES

 

The Corporation’s consolidated financial statements are prepared in accordance with United States generally accepted accounting principles (GAAP). Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements. As this information changes, the consolidated financial statements could reflect different estimates, assumptions and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value or when a decline in the value of an asset not carried at fair value on the financial statements warrants an impairment write-down or a valuation reserve to be established. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third-party sources, when available. When third-party information is not available, valuation adjustments are estimated by management primarily through the use of internal discounted cash flow analysis.

 

The most significant accounting policies followed by the Corporation are presented in Note A to the consolidated financial statements. These policies, along with the disclosures presented in the other notes to the consolidated financial statements and in “Management’s Discussion and Analysis,” provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, estimates and assumptions underlying those amounts, management has identified the determination of the allowance for loan losses, pension plan accounting, income and other taxes, capitalization and valuation of real estate mortgage loan servicing rights, and the evaluation of goodwill impairment to be the accounting areas that require the most subjective or complex judgments, and as such, could be most subject to revision as new

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

CRITICAL ACCOUNTING POLICIES (CONTINUED)

or additional information becomes available or circumstances change, including overall changes in the economic climate and/or market interest rates.

 

Allowance for Loan Losses

The allowance for loan losses (allowance) is calculated with the objective of maintaining a reserve sufficient to absorb inherent loan losses of the loan portfolio. The loan portfolio represents the largest asset type on the consolidated statements of financial position. The determination of the amount of the allowance is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected cash flows on impaired loans, estimated losses on commercial, real estate commercial and real estate construction-commercial loans and on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The principal assumption used in deriving the allowance is the estimate of a loss percentage for each type of loan. It is extremely difficult to precisely measure the amount of losses that are inherent in the Corporation’s loan portfolio. The Corporation uses a rigorous process to accurately quantify the necessary allowance and related provision for loan losses, but there can be no assurance that the modeling process will successfully identify and estimate all of the losses that are inherent in the loan portfolio. As a result, the Corporation could record future provisions for loan losses that may be significantly different than the levels that have been recorded in the three-year period ended December 31, 2006. Note A to the consolidated financial statements describes the methodology used to determine the allowance. In addition, a discussion of the factors driving changes in the amount of the allowance is included under the subheading “Provision and Allowance for Loan Losses” in “Management’s Discussion and Analysis.”

 

Pension Plan Accounting

The Corporation has a defined benefit pension plan for certain salaried employees. Effective June 30, 2006, benefits under the defined benefit pension plan were frozen for approximately two-thirds of the Corporation’s salaried employees. Pension benefits continued unchanged for the remaining salaried employees. The Corporation’s pension benefit obligations and related costs are calculated using actuarial concepts and measurements. Benefits under the plan are based on years of vested service, age and compensation. Assumptions are made concerning future events that will determine the amount and timing of required benefit payments, funding requirements and pension expense.

 

The key actuarial assumptions used in the pension plan are the discount rate and long-term rate of return on plan assets. These assumptions have a significant effect on the amounts reported for net periodic pension expense, as well as the respective benefit obligation amounts. The Corporation evaluates these critical assumptions annually.

 

At December 31, 2006, December 31, 2005 and December 31, 2004, the Corporation calculated the discount rate for the pension plan using the results from a bond matching technique, which matched cash flows of the pension plan against both a bond portfolio derived from the S&P bond database of AA or better bonds and the Citigroup Pension Discount Curve, to determine the discount rate. As of December 31, 2006, the discount rate was established at 6.0% to reflect market interest rate conditions.

 

The assumed long-term rate of return on pension plan assets represents an estimate of long-term returns on an investment portfolio consisting primarily of equities and fixed income investments. When determining the expected long-term return on pension plan assets, the Corporation considers long-term rates of return on the asset classes in which the Corporation expects the pension funds to be invested. The expected long-term rate of return is based on both historical and forecasted returns of the overall stock and bond markets and the actual portfolio. The Corporation reduced its projection of forecasted returns on the portfolio of pension plan assets during 2006. The following rates of return by asset class were considered in setting the long-term return on pension plan assets assumption:

 

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

The long-term return on pension plan assets is used to compute the subsequent year’s expected return on assets, using the “market-related value” of pension plan assets. The difference between the expected return and the actual return on pension plan assets during the year is either an asset gain or loss, which may be deferred and amortized over future periods when determining net periodic pension expense. The actual average annual return on pension plan assets was 6.8% over the ten years ended December 31, 2006.

 

Other assumptions made in the pension plan involve employee demographic factors such as retirement patterns, mortality turnover and the rate of compensation increase.

 

The key actuarial assumptions that will be used to calculate 2007 pension expense for the defined benefit pension plan are a discount rate of 6.0%, a long-term rate of return on pension plan assets of 7.0% and a rate of compensation increase of 4.25%. Pension expense in 2007 is expected to be approximately $1.0 million, a decrease of $0.9 million from $1.9 million of pension expense in 2006. The projected decrease in 2007, compared to 2006, is mostly attributable to the partial freeze of the pension plan during 2006 and an increase in the discount rate used to measure the present value of the pension plan’s obligations. A change in the discount rate of fifty basis points in 2007 was estimated to have an impact on pension expense of $0.25 million.

 

There are uncertainties associated with the underlying key actuarial assumptions, and the potential exists for significant, and possibly material, impacts on either the results of operations or cash flows (e.g., additional pension expense and/or additional pension plan funding, whether expected or required) from changes in the key actuarial assumptions. If the Corporation were to determine that more conservative assumptions are necessary, pension expense would increase and have a negative impact on results of operations in the period in which the increase occurs.

 

In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 158, “Employers’ Accounting For Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (SFAS 158). The Corporation adopted SFAS 158 on December 31, 2006, as required. The purpose of SFAS 158 is to improve the overall financial statement presentation of pension and other postretirement plans, but does not impact the determination of the net periodic benefit cost or measurement of plan assets or obligations. SFAS 158 requires companies to recognize the over- or under-funded status of a plan as an asset or liability as measured by the difference between the fair value of the plan assets and the benefit obligation and requires any unrecognized prior service costs and actuarial gains and losses to be recognized as a component of accumulated other comprehensive income (loss). The impact of the adoption of SFAS 158 on the statement of financial position at December 31, 2006 is summarized in Note L to the consolidated financial statements.

 

Income and Other Taxes

The Corporation is subject to the income and other tax laws of the United States and the state of Michigan. These laws are complex and are subject to different interpretations by the taxpayer and the various taxing authorities. In determining the provisions for income and other taxes, management must make judgments and estimates about the application of these inherently complex laws, related regulations and case law. In the process of preparing the Corporation’s tax returns, management attempts to make reasonable interpretations of the tax laws. These interpretations are subject to challenge by the taxing authorities upon audit or to reinterpretation based on management’s ongoing assessment of facts and evolving case law.

