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Table of Contents

mac

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2020

OR

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

For the transition period from <> to <>

Commission file number: 0-20167

MACKINAC FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

MICHIGAN

38-2062816

(State or other jurisdiction of

(I.R.S. Employer Identification No.)

incorporation or organization)

130 SOUTH CEDAR STREET, MANISTIQUE, MI

49854

(Address of principal executive offices)

(Zip Code)

Registrant’s telephone number, including area code: (888) 343-8147

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

Title of each class:

    

Trading Symbol

    

Name of each exchange on which registered:

Commmon Stock, No par value

MFNC

The NASDAQ Stock Market, LLC

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, (or for such shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes       No  

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).  Yes       No  

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

Large Accelerated Filer  

Accelerated Filer  

Non-accelerated Filer     

Smaller reporting company  

Emerging growth company  

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes       No  

As of November 6, 2020, there were outstanding 10,533,589 shares of the registrant’s common stock, no par value.

Table of Contents

MACKINAC FINANCIAL CORPORATION

INDEX

    

Page No.

PART I.

FINANCIAL INFORMATION

Item 1.

Financial Statements

Condensed Consolidated Balance Sheets – September 30, 2020 (Unaudited), December 31, 2019

1

Condensed Consolidated Statements of Operations — Three and Nine Months Ended September 30, 2020 (Unaudited) and September 30, 2019 (Unaudited)

2

Condensed Consolidated Statements of Comprehensive Income — Three and Nine Months Ended September 30, 2020 (Unaudited) and September 30, 2019 (Unaudited)

3

Condensed Consolidated Statements of Changes in Shareholders’ Equity — Three and Nine Months Ended September 30, 2020 (Unaudited) and September 30, 2019 (Unaudited)

4

Condensed Consolidated Statements of Cash Flows – Nine Months Ended September 30, 2020 (Unaudited) and September 30, 2019 (Unaudited)

6

Notes to Condensed Consolidated Financial Statements (Unaudited)

7

Item 2.

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

29

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

42

Item 4.

Controls and Procedures

46

PART II.

OTHER INFORMATION

Item 1.

Legal Proceedings

47

Item 1A.

Risk Factors

47

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

47

SIGNATURES

49

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MACKINAC FINANCIAL CORPORATION

PART I.  FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)

    

September 30,

    

December 31,

 

2020

2019

 

(Unaudited)

ASSETS

Cash and due from banks

$

173,693

$

49,794

Federal funds sold

 

76

 

32

Cash and cash equivalents

 

173,769

 

49,826

Interest-bearing deposits in other financial institutions

 

5,367

 

10,295

Securities available for sale

 

106,830

 

107,972

Federal Home Loan Bank stock

 

4,924

 

4,924

Loans:

Commercial

 

865,726

 

765,524

Mortgage

 

259,024

 

272,014

Consumer

 

19,575

 

21,238

Total Loans

 

1,144,325

 

1,058,776

Allowance for loan losses

 

(5,832)

 

(5,308)

Net loans

 

1,138,493

 

1,053,468

Premises and equipment

 

25,754

 

23,608

Other real estate held for sale

 

1,851

 

2,194

Deferred tax asset

 

1,758

 

3,732

Deposit based intangibles

4,537

5,043

Goodwill

19,574

19,574

Other assets

 

40,060

 

39,433

TOTAL ASSETS

$

1,522,917

$

1,320,069

LIABILITIES AND SHAREHOLDERS’ EQUITY

LIABILITIES:

Deposits:

Noninterest bearing deposits

$

432,390

$

287,611

NOW, money market, interest checking

 

417,508

 

373,165

Savings

 

129,633

 

109,548

CDs<$250,000

 

215,531

 

233,956

CDs>$250,000

 

15,654

 

12,775

Brokered

 

70,171

 

58,622

Total deposits

 

1,280,887

 

1,075,677

Federal funds purchased

6,225

Borrowings

 

63,505

 

64,551

Other liabilities

 

12,357

 

11,697

Total liabilities

 

1,356,749

 