 

The Corporation and its subsidiary file a consolidated federal income tax return. The provision for federal income taxes is based on income and expenses, as reported in the consolidated financial statements, rather than amounts reported on the Corporation’s federal income tax return. When income and expenses are recognized in different periods for tax purposes than for book purposes, applicable deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.

 

On a quarterly basis, management assesses the reasonableness of its effective federal and state tax rates based upon its current best estimate of net income and the applicable taxes expected for the full year. Deferred tax assets and liabilities are reassessed on an annual basis, or sooner, if business events or circumstances warrant. Reserves for uncertain tax positions are reviewed

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

CRITICAL ACCOUNTING POLICIES (CONTINUED)

quarterly for adequacy based upon developments in tax law and the status of examinations or audits. For the years ended December 31, 2006 and 2005, net federal income tax benefits of $0.23 million and $0.94 million, respectively, were recorded based on the regular reassessment of required tax accruals for these uncertain tax positions. No such tax benefits were recorded in 2004.

 

Real Estate Mortgage Loan Servicing Rights

At December 31, 2006, the Corporation had approximately $2.4 million of real estate mortgage loan servicing rights capitalized on the consolidated statement of financial position. The two critical assumptions involved in establishing the value of this asset are the estimated future prepayment speeds on the underlying real estate mortgage loans and the interest rate used to discount the net cash flows from the real estate mortgage loan portfolio being serviced. Other assumptions include the estimated amount of ancillary income that will be received in the future (such as late fees) and the estimated cost to service the real estate mortgage loans. The Corporation utilizes a third-party modeling software program to value mortgage servicing rights. The Corporation believes the assumptions utilized in the valuation are reasonable based upon market interest rates and accepted industry practices for valuing mortgage servicing rights and represent neither the most conservative nor the most aggressive assumptions.

 

Goodwill

At December 31, 2006, the Corporation had $70.1 million of goodwill recorded on the consolidated statement of financial position. Goodwill increased $6.8 million during 2006 from the acquisition of two branch banking offices. Under SFAS No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), amortization of goodwill ceased, and instead, goodwill is tested annually for impairment. The Corporation’s goodwill impairment review is performed at least annually by management and additionally assessed by an independent third-party appraisal firm utilizing the methodology and guidelines established in SFAS 142. This methodology involved assumptions regarding the valuation of the Corporation’s subsidiary bank that purchased the acquired entities and resulted in the recording of goodwill. The Corporation believes that the assumptions utilized are reasonable, and even utilizing more conservative assumptions on the valuation would not presently result in impairment in the amount of goodwill that has been recorded. However, the Corporation may incur impairment charges related to goodwill in the future due to changes in business prospects or other matters that could affect the valuation assumptions.

 

MERGERS AND ACQUISITIONS

 

The Corporation’s primary method of expansion into new banking markets has been through acquisitions of other financial institutions and bank branches. During the three years ended December 31, 2006, the Corporation completed the following acquisition:

 

In August 2006, the Corporation acquired two branch bank offices in Hastings and Wayland, Michigan from First Financial Bank, N.A., headquartered in Hamilton, Ohio, operating as Sand Ridge Bank. The Corporation acquired deposits of $47 million, loans of $64 million and other miscellaneous assets of $1.7 million. The Corporation recorded goodwill of $6.8 million, including purchase accounting adjustments of $2.5 million, and core deposit intangible assets of $2.7 million. The core deposit intangible assets are being amortized on an accelerated basis over ten years, with $0.2 million of amortization expense recognized in 2006. The loans acquired were comprised of $6 million in commercial loans, $13 million in real estate commercial loans, $38 million in real estate residential loans and $7 million in consumer loans. During December 2006, the Corporation sold $14 million of long-term fixed interest rate real estate residential loans that were acquired in this transaction and recognized gains totaling approximately $1 million.

 

On December 31, 2005, the Corporation completed an internal consolidation whereby two of its wholly-owned subsidiary banks, Chemical Bank Shoreline and Chemical Bank West, were consolidated into Chemical Bank and Trust Company (CBT). CBT’s name was changed to Chemical Bank on December 31, 2005.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

NET INCOME

 

Net income in 2006 was $46.8 million, or $1.88 per diluted share, net income in 2005 was $52.9 million, or $2.10 per diluted share, and net income in 2004 was $56.7 million, or $2.25 per diluted share. Net income in 2006 represented an 11.4% decrease from 2005 net income, while 2005 net income represented a 6.7% decrease from 2004 net income. Net income per share in 2006 was 10.5% less than in 2005, while net income per share in 2005 was 6.7% less than in 2004. The decreases in net income in both 2006 and 2005 were primarily due to decreases in net interest income.

 

The Corporation’s return on average assets was 1.24% in 2006, 1.40% in 2005 and 1.47% in 2004. The Corporation’s return on average shareholders’ equity was 9.2% in 2006, 10.7% in 2005 and 12.0% in 2004.

 

DEPOSITS

 

Total deposits at December 31, 2006 were $2.90 billion, an increase of $78 million, or 2.8%, over total deposits at December 31, 2005 of $2.82 billion. The increase in total deposits was largely attributable to the acquisition of two branch banking offices from First Financial Bank, N.A. in Hastings and Wayland, Michigan in August 2006. The acquisition added total deposits of $47 million.

 

The Corporation’s average deposit balances and average rates paid on deposits for the past three years are included in Table 1. Average total deposits in 2006 were $2.86 billion, $24 million, or 0.8%, lower than in 2005. Average deposits of $2.89 billion in 2005 were $90 million, or 3.0%, less than in 2004. The decreases in average deposits in 2006 and 2005, compared to the prior year, were primarily attributable to declines in consumer deposits that resulted from intense competition in the marketplace for retail deposits. The Corporation did not have any brokered deposits as of December 31, 2006, compared to $3.4 million as of December 31, 2005.

 

It is the Corporation’s strategy to develop customer relationships that will drive core deposit growth and stability. The Corporation has historically gathered deposits from the local markets of its subsidiary bank, although rising market interest rates and strong competition impeded the Corporation’s ability to internally generate deposits during the three years ended December 31, 2006.

 

The growth of the Corporation’s deposits is also impacted by competition from other investment products, such as brokerage accounts, mutual funds and various annuity products. These investment products are sold by a wide spectrum of organizations, such as brokerage and insurance companies, as well as by financial institutions. The Corporation also competes with credit unions in most of its markets. These institutions are challenging competitors, as credit unions are exempt from federal income taxes, allowing them to potentially offer higher deposit rates and lower loan rates to customers.

 

In response to the competition for other investment products, the Corporation’s subsidiary bank, through “CFC Investment Center,” offers a wide array of mutual funds, annuity products and market securities through an alliance with an independent, registered broker/dealer. During 2006 and 2005, customers purchased $73 million and $52 million, respectively, of annuity and mutual fund investments through “CFC Investment Center.”

 

ASSETS

 

Average assets were $3.76 billion during 2006, a decrease of $25.4 million, or 0.7%, from average assets during 2005 of $3.79 billion. The decrease in average assets during 2006 was primarily attributable to the utilization of available liquidity resulting from a portion of investment securities maturities to pay off a portion of Federal Home Loan Bank advances — long-term that matured during 2006. The Corporation acquired two branch banking offices on August 18, 2006, increasing total assets by $73.3 million as of the acquisition date. Average assets of $3.86 billion in 2005 were $67.6 million, or 1.8%, less than average assets in 2004. Average assets declined in 2005 due to the Corporation utilizing a portion of investment securities maturities to fund a slight decline in total deposits.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

CASH DIVIDENDS

 

The Corporation’s annual cash dividends paid per share over the past five years, adjusted for all stock dividends, were as follows:

 

 

During 2006, cash dividends paid per share of $1.10 were up 3.8% over cash dividends paid per share in 2005 of $1.06.

 

The Corporation has paid regular cash dividends every quarter since it began operating as a bank holding company in 1973. The compound annual growth rate of the Corporation’s cash dividends paid per share over the past five- and ten-year periods ended December 31, 2006 was 5.8% and 8.7%, respectively. The earnings of the Corporation’s subsidiary bank are the principal source of funds to pay cash dividends to shareholders. Cash dividends are dependent upon the earnings of the Corporation’s subsidiary bank, as well as capital requirements, regulatory restraints and other factors affecting the Corporation’s subsidiary bank.

 

NET INTEREST INCOME

 

Interest income is the total amount earned on funds invested in loans, investment and other securities, other interest-bearing deposits and federal funds sold. Interest expense is the amount of interest paid on interest-bearing checking and savings accounts, time deposits, short-term borrowings and FHLB advances — long-term. Net interest income, on a fully taxable equivalent (FTE) basis, is the difference between interest income and interest expense adjusted for the tax benefit received on tax-exempt commercial loans and investment securities. Net interest margin is calculated by dividing net interest income (FTE) by average interest-earning assets. Net interest spread is the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Because noninterest-bearing sources of funds, or free funds (principally demand deposits and shareholders’ equity) also support earning assets, the net interest margin exceeds the net interest spread.

 

The presentation of net interest income on a FTE basis is not in accordance with United States generally accepted accounting principles (GAAP) but is customary in the banking industry. This non-GAAP measure ensures comparability of net interest income arising from both taxable and tax-exempt loans and investment securities. The adjustments to determine tax equivalent net interest income were $2.11 million, $1.61 million and $1.54 million for 2006, 2005 and 2004, respectively. These adjustments were computed using a 35% tax rate.

 

Net interest income is the most important source of the Corporation’s earnings and thus is critical in evaluating the results of operations. Changes in the Corporation’s net interest income are influenced by a variety of factors, including changes in the level of interest-earning assets, changes in the mix of interest-earning assets and interest-bearing liabilities, the level and direction of interest rates, the difference between short-term and long-term interest rates (the steepness of the yield curve), and the general strength of the economies in the Corporation’s markets. Risk management plays an important role in the Corporation’s level of net interest income. The ineffective management of credit risk, and more significantly interest rate risk, can adversely impact the Corporation’s net interest income. Management monitors the Corporation’s consolidated statement of financial position to reduce the potential adverse impact on net interest income caused by significant changes in interest rates. The Corporation’s policies in this regard are further discussed under the subheading “Market Risk.”

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

 

 

Table 1 presents for 2006, 2005 and 2004 average daily balances of the Corporation’s major categories of assets and liabilities, interest income and expense on a FTE basis, average interest rates earned and paid on the assets and liabilities, net interest income (FTE), net interest spread and net interest margin.

 

Net interest income (FTE) in 2006, 2005 and 2004 was $134.3 million, $143.5 million and $149.2 million, respectively. Net interest income (FTE) in 2006 was $9.1 million, or 6.4%, lower than 2005 net interest income (FTE) of $143.5 million, while net interest income (FTE) in 2005 was $5.7 million, or 3.8%, lower than 2004 net interest income (FTE) of $149.2 million. The decreases in net interest income in 2006 and 2005 were primarily attributable to the continuing effect of the interest rate environment, lower interest-earning assets, funds migrating within the deposit portfolio from lower cost transaction and savings accounts to higher cost savings and time deposits and continued pricing pressure on loans.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

NET INTEREST INCOME (CONTINUED)

 

 

 

The $9.1 million decrease in net interest income (FTE) during 2006, as compared to 2005, was primarily attributable to a combination of the adverse impact of the increase in short-term interest rates and the flat interest yield curve on interest expense on deposits and short-term borrowings, a $29 million decrease in average interest-earning assets between 2006 and 2005 and changes in the mix of interest-bearing liabilities from lower cost transaction and savings deposits to higher cost time and municipal customer deposits. These unfavorable items were partially offset by an increase in the yield on interest-earning assets and a positive change in the mix of interest-earning assets, with average loans up $126 million, or 4.8%, in 2006, as compared to 2005. The reduction in average interest-earning assets during 2006 was primarily attributable to a reduction in investment securities. The Corporation’s investment securities portfolio declined partially as investment securities maturities were used to decrease Federal Home Loan Bank advances — long-term.

 

In 2006, the Federal Open Market Committee (FOMC) raised the Discount and Federal Funds rates by twenty-five basis points four times during the year that did result in an equal increase each time in the prime rate. The Discount and Federal Funds rates were 5.25% on December 31, 2006, compared to 4.25% on December 31, 2005. The prime rate was 8.25% on December 31, 2006, compared to 7.25% on December 31, 2005. While short-term interest rates increased throughout 2006, long-term interest rates rose only slightly to produce an inverted interest yield curve at December 31, 2006. The ten-year U.S. Treasury note, which is generally used to price both 15- and 30-year residential mortgage loans, was 4.71% at the end of 2006, compared to 4.35% at the end of 2005.