1,158,150

SHAREHOLDERS’ EQUITY:

Common stock and additional paid in capital - No par value Authorized - 18,000,000 shares Issued and outstanding - 10,533,589 and 10,748,712 respectively

 

127,426

 

129,564

Retained earnings

 

37,144

 

31,740

Accumulated other comprehensive income (loss)

 

 

Unrealized gains on available for sale securities

2,008

1,025

Minimum pension liability

(410)

(410)

Total shareholders’ equity

 

166,168

 

161,919

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

$

1,522,917

$

1,320,069

1

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MACKINAC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in Thousands, Except per Share Data)

Three Months Ended

Nine Months Ended

September 30,

September 30,

    

2020

    

2019

    

2020

    

2019

 

(Unaudited)

(Unaudited)

INTEREST INCOME:

Interest and fees on loans:

Taxable

$

13,852

$

14,829

$

44,014

$

45,010

Tax-exempt

 

47

 

45

176

134

Interest on securities:

Taxable

 

519

 

675

1,700

2,058

Tax-exempt

 

151

 

78

390

261

Other interest income

 

119

 

403

514

1,155

Total interest income

 

14,688

 

16,030

 

46,794

 

48,618

INTEREST EXPENSE:

Deposits

 

1,352

 

2,464

4,986

7,333

Borrowings

 

284

 

242

901

728

Total interest expense

 

1,636

 

2,706

 

5,887

 

8,061

Net interest income

 

13,052

 

13,324

 

40,907

 

40,557

Provision for loan losses

 

400

 

50

600

350

Net interest income after provision for loan losses

 

12,652

 

13,274

 

40,307

 

40,207

OTHER INCOME:

Deposit service fees

 

260

383

900

1,197

Income from mortgage loans sold on the secondary market

 

1,968

586

4,018

1,253

SBA/USDA loan sale gains

 

476

496

1,460

650

Net mortgage servicing fees

 

247

238

640

486

Other

 

165

175

402

519

Total other income

 

3,116

 

1,878

 

7,420

 

4,105

OTHER EXPENSE:

Salaries and employee benefits

 

6,487

5,669

19,547

16,615

Occupancy

 

1,163

987

3,295

3,072

Furniture and equipment

 

846

768

2,452

2,209

Data processing

 

801

785

2,478

2,202

Advertising

168

203

692

726

Professional service fees

 

474

536

1,546

1,517

Loan origination expenses and deposit and card related fees

 

413

314

1,200

677

Writedowns and losses on other real estate held for sale

 

(21)

(24)

13

77

FDIC insurance assessment

 

135

(141)

450

70

Communications

 

248

221

685

681

Other

 

847

1,126

2,927

3,105

Total other expenses

 

11,561

 

10,444

 

35,285

 

30,951

Income before provision for income taxes

 

4,207

 

4,708

 

12,442

 

13,361

Provision for income taxes

 

883

989

2,613

2,806

NET INCOME

$

3,324

$

3,719

$

9,829

$

10,555

INCOME PER COMMON SHARE:

Basic

$

0.32

$

0.35

$

0.93

$

0.98

Diluted

$

0.32

$

0.35

$

0.93

$

0.98

2

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MACKINAC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS COMPREHENSIVE INCOME

(Dollars in Thousands)

(Unaudited)

Three Months Ended

Nine Months Ended

September 30,

September 30,

2020

    

2019

2020

    

2019

Net income

$

3,324

$

3,719

$

9,829

$

10,555

Other comprehensive income (loss)

Change in securities available for sale:

Unrealized gains (losses) arising during the period

 

(65)

101

 

1,244

1,756

Tax effect

 

14

(21)

 

(261)

(369)

Net change in unrealized gains on available for sale securities

(51)

80

983

1,387

Total comprehensive income

$

3,273

$

3,799

$

10,812

$

11,942

3

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MACKINAC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Dollars in Thousands)

(Unaudited)

Nine Months Ended

September 30,

2020

Common

Accumulated

Shares of

Stock and

Other

Common

Additional

Retained

Comprehensive

    