 

Net interest margin was 3.82% in 2006, compared to 4.04% in 2005. The decrease in net interest margin during 2006, compared to 2005, was primarily attributable to the increase in the average yield on interest-earning assets not keeping pace with the increase in the average cost of interest-bearing liabilities, as occurred in 2005 although to a lesser extent. The average yield on interest-earning assets increased 57 basis points to 6.23% in 2006. In comparison, the average cost of interest-bearing liabilities increased 105 basis points to 3.16% in 2006. The increase in the cost of interest-bearing liabilities was attributable to a combination of factors, including the overall increase in market interest rates, the migration of customer funds from lower

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

yielding deposit products into higher yielding time deposits and a slight change in the mix of deposits, with a slight decline in lower cost consumer deposits being offset by increases in higher cost business and municipal customer deposits. The yield on the Corporation’s loan portfolio has increased only moderately during a two-year period of continually rising interest rates due to the loan portfolio being comprised predominately of fixed interest rate loans or loans with interest rates fixed for at least five years. In addition, the competition for loan volume remained strong in the Corporation’s local markets, resulting in heightened pricing competition for new loan originations, and lower than expected yields on new and refinanced loans, considering the overall increase in market interest rates.

 

The Corporation’s competitive position within many of its market areas limits its ability to materially increase deposits without adversely impacting the weighted average cost of core deposits. Accordingly, the increase in short-term market interest rates in both 2006 and 2005 and strong competition resulted in a significant increase in the average cost of deposits and wholesale borrowings, and a decrease in consumer deposits in 2006, compared to 2005.

 

Table 2 allocates the dollar change in net interest income (FTE) between the portion attributable to changes in the average volume of interest-earning assets and interest-bearing liabilities, including changes in the mix of assets and liabilities, and changes in average interest rates earned and paid.

 

The $9.1 million reduction in net interest income (FTE) in 2006, as compared to 2005, is analyzed in detail in Table 2. The net impact on net interest income (FTE) in 2006 from the favorable effect of an increase in average loans and the unfavorable effect of a lower level of interest-earning assets and change in the composition of deposit accounts, was an increase in net interest income (FTE) of $1.3 million. This increase was more than offset by the Corporation experiencing a $10.4 million reduction in net interest income (FTE) due to the effect of the rising interest rate environment and the flattening of the interest yield curve. Interest income on loans, investment securities and other investable funds increased $16.4 million due to rising interest rates and the repricing of loans and investment securities, although interest expense on deposits and borrowings increased $26.8 million, as market interest rates increased and deposits and wholesale borrowings repriced in 2006. The Corporation’s balance sheet was liability sensitive throughout 2006, with a higher percentage of interest-bearing liabilities repricing than interest-earning assets.

 

In 2005, the FOMC raised the Discount and Federal Funds rates by twenty-five basis points eight times that did result in an equal increase each time in the prime rate. The prime rate was 5.25% on January 1, 2005 and 7.25% on December 31, 2005. While short-term interest rates increased throughout 2005, long-term interest rates rose only slightly to produce a virtually flat interest yield curve at December 31, 2005. The ten-year U.S. Treasury note, which is generally used to price both 15- and 30-year residential mortgage loans, was 4.24% at the end of 2004 compared to 4.35% at the end of 2005.

 

Net interest income (FTE) in 2005 was $143.5 million, $5.7 million, or 3.8%, lower than in 2004. The decline in net interest income during 2005 was primarily attributable to a slight decrease in average interest-earning assets and the effects of the significant increase in short-term interest rates and the flattening of the interest yield curve during the year. These factors were partially offset by a positive change in the mix of interest-earning assets with average loans up $73.5 million, or 2.9%, in 2005 compared to 2004. Average interest-earning assets of $3.55 billion in 2005 were down $57.5 million, or 1.6%, from 2004. The reduction in average interest-earning assets during 2005 was primarily attributable to a reduction in investment securities. A portion of investment securities maturities in 2005 were used to fund a slight decline in total deposits.

 

Net interest margin was 4.04% in 2005, compared to 4.13% in 2004. The decrease in net interest margin in 2005 occurred as a result of the increases in the average yield on interest-earning assets not keeping pace with the increases in the average cost of interest-bearing liabilities. In 2005, the average yield on interest-earning assets increased 37 basis points to 5.66%, while the average cost of interest-bearing liabilities increased 63 basis points to 2.11%. Consequently, the increase in the interest yield on loans was not sufficient to offset the increase in the Corporation’s funding costs. Short-term market interest rates increased throughout 2005, although the yield on the Corporation’s loan portfolio increased only modestly as the majority of the loan portfolio was and remains comprised primarily of fixed interest rate loans. The competition for loan volume was strong in 2005 in the Corporation’s local markets, which resulted in lower interest rates on new and renewed loans than otherwise would have been expected.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

LOANS

 

The Corporation’s subsidiary bank is a full-service commercial bank and, therefore, the acceptance and management of credit risk is an integral part of the Corporation’s business. The Corporation maintains conservative loan policies and credit underwriting standards. These standards include the granting of loans generally only within the Corporation’s market areas. The Corporation’s lending markets generally consist of small communities across the middle to southern and western sections of the lower peninsula of Michigan. The Corporation has no foreign loans or any loans to finance highly leveraged transactions. The Corporation’s lending philosophy is implemented through strong administrative and reporting controls at the subsidiary bank level, with additional oversight at the corporate level. The Corporation maintains a centralized independent loan review function, which monitors asset quality of the loan portfolio.

 

The Corporation’s subsidiary bank has extended loans to its directors, executive officers and their affiliates. The loans were made in the ordinary course of business upon normal terms, including collateralization and interest rates prevailing at the time and did not involve more than the normal risk of repayment by the borrower or present other unfavorable features. Note F to the consolidated financial statements includes more information on loans to the Corporation’s directors, executive officers and their affiliates.

 

The Corporation experiences competition for commercial loans primarily from larger regional banks located both within and outside of the Corporation’s market areas, and from other community banks located within the Corporation’s lending markets. The Corporation’s competition for real estate residential loans primarily includes community banks, larger regional banks, savings associations, credit unions and mortgage companies. The competition for real estate residential loans has increased over the last five years as mortgage lending companies have expanded their sales and marketing efforts. The Corporation experiences competition for consumer loans mostly from captive automobile finance companies, larger regional banks, community banks and local credit unions. The Corporation’s loan portfolio is generally diversified along industry lines and, therefore, the Corporation believes that its loan portfolio is reasonably sheltered from material adverse local economic impact.

 

Table 3 includes the composition of the Corporation’s loan portfolio, by major loan category, as of December 31, 2006, 2005, 2004, 2003 and 2002.

 

Total loans at December 31, 2006 were $2.81 billion, an increase of $101 million, or 3.7%, over total loans at December 31, 2005. The growth in the loan portfolio was largely due to the acquisition of two branch banking offices from First Financial Bank, N.A. in Hastings and Wayland, Michigan (2006 branch transaction). The purchase added total loans of $64 million. The loans acquired were comprised of $6 million in commercial loans, $13 million in real estate commercial loans, $38 million in real estate residential loans and $7 million in consumer loans. During December 2006, the Corporation sold $14 million of the real estate residential loans that were acquired in this transaction and recognized gains totaling approximately $1 million. The numbers set forth in the following discussion include the loans generated by the acquired branches unless stated otherwise.