Stock

    

Paid in Capital

    

Earnings

    

Income (loss)

    

Total

 

Balance, beginning of period

10,748,712

 

$

129,564

 

$

31,740

 

$

615

 

$

161,919

Net income for period

 

 

9,829

 

 

9,829

Other comprehensive income

Net unrealized gain on securities available for sale

 

 

 

983

 

983

Total comprehensive income

 

 

9,829

 

983

 

10,812

Stock compensation

 

591

 

 

 

591

Issuance of common stock:

Restricted stock award vesting

25,521

 

 

 

 

Repurchase of common stock

(240,644)

(2,729)

(2,729)

Dividend on common stock

 

 

(4,425)

 

 

(4,425)

Balance, end of period

10,533,589

 

$

127,426

 

$

37,144

 

$

1,598

 

$

166,168

Nine Months Ended

September 30,

2019

Common

Accumulated

Shares of

Stock and

Other

Common

Additional

Retained

Comprehensive

    

Stock

    

Paid in Capital

    

Earnings

    

Income (Loss)

    

Total

 

Balance, beginning of period

10,712,745

$

129,066

$

23,466

$

(463)

$

152,069

Net income for period

 

 

10,555

 

 

10,555

Other comprehensive income

Net unrealized gain on securities available for sale

 

 

 

1,387

 

1,387

Total comprehensive income

 

 

10,555

 

1,387

 

11,942

Stock compensation

 

226

 

 

226

Issuance of common stock:

Restricted stock award vesting

27,967

 

 

 

 

Dividend on common stock

 

 

(4,072)

 

 

(4,072)

Balance, end of period

10,740,712

$

129,292

$

29,949

$

924

$

160,165

4

Table of Contents

MACKINAC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Dollars in Thousands)

(Unaudited)

Three Months Ended

September 30,

2020

Common

Accumulated

Shares of

Stock and

Other

Common

Additional

Retained

Comprehensive

    

Stock

    

Paid in Capital

    

Earnings

    

Income

    

Total

 

Balance, beginning of period

 

10,533,589

 

$

127,213

 

$

35,295

 

$

1,649

 

$

164,157

Net income for period

 

 

 

3,324

 

 

3,324

Other comprehensive income

Net unrealized gain on securities available for sale

 

 

 

 

(51)

 

(51)

Total comprehensive income

 

 

 

3,324

 

(51)

 

3,273

Stock compensation

 

 

213

 

 

 

213

Issuance of common stock:

Restricted stock award vesting

 

 

 

 

 

Repurchase of common stock

 

 

 

 

 

Dividend on common stock

 

 

 

(1,475)

 

 

(1,475)

Balance, end of period

 

10,533,589

 

$

127,426

 

$

37,144

 

$

1,598

 

$

166,168

Three Months Ended

September 30,

2019

Common

Accumulated

Shares of

Stock and

Other

Common

Additional

Retained

Comprehensive

    

Stock

    

Paid in Capital

    

Earnings

    

Income

    

Total

 

Balance, beginning of period

10,740,712

$

129,262

$

27,734

$

844

$

157,840

Net income for period

 

 

3,719

 

 

3,719

Other comprehensive income

Net unrealized gain on securities available for sale

 

 

 

80

 

80

Total comprehensive income

 

 

3,719

 

80

 

3,799

Stock compensation

 

30

 

 

30

Issuance of common stock:

Restricted stock award vesting

 

 

 

 

Dividend on common stock

 

 

(1,504)

 

 

(1,504)

Balance, end of period

10,740,712

$

129,292

$

29,949

$

924

$

160,165

5

Table of Contents

MACKINAC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

(Unaudited)

Nine Months Ended

September 30,

    

2020

    

2019

 

Cash Flows from Operating Activities:

Net income

 

$

9,829

 

$

10,555

Adjustments to reconcile net income to net cash provided by operating activities:

Depreciation and amortization

 

2,151

 

2,885

Provision for loan losses

 

600

 

350

Deferred tax expense, net

 