 

Commercial loans totaled $545.6 million at December 31, 2006, an increase of $27.7 million, or 5.4%, from total commercial loans at December 31, 2005 of $517.9 million. A portion of the increase in commercial loans during 2006 was attributable to the 2006 branch transaction. The internal growth of commercial loans was low during 2006 as a result of a slower than average economic climate within the Corporation’s market areas during the year. Commercial loans increased $48.9 million, or 10.4%, in 2005 from $469.0 million at December 31, 2004. The increase in commercial loans in 2005 was largely attributable to the Corporation’s emphasis to increase this portion of the loan portfolio. Commercial loans represented 19.4%, 19.1% and 18.2% of total loans outstanding at December 31, 2006, 2005 and 2004, respectively.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

Real estate loans include real estate commercial loans, real estate construction loans and real estate residential loans. At December 31, 2006, 2005 and 2004, real estate loans totaled $1.71 billion, $1.65 billion and $1.58 billion, respectively. Real estate loans increased $59.5 million, or 3.6%, in 2006. Approximately 62% of the increase in real estate loans was attributable to the 2006 branch transaction, which added $37 million in real estate loans, net of the sale of $14 million of loans sold, as discussed above. Real estate loans increased $71 million, or 4.5%, in 2005. Real estate loans as a percentage of total loans at December 31, 2006, 2005 and 2004 were 60.9%, 60.9% and 61.1%, respectively.

 

Real estate commercial loans increased $21.9 million, or 3.1%, during 2006 to $726.6 million at December 31, 2006. This includes $13 million attributable to the 2006 branch transaction. Real estate commercial loans increased $6.9 million, or 1.0%, during 2005 to $704.7 million at December 31, 2005. The modest internal growth in this category of loans in 2006 and 2005 was largely due to minimal economic expansion in the majority of the Corporation’s community bank market areas. At December 31, 2006, 2005 and 2004, real estate commercial loans as a percentage of total loans were 25.9%, 26.0% and 27.0%, respectively.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

LOANS (CONTINUED)

 

Commercial lending and real estate commercial lending are generally considered to involve a higher degree of risk than one-to four-family residential lending. Such lending typically involves large loan balances concentrated in a single borrower. In addition, the payment experience on loans secured by income-producing properties is typically dependent on the success of the operation of the related project and is typically affected by adverse conditions in the real estate market and in the economy. The Corporation generally attempts to mitigate the risks associated with commercial lending by, among other things, lending primarily in its market areas and using conservative loan-to-value ratios in the underwriting process.

 

Real estate construction loans are originated for both business, including land development, and residential properties. These loans generally convert to a real estate loan at the completion of the construction or development period. Real estate construction loans were $145.9 million at December 31, 2006, a decrease of $12.4 million, or 7.9%, from December 31, 2005. The decrease in real estate construction loans during 2006 was largely reflective of the economic climate within Michigan in 2006 and a corresponding reduction in business expansion and development throughout most of the Corporation’s community bank market areas. Real estate construction loans increased $37.5 million, or 31.0%, during 2005 from $120.9 million at December 31, 2004, as the economic climate was favorable in 2005. At December 31, 2006, 2005 and 2004, real estate construction loans as a percentage of total loans were 5.2%, 5.9% and 4.7%, respectively.

 

Construction lending involves a higher degree of risk than one- to four-family residential lending because of the uncertainties of construction, including the possibility of costs exceeding the initial estimates and the need to obtain a tenant or purchaser of the property if it will not be owner-occupied. The Corporation generally attempts to mitigate the risks associated with construction lending by, among other things, lending primarily in its market areas, using conservative underwriting guidelines, and closely monitoring the construction process.

 

Table 4 presents the maturity distribution of commercial, real estate commercial, and real estate construction loans. These loans represented 51% of total loans at both December 31, 2006 and December 31, 2005. The percentage of these loans maturing within one year was 33% at December 31, 2006, compared to 30% at December 31, 2005. The percentage of these loans maturing beyond five years remained low at 9% at both December 31, 2006 and December 31, 2005. Of those loans with maturities beyond one year, the percentage of loans with variable interest rates was 17% at December 31, 2006, compared to 23% at December 31, 2005. The decrease in variable interest rate loans with maturities greater than one year was due to both a strong customer preference to secure fixed interest rate financing in a rising interest rate environment and equally strong competitive conditions.

 

Real estate commercial loans are generally written as balloon-type mortgages at fixed interest rates for balloon time periods ranging from three to ten years. As of December 31, 2006, the Corporation held $129 million in commercial, real estate commercial and real estate construction-commercial loans that had maturities extending beyond five years, with the majority of these loans having fixed interest rates.

 

Real estate residential loans increased $50.1 million, or 6.4%, during 2006 to $835.3 million. The 2006 branch transaction added $24 million in real estate residential loans, after a portion of the loans acquired were sold in December 2006. The internal growth of real estate residential loans was low as the housing market across much of the state of Michigan was weak throughout the year. Real estate residential loans increased $27.8 million, or 3.7%, during 2005 to $785.2 million. The increase in real estate residential loans during 2005 was primarily attributable to growth in the adjustable interest rate loan type, that includes a fixed interest rate period for one, three, five or seven years. Market interest rates of this type loan decreased during 2005 making these loans more attractive to customers. The Corporation generally keeps adjustable interest rate loans in its loan portfolio, rather than selling them in the secondary mortgage market. At December 31, 2006, 2005 and 2004, real estate residential loans as a percentage of total loans were 29.8%, 29.0% and 29.4%, respectively.

 

The Corporation’s real estate residential loans primarily consist of one- to four-family residential loans with original terms of less than fifteen years. The loan-to-value ratio at the time of origination is generally 80% or less. Loans with more than an 80% loan-to-value ratio generally require private mortgage insurance.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

 

The Corporation’s general practice is to sell residential real estate loan originations with maturities of fifteen years and longer in the secondary market. The Corporation sold $118 million of long-term fixed rate real estate residential loans during 2006 in the secondary market, excluding $14 million of loans sold that were acquired in the 2006 branch transaction, compared to the sale of $111 million of real estate residential loans during 2005.

 

At December 31, 2006, the Corporation was servicing $552 million of real estate residential loans that had been originated by the Corporation in its market areas and subsequently sold in the secondary mortgage market. At December 31, 2005, the Corporation serviced for others approximately $544 million of real estate residential loans. The loans sold from the 2006 branch transaction were sold servicing retained and account for the increase in the Corporation’s servicing portfolio during 2006.