(65)

 

883

Gain on sale of loans sold in the secondary market

 

(3,472)

 

(1,032)

Origination of loans held for sale in the secondary market

 

(155,179)

 

(55,134)

Proceeds from sale of loans in the secondary market

 

160,972

 

56,166

Gain (Loss) on sale of other real estate held for sale

 

(38)

 

18

Writedown of other real estate held for sale

 

51

 

59

Stock compensation

 

591

 

226

Change in other assets

 

768

 

(8,350)

Change in other liabilities

 

598

 

3,509

Net cash provided by operating activities

 

16,806

 

10,135

Cash Flows from Investing Activities:

Net increase in loans

 

(87,443)

(24,650)

Net decrease in interest bearing deposits in other financial institutions

 

4,928

2,177

Purchase of securities available for sale

 

(26,783)

(7,776)

Proceeds from maturities, sales, calls or paydowns of securities available for sale

 

29,054

18,359

Capital expenditures

 

(4,528)

(1,828)

Proceeds from sale of other real estate, premises and fixed assets

 

1,124

742

Net cash used in investing activities

 

(83,648)

 

(12,976)

Cash Flows from Financing Activities:

Net increase in deposits

 

205,210

16,042

Net decrease in fed funds purchased

(6,225)

(2,905)

New term debt issuance

100,281

25,000

Principal payments on borrowings

 

(101,327)

(12,457)

Repurchase of common stock

(2,729)

Dividend on common stock

 

(4,425)

(4,072)

Net cash provided by financing activities

 

190,785

 

21,608

Net increase (decrease) in cash and cash equivalents

 

123,943

 

18,767

Cash and cash equivalents at beginning of period

 

49,826

 

64,157

Cash and cash equivalents at end of period

 

$

173,769

 

$

82,924

Supplemental Cash Flow Information:

Cash paid during the year for:

Interest

 

$

6,006

 

$

7,749

Income taxes

 

 

1,500

Noncash Investing and Financing Activities:

Transfers of Foreclosures from Loans to Other Real Estate Held for Sale

 

503

 

1,331

Transfers of Other Real Estate Held for Sale to Fixed Assets

1,013

6

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The unaudited condensed consolidated financial statements of Mackinac Financial Corporation (the “Corporation”) have been prepared in accordance with generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended September 30, 2020 are not necessarily indicative of the results that may be expected for the year ending December 31, 2020. The unaudited consolidated financial statements and footnotes thereto should be read in conjunction with the audited consolidated financial statements and footnotes thereto included in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2019.

In order to properly reflect some categories of other income and other expenses, reclassifications of expense and income items have been made to prior period numbers. The “net” other income and other expenses were unchanged by these reclassifications.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of investment securities, the valuation of foreclosed real estate, deferred tax assets, mortgage servicing rights, the assessment of goodwill for impairment, and the fair value of assets and liabilities acquired in business combinations.

Acquired Loans

Loans acquired with evidence of credit deterioration since inception and for which it is probable that all contractual payments will not be received are accounted for under ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”). These loans are recorded at fair value at the time of acquisition, with no carryover of the related allowance for loan losses. Fair value of acquired loans is determined using a discounted cash flow methodology based on assumptions about the amount and timing of principal and interest payments, principal prepayments and principal defaults and losses, and current market rates.

In recording the fair values of acquired impaired loans at acquisition date, management calculates a non-accretable difference (the credit component of the purchased loans) and an accretable difference (the yield component of the purchased loans).

Over the life of the acquired loans, management continues to estimate cash flows expected to be collected. We evaluate at each balance sheet date whether it is probable that we will be unable to collect all cash flows expected at acquisition and if so, recognize a provision for loan loss in our consolidated statement of operations. For any significant increases in cash flows expected to be collected, we adjust the amount of the accretable yield recognized on a prospective basis over the pool’s remaining life.