 

Consumer loans totaled $554.3 million at December 31, 2006, an increase of $13.7 million, or 2.5%, from total consumer loans at December 31, 2005 of $540.6 million. Approximately $7 million of the 2006 increase was attributable to the 2006 branch transaction. Consumer loans increased $3.5 million, or 0.7%, during 2005 from $537.1 million at December 31, 2004. The minimal increases during both 2006 and 2005 were largely attributable to increased competition from captive auto finance companies on new personal vehicle loans and slow economic conditions in the Corporation’s market areas, as evidenced by the unemployment level in Michigan at approximately twice the national average at December 31, 2006. Consumer loans represented 19.7%, 20.0% and 20.8% of total loans outstanding at December 31, 2006, 2005 and 2004, respectively.

 

Consumer loans generally have shorter terms than mortgage loans but generally involve more credit risk than one- to four-family residential lending because of the type and nature of the collateral. Collateral values, particularly those of automobiles, are negatively impacted by many factors, such as new car promotions, vehicle condition and a slow economy. Consumer lending collections are dependent on the borrowers’ continuing financial stability, and thus are more likely to be affected by adverse personal situations.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

NONPERFORMING ASSETS

 

A five-year history of nonperforming assets is presented in Table 5. Nonperforming assets are comprised of loans accounted for on a nonaccrual basis, accruing loans contractually past due 90 days or more as to interest or principal payments, and other real estate and repossessed assets. There were no restructured loans at December 31, 2006, 2005, 2004, 2003 or 2002.

 

Nonaccrual loans were $20.2 million at December 31, 2006, compared to $14.6 million at December 31, 2005 and $8.4 million at December 31, 2004. The increase in nonaccrual loans in 2006 was partially attributable to the decline in the Michigan economy and the resultant level of unemployment in the state of Michigan of 7.1%, approximately twice that of the national average. Accordingly, the decline in the economic condition in Michigan has resulted in higher business and consumer delinquencies, bankruptcies and foreclosures. At December 31, 2006, eight commercial, real estate commercial and real estate construction — commercial nonaccrual loans, totaling $10.4 million, comprised 51% of total nonaccrual loans as of that date. Nonaccrual loans as a percentage of total loans were 0.72% at December 31, 2006, 0.54% at December 31, 2005 and 0.32% at December 31, 2004.

 

Accruing loans past due 90 days or more were $6.7 million at December 31, 2006, $5.1 million at December 31, 2005 and $1.7 million at December 31, 2004. The Corporation experienced an improvement in real estate residential past due loans 90 days or more of $0.5 million during 2006, although this reduction was offset by increases in past due loans greater than 90 days in commercial loan types of $1.3 million and consumer loans of $0.8 million.

 

Total nonperforming loans were $26.9 million, or 0.96% of total loans, at December 31, 2006, compared to $19.7 million, or 0.73% of total loans, at December 31, 2005. As previously discussed, the level and composition of nonperforming loans were affected by economic conditions in the state of Michigan and in the Corporation’s local markets.

 

Other real estate and repossessed assets totaled $8.9 million at December 31, 2006, and consisted of commercial real estate of $6.0 million, residential real estate of $2.6 million and other repossessions, mostly automobiles, boats and recreational vehicles, of $0.3 million. Other real estate and repossessed assets totaled $6.8 million at December 31, 2005, and consisted of commercial real estate of $3.8 million, residential real estate of $2.6 million and other repossessions, mostly automobiles, boats and recreational vehicles, of $0.4 million. The increase in other real estate during 2006 was primarily attributable to the foreclosure on a twelve-unit residential condominium project in Bay City, Michigan. Based on current economic conditions, the Corporation anticipates a two-year time frame to fully liquidate this property.

 

The Corporation considers a loan as impaired when management determines it is probable that all of the principal and interest due under the contractual terms of the loan will not be collected. The Corporation measures impairment on commercial, real estate commercial and real estate construction-commercial loans. In most instances, the impairment is measured based on the fair value of the underlying collateral. Impairment may also be measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate.

 

Impaired loans were $19.8 million as of December 31, 2006, $9.8 million as of December 31, 2005 and $4.6 million as of December 31, 2004. All nonaccrual commercial, real estate commercial and real estate construction — commercial loans, which totaled $16.4 million at December 31, 2006, met the definition of an impaired loan. The Corporation also identified loans in each of these loan types totaling $3.4 million that were in an accrual status as of December 31, 2006 that met the definition of an impaired loan. After analyzing the various components of the customer relationships and evaluating the underlying collateral of impaired loans, it was determined that the total of impaired loans requiring an allowance for loan losses was $3.8 million at December 31, 2006, $5.1 million at December 31, 2005 and $0.8 million at December 31, 2004. The allowance for loan losses on impaired loans was $0.9 million at December 31, 2006, $1.3 million at December 31, 2005 and $0.4 million at December 31, 2004. The process of measuring impaired loans and the allocation of the allowance for loan losses requires judgment and estimation, therefore the eventual outcome may differ from the estimates used on these loans.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

 

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

PROVISION AND ALLOWANCE FOR LOAN LOSSES

 

The provision for loan losses (provision) is the amount added to the allowance for loan losses (allowance) to absorb inherent loan losses (charge-offs) in the loan portfolio. A summary of the activity in the allowance for years 2006 back through 2002 is included in Table 3. Management quarterly evaluates the allowance to ensure the level is adequate to absorb losses inherent in the loan portfolio. This evaluation is based on a continuous review of the loan portfolio, both individually and by category, and includes consideration of changes in the mix and volume of the loan portfolio, actual loan loss experience and loan loss trends, the financial condition of the borrowers, industry and geographical exposures within the portfolio, economic conditions and employment levels of the Corporation’s local markets, and special factors affecting business sectors. A formal evaluation of the allowance is prepared quarterly to assess the risk in the loan portfolio and to determine the adequacy of the allowance. The Corporation’s loan review function is independent of the loan origination function and reviews this evaluation. The Corporation’s loan review function was performed by a combination of internal staff and third-party consulting firms during 2006 and 2005. Prior to 2005, the loan review function was performed solely by internal staff. Loan review performs a detailed credit quality review at least annually on large commercial, real estate commercial and real estate construction-commercial loans, particularly focusing on loans that have deteriorated below certain levels of credit risk.

 

The allowance provides for probable losses that have been identified with specific customer relationships and for probable losses believed to be inherent in the remainder of the loan portfolio but that have not been specifically identified. The allowance for loan losses is comprised of specific allowances (assessed for loans that have known credit weaknesses), allowances based on assigned risk ratings, general allowances on the remainder of the loan portfolio based primarily on historical loan loss experience, and an unallocated allowance for the imprecision in the subjective nature of the specific and general allowance methodology. Factors contributing to the determination of specific allocations include the financial condition of the borrower, changes in the value of pledged collateral and general economic conditions. The Corporation establishes the allowance allocations by the application of projected loss percentages to adversely-graded commercial, real estate commercial and real estate construction-commercial loans by grade categories. General allowances are allocated to all other loans by loan category, based on a defined methodology, that focuses on loan loss experience and trends. Allocations to loan categories are developed based on historical loss and past due trends, management’s judgment concerning those trends and other relevant factors, including delinquency, default, and loss rates, as well as general economic conditions. Some loans will not be repaid in full. Therefore, an allowance for loan losses is maintained at a level that represents management’s best estimate of inherent losses within the loan portfolio.

 

In determining the allowance and the related provision for loan losses, the Corporation considers four principal elements: (i) specific allocations based upon probable losses identified during the review of impaired commercial, real estate commercial and real estate construction-commercial loan portfolios, (ii) allocations established for adversely-rated commercial, real estate commercial and real estate construction-commercial loans, (iii) allocations on all other loans based principally on historical loan loss experience, and (iv) an unallocated allowance based on the imprecision in the overall allowance methodology.

 

The first element reflects the Corporation’s estimate of probable losses based upon the systematic review of impaired commercial, real estate commercial and real estate construction-commercial adversely-graded loans. These estimates are based upon a number of objective factors, such as payment history, financial condition of the borrower, and discounted collateral exposure. The Corporation measures the investment in an impaired loan based on one of three methods: the loan’s observable market price, the fair value of the collateral, or the present value of expected future cash flows discounted at the loan’s effective interest rate.

 

The second element reflects the application of the Corporation’s loan grading system. This grading system is similar to those employed by state and federal banking regulators. Commercial, real estate commercial and real estate construction-commercial loans that are risk rated below a certain predetermined risk grade are assigned a loss allocation factor that is based upon a historical analysis of losses incurred within the specific risk grade category. The lower the grade assigned to a loan or category, the greater the allocation percentage that is generally applied.

 

The third element is determined by assigning allocations based principally upon the three-year average of loss experience for each type of loan. Average losses may be adjusted based on current loan loss and delinquency trends and for the projected impact of loans acquired in branch and bank acquisitions. Loan loss analyses are conducted at least annually.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

 

 

 

The fourth element is based on factors that cannot be associated with a specific credit or loan category and reflects an attempt to ensure that the overall allowance for loan losses appropriately reflects a margin for the imprecision necessarily inherent in the estimates of expected loan losses. Management maintains an unallocated allowance to recognize the uncertainty and imprecision underlying the process of estimating projected loan losses. Determination of the probable losses inherent in the portfolio, which are not necessarily captured by the allocation methodology discussed above, involves the exercise of judgment. The unallocated allowance associated with the imprecision in the risk rating system is based on a historical evaluation of the accuracy of the risk ratings associated with loans. This unallocated portion of the allowance is judgmentally determined and generally serves to compensate for the uncertainty in estimating losses, particularly in times of changing economic conditions, and also considers the possibility of improper risk ratings. The unallocated allowance considers the lagging impact of historical charge-off ratios in periods where future loan charge-offs are expected to increase, trends in delinquencies and nonaccrual loans, the changing portfolio mix in terms of collateral, average loan balance, loan growth, the degree of seasoning in the various loan portfolios, and loans recently acquired through acquisitions.

 

The underlying credit quality of the Corporation’s real estate residential and consumer loan portfolios is dependent primarily on each borrower’s ability to continue to make required loan payments and, in the event a borrower is unable to continue to do so, the value of the collateral, if any, securing the loan. A borrower’s ability to pay typically is dependent primarily on employment and other sources of income, which in turn is impacted by general economic conditions, although other factors may also impact a borrower’s ability to pay.

 

The provision for loan losses was $5.20 million in 2006, $4.29 million in 2005, and $3.82 million in 2004. The Corporation experienced net loan charge-offs of $5.65 million in 2006, $4.30 million in 2005 and $2.83 million in 2004. Net loan charge-offs as a percentage of average loans were 0.20% in 2006, 0.16% in 2005 and 0.11% in 2004. The increase in net loan charge-offs in 2006 occurred in the commercial loan types. The three largest commercial loan charge-offs were real estate based loans and totaled $2.1 million. These three loan charge-offs represented 51% of total gross commercial loan type charge-offs in 2006. The Corporation’s allowance was $34.1 million at December 31, 2006 and represented 1.21% of total loans, compared to $34.1 million and 1.26% of total loans at December 31, 2005. During 2006, the Corporation acquired an allowance of $0.4 million in the 2006 branch transaction.

 

The Corporation’s provision for loan losses was approximately $0.9 million higher in 2006 than in 2005. This increase was primarily attributable to the increase in net loan charge-offs in 2006, as compared to 2005. The calculation of the provision for loan losses is based upon the results of the Corporation’s analysis of its loan portfolio, net loan charge-offs and allowance for loan loss methodology. The Corporation’s provision for loan losses in 2006 was lower than net loan charge-offs primarily due to a $0.4 million decrease in the specific allocation of the allowance on impaired loans. The Corporation’s total specific allowance on impaired loans decreased to $0.9 million at December 31, 2006 from $1.3 million at December 31, 2005.

 

Impaired loans were $19.8 million as of December 31, 2006, $9.8 million as of December 31, 2005 and $4.6 million as of December 31, 2004. After analyzing the various components of the customer relationships and evaluating the underlying collateral of impaired loans, it was determined that the total of impaired loans requiring an allocation of the allowance for loan losses was $3.8 million at December 31, 2006, $5.1 million at December 31, 2005 and $0.8 million at December 31, 2004. The allowance for loan losses allocated to impaired loans was as follows: $0.9 million at December 31, 2006, $1.3 million at December 31, 2005, and $0.4 million at December 31, 2004. The process of measuring impaired loans and the allocation of the allowance for loan losses requires judgment and estimation, therefore the eventual outcome may differ from the estimates used on these loans.

 

While the Corporation uses relevant information to recognize losses on loans, additional provisions for related losses may be necessary based on changes in economic conditions, customer circumstances and other credit risk factors.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

PROVISION AND ALLOWANCE FOR LOAN LOSSES (CONTINUED)

 

The allocation of the allowance in Table 6 is based upon ranges of estimates and is not intended to imply either limitations on the usage of the allowance or exactness of the specific amounts. The entire allowance is available to absorb future loan losses without regard to the categories in which the loan losses are classified. The allocation of the allowance is based upon a combination of factors, including historical loss factors, credit-risk grading, past-due experiences, and the trends in these, as well as other factors, as discussed above.

 

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

NONINTEREST INCOME

 

Noninterest income totaled $40.1 million in 2006, $39.2 million in 2005 and $39.3 million in 2004. Noninterest income increased $0.9 million, or 2.4%, in 2006 and declined $0.1 million, or 0.3%, in 2005 compared to the prior year. Noninterest income as a percentage of net revenue (net interest income plus noninterest income) was 23.3% in 2006, 21.7% in 2005 and 21.0% in 2004.