Performing acquired loans are accounted for under Financial Accounting Standards Board (“FASB”) Topic 310-20, Receivables – Nonrefundable Fees and Other Costs. Performance of certain loans may be monitored and based on management’s assessment of the cash flows and other facts available, portions of the accretable difference may be delayed or suspended if management deems appropriate. The Corporation’s policy for determining when to discontinue accruing interest on performing acquired loans and the subsequent accounting for such loans is essentially the same as the policy for originated loans.

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Allowance for Loan Losses

The allowance for loan losses includes specific allowances related to loans, when they have been judged to be impaired. A loan is impaired when, based on current information, it is probable that the Corporation will not collect all amounts due in accordance with the contractual terms of the loan agreement. These specific allowances are based on discounted cash flows of expected future payments using the loan’s initial effective interest rate or the fair value of the collateral if the loan is collateral dependent.

The Corporation also has an unallocated allowance for loan losses for loans not considered impaired. The allowance for loan losses is maintained at a level which management believes is adequate to provide for probable loan losses. Management periodically evaluates the adequacy of the allowance using the Corporation’s past loan loss experience, known and inherent risks in the portfolio, composition of the portfolio, current economic conditions, and other factors. The allowance does not include the effects of expected losses related to future events or future changes in economic conditions. This evaluation is inherently subjective since it requires material estimates that may be susceptible to significant change. Loans are charged against the allowance for loan losses when management believes the collectability of the principal is unlikely. In addition, various regulatory agencies periodically review the allowance for loan losses. These agencies may require additions to the allowance for loan losses based on their judgments of collectability.

In management’s opinion, the allowance for loan losses is adequate to cover probable losses relating to specifically identified loans, as well as probable losses inherent in the balance of the loan portfolio as of the balance sheet date.

Stock Compensation Plans

On May 22, 2012, the Corporation’s shareholders approved the Mackinac Financial Corporation 2012 Incentive Compensation Plan, under which current and prospective employees, non-employee directors and consultants may be awarded incentive stock options, non-statutory stock options, shares of restricted stock awards (“RSAs”), stock grants, or stock appreciation rights. The aggregate number of shares of the Corporation’s common stock issuable under the plan is 575,000. At September 30, 2020 there were 78,560 shares available for issuance under this plan. Awards are made to certain other senior officers at the discretion of the Corporation’s management. Compensation cost equal to the fair value of the award is recognized over the vesting period.

2.

RECENT ACCOUNTING PRONOUNCEMENTS

In September 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"). ASU 2016-13 changes how entities will measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income.

ASU 2016-13 requires an entity to measure expected credit losses for financial assets over the estimated lifetime of expected credit loss and record an allowance that, when deducted from the amortized cost basis of the financial asset, presents the net amount expected to be collected on the financial asset. The standard includes the following core concepts in determining the expected credit loss.  The estimate must: (a) be based on an asset’s amortized cost (including premiums or discounts, net deferred fees and costs, foreign exchange and fair value hedge accounting adjustments), (b) reflect losses expected over the remaining contractual life of an asset (considering the effect of voluntary prepayments), (c) consider available relevant information about the estimated collectability of cash flows (including information about past events, current conditions, and reasonable and supportable forecasts), and (d) reflect the risk of loss, even when that risk is remote.

ASU 2016-13 also amends the recording of purchased credit-deteriorated assets. Under the new guidance, an allowance will be recognized at acquisition through a gross-up approach whereby an entity will record as the initial amortized cost the sum of (a) the purchase price and (b) an estimate of credit losses as of the date of acquisition. In addition, the guidance also requires immediate recognition in earnings of any subsequent changes, both favorable and unfavorable, in expected cash flows by adjusting this allowance.

ASU 2016-13 also amends the impairment model for available-for-sale debt securities and requires entities to determine whether all or a portion of the unrealized loss on an available-for-sale debt security is a credit loss. Management may not use the length of time a security has been in an unrealized loss position as a factor in concluding whether a credit loss exists, as is currently permitted. In addition, an entity will recognize an allowance for credit losses on available-for-sale

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debt securities as a contra-account to the amortized cost basis rather than as a direct reduction of the amortized cost basis of the investment, as is currently required. As a result, entities will recognize improvements to credit losses on available-for-sale debt securities immediately in earnings rather than as interest income over time under current practice.

New disclosures required by ASU 2016-13 include: (a) for financial assets measured at amortized cost, an entity will be required to disclose information about how it developed its allowance, including changes in the factors that influenced management’s estimate of expected credit losses and the reasons for those changes, (b) for financial receivables and net investments in leases measured at amortized cost, an entity will be required to further disaggregate the information it currently discloses about the credit quality of these assets by year or the asset’s origination or vintage for as many as five annual periods, and (c) for available-for-sale debt securities, an entity will be required to provide a roll-forward of the allowance for credit losses and an aging analysis for securities that are past due.

Upon adoption of ASU 2016-13, a cumulative-effect adjustment to retained earnings will be recorded as of the beginning of the first reporting period in which the guidance is effective. The Corporation is currently evaluating the provisions of ASU 2016-13 to determine the potential impact on the Corporation's consolidated financial condition and results of operations.  The Corporation has formed a cross-functional implementation team consisting of individuals from finance, credit and information systems.  A project plan and timeline has been developed and the implementation team meets regularly to assess the project status to ensure adherence to the timeline.  The implementation team has also been working with a software vendor to assist in implementing required changes to credit loss estimation models and proceses, and is finalizing the historical data collected to be utilized in the credit loss models.  The Corporation expects to recognize a cumulative effect adjustment to the opening balance of retained earnings as of the beginning of the first reporting period in which ASU 2016-13 is effective.  The Corporation has not yet determined the magnitude of any such one-time adjustment or the potential impact of ASU 2016-13 on its condensed consolidated financial statements.  In October 2019 the Financial Accounting Standards Board (FASB) voted to defer the effective date of ASU 2016-13 to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years, for smaller reporting companies (as defined by the Securities Exchange Commission).  As the Corporation qualifies as a smaller reporting company, management plans to delay the implementation of CECL beyond 2020 and adjust the timetable of the various CECL implementation tasks.  Management believes that the Corporation will benefit from additional time to run parallel testing and refine credit loss estimation models.

3.

EARNINGS PER SHARE

Diluted earnings per share, which reflects the potential dilution that could occur if stock awards were fully vested and resulted in the issuance of common stock that then shared in our earnings, is computed by dividing net income by the weighted average number of common shares outstanding and common stock equivalents, after giving effect for dilutive shares issued. For the three and nine month periods ended September 30, 2020, approximately 169,000 unvested restricted stock awards were excluded from the calculation of earnings per share because they were antidilutive. For the three and nine month periods ended September 30, 2019, no awards were antidilutive.

The following shows the computation of basic and diluted earnings per share for the three and nine months ended September 30, 2020 and 2019 (dollars in thousands, except per share data):

Three Months Ended September 30,

Nine Months Ended September 30,

    

2020

    

2019

    

2020

    

2019

 

(Numerator):

Net income

$

3,324

$

3,719

$

9,829

$

10,555

(Denominator):

Weighted average shares outstanding

 

10,533,589

 

10,740,712

 

10,594,824

 

10,730,477

Effect of restricted stock awards

 

 

11,466

 

 

13,642

Diluted weighted average shares outstanding

 

10,533,589

 

10,752,178

 

10,594,824

 

10,744,119

Income per common share:

Basic

$

0.32

$

0.35

$

0.93

$

0.98

Diluted

$

0.32

$

0.35

$

0.93

$

0.98

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Table of Contents

4.