 

The following schedule includes the major components of noninterest income during the past three years.

 

 

Service charges on deposit accounts were $21.0 million in 2006, $20.4 million in 2005 and $19.3 million in 2004. The increases of $0.6 million, or 3.1%, in 2006 and $1.1 million, or 5.5%, in 2005 were primarily attributable to increases in fees assessed and a higher level of customer activity in areas where fees and service charges are applicable.

 

Trust and investment services revenue (trust services revenue) was $7.9 million in 2006, $7.9 million in 2005 and $7.4 million in 2004. Trust services revenue in 2006 was virtually unchanged from trust services revenue in the prior year, as discretionary assets under management were approximately the same during 2006 and 2005. While positive investment returns in the equity markets produced additional trust services revenue in 2006, it was offset by the effect of modest changes in the composition of assets under management. Trust services revenue increased $0.5 million, or 6.9%, in 2005 compared to 2004. The increase in 2005 was due primarily to increases in discretionary assets coupled with investment returns in the equity markets.

 

Other fees for customer services were $3.1 million in 2006, $2.4 million in 2005 and $2.1 million in 2004. The 2006 increase of $0.7 million, or 29.8%, was primarily attributable to $0.6 million of float income earned on the sale of bank money orders to customers that was recognized in noninterest income in 2006, compared to being recognized in interest income in 2005, as a result of the transfer of the bank money order proceeds to a third party vendor. The 2005 increase of $0.2 million, or 11.4%, was due to increases in both fees assessed and volume generated.

 

ATM and network user fees were $2.7 million in 2006, $2.7 million in 2005 and $2.5 million in 2004. ATM and network user fees in 2006 were virtually unchanged from the prior year, while they increased $0.2 million, or 7.3%, in 2005 compared to 2004. Management believes that the expansion of ATMs by non-banking institutions was the primary reason for the lack of growth of this revenue in 2006.

 

Investment fees of $2.5 million in 2006 were up $0.6 million, or 32%, compared to investment fees of $1.9 million in 2005. Investment fees in 2005 increased $1.3 million, or 214% compared to investment fees of $0.6 million in 2004. The increase in investment fees in 2006 was a result of a broader mix of products and services being offered to customers through the “CFC Investment Center” program. The significant increase in 2005 was primarily attributable to a change in the operation of the Corporation’s “CFC Investment Center” program on January 1, 2005. Prior to January 1, 2005, the sales of mutual fund and annuity investment products and life insurance products were accomplished through a third party vendor relationship, an independent, registered broker/dealer. The Corporation incurred minimal operating expenses with this program through December 31, 2004, as the individuals responsible for the sales of mutual fund and annuity investment products were employees of the third party vendor. Effective January 1, 2005, the Corporation brought the program in-house and the

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

NONINTEREST INCOME (CONTINUED)

employees of the third party vendor associated with the “CFC Investment Center” program became employees of the Corporation. The Corporation continued to utilize the same third party vendor to facilitate the operation of the “CFC Investment Center” program in 2006 and 2005 as in 2004. Accordingly, both investment fees earned and operating expenses incurred increased as of January 1, 2005.

 

Insurance commissions were $0.8 million in 2006, $0.9 million in 2005 and $1.3 million in 2004. The decrease in 2005, as compared to 2004, was primarily attributable to lower title insurance commissions, which occurred as a direct result of lower real estate residential loan activity and the sale of the Corporation’s property and casualty insurance business in 2004.

 

Mortgage banking revenue (MBR) was $1.74 million in 2006, $1.66 million in 2005 and $3.33 million in 2004. During 2006, the Corporation sold $118 million of real estate residential loans in the secondary market, compared to $111 million in 2005 and $153 million in 2004. During 2006, generally all fifteen-year and longer term mortgages were sold in the secondary market. Based on similar market conditions and amount of loans sold, MBR for 2006 compared to 2005 was relatively unchanged. Real estate residential loan activity, both refinancing and new loan originations, declined in 2005 compared to 2004 as a result of higher market interest rates and slower economic conditions. The Corporation generally sells the majority of its long-term fixed interest rate real estate residential loan originations in the secondary market as a part of its interest rate risk management strategy. The reduction in real estate residential loans sold in the secondary market in 2005 was partially attributable to the Corporation’s success in marketing balloon and adjustable interest rate type loans which are held in the Corporation’s loan portfolio. Consequently, MBR of $1.66 million in 2005 was $1.67 million or 50% less than MBR earned in 2004.

 

During the fourth quarter of 2006, the Corporation recognized a $1.1 million gain on the sale of $14 million in long-term fixed interest rate real estate residential mortgage loans that were acquired in the 2006 branch transaction. There was no such sale of loans from acquisitions in 2005 or 2004.

 

The Corporation recognized losses on the sale of investment securities of $1.3 million during 2006, net gains of $0.5 million in 2005 and net gains of $1.4 million in 2004. During the fourth quarter of 2006, the Corporation sold $68 million of U.S. Treasury and government sponsored agency investment securities scheduled to mature in 2007 and 2008 that had an average yield of 3.12%, and realized a $1.3 million loss. The Corporation had a significant volume of investment securities maturing in 2007 and management deemed it prudent to sell and reinvest a portion of these securities during 2006 as part of its interest rate risk management program. The proceeds from the sale were reinvested in U.S. Treasury and government sponsored agency investment securities with an average life of 3 years and an average yield of 4.81%. In 2005, the Corporation extended the average life of the investment securities portfolio and funded loan growth by selling $109 million of short-term investment securities for a net gain of $0.5 million. In 2004, the Corporation extended the average life of the investment securities portfolio by selling $106 million of short-term investment securities and reinvesting in longer-term securities resulting in a $1.4 million net gain.

 

Noninterest income, excluding investment securities net gains and losses and the gain on the sale of loans in 2006, was $40.4 million in 2006, $38.7 million in 2005 and $38.0 million in 2004. Noninterest income, excluding investment securities net gains and losses and the gain on the sale of loans in 2006, increased $1.7 million, or 4.5%, in 2006 and increased $0.7 million, or 1.9%, in 2005. The increase in 2006, compared to 2005, was primarily attributable to increases in service charges on deposit accounts, other fees for customer services and investment fees. The increase in 2005, compared to 2004, was primarily attributable to higher service charges on deposit accounts, investment fees and trust services revenue that was partially offset by lower mortgage banking revenue and insurance commissions.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS

OPERATING EXPENSES

 

Total operating expenses were $97.9 million in 2006 and $98.5 million in 2005 and 2004.

 

The following schedule includes the major categories of operating expenses during the past three years.