INVESTMENT SECURITIES

At September 30, 2020 the Corporation had an investment security portfolio totaling $106.830 million, a decrease of $1.142 million from the December 31, 2019 balance of $107.972 million. The amortized cost and estimated fair value of investment securities available for sale as of September 30, 2020 and December 31, 2019 are as follows (dollars in thousands):

Gross

Gross

 

Amortized

Unrealized

Unrealized

Estimated

 

    

Cost

    

Gains

    

Losses

    

Fair Value

 

September 30, 2020

Corporate

 

$

21,151

$

192

$

(111)

$

21,232

US Agencies

 

9,472

143

9,615

US Agencies - MBS

31,557

948

(8)

32,497

Obligations of states and political subdivisions

 

42,109

 

1,377

 

43,486

Total securities available for sale

 

$

104,289

 

$

2,660

 

$

(119)

 

$

106,830

December 31, 2019

Corporate

 

$

20,779

$

160

$

(1)

$

20,938

US Agencies

14,450

47

(1)

14,496

US Agencies - MBS

 

34,063

 

492

 

(29)

 

34,526

Obligations of states and political subdivisions

 

37,382

 

630

 

 

38,012

Total securities available for sale

 

$

106,674

 

$

1,329

 

$

(31)

 

$

107,972

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Table of Contents

The following table presents the amortized cost and estimated fair value of investment securities by contractual maturity as of September 30, 2020 and December 31, 2019 (dollars in thousands):

September 30,

December 31,

2020

2019

Amortized

Estimated

Amortized

Estimated

Cost

    

Fair Value

    

Cost

    

Fair Value

    

Available -for-sale securities

Under 1 year

$

12,042

$

12,147

$

21,532

$

21,575

After 1 year through 5 years

31,232

32,085

40,063

40,664

After 5 years through 10 years

12,944

13,067

10,019

10,189

After 10 years

16,514

17,034

997

1,018

Subtotal

72,732

74,333

72,611

73,446

US Agencies - MBS

31,557

32,497

34,063

34,526

Total available -for-sale securities

$

104,289

$

106,830

$

106,674

$

107,972

The following is information pertaining to securities with gross unrealized losses at September 30, 2020 and December 31, 2019 (dollars in thousands):

Less Than Twelve Months

Over Twelve Months

Total

Number

Gross

Number

Gross

Number

Gross

    

of

    

Fair

    

Unrealized

of

    

Fair

    

Unrealized

of

    

Fair

    

Unrealized

September 30, 2020

Securities

Value

Loss

Securities

Value

Loss

Securities

Value

Loss

Corporate

2

$

3,890

$

(111)

$

$

2

$

3,890

$

(111)

US Agencies

US Agencies - MBS

5

209

(7)

1

19

(1)

6

228

(8)

Obligations of states and political subdivisions

Total

7

$

4,099

$

(118)

1

$

19

$

(1)

8

$

4,118

$

(119)

Less Than Twelve Months

Over Twelve Months

Total

Number

Gross

Number

Gross

Number

Gross

    

of

    

Fair

    

Unrealized

of

    

Fair

    

Unrealized

of

    

Fair

    

Unrealized

December 31, 2019

Securities

Value

Loss

Securities

Value

Loss

Securities

Value

Loss

Corporate

1

$

2,502

$

(1)

$

$

1

$

2,502

$

(1)

US Agencies

1

500

(1)

1

500

(1)

US Agencies - MBS

10

6,966

(9)

13

1,233

(20)

23

8,199

(29)

Obligations of states and political subdivisions

1

115

1

115

Total

11

$

9,468

$

(10)

15

$

1,848

$

(21)

26

$

11,316

$

(31)

The Corporation has evaluated gross unrealized losses that exist within the portfolio and considers them temporary in nature. The Corporation has both the ability and the intent to hold the investment securities until their respective maturities and therefore does not anticipate the realization of the temporary losses.

The amortized cost and estimated fair value of investment securities pledged to secure FHLB borrowings and customer relationships were $26.802 million and $27.594 million, respectively, at September 30, 2020.

11

Table of Contents

5.

LOANS

The composition of loans is as follows (dollars in thousands):

    

September 30,

December 31,

2020

    

2019

    

Commercial real estate

$

499,793

$

514,394

Commercial, financial, and agricultural

 

326,771

 

211,023

Commercial construction

 

39,162

 

40,107

One to four family residential real estate

 

237,336

 

253,918

Consumer

 

19,575

 

21,238

Consumer construction

21,688

18,096

Total loans

$

1,144,325

$

1,058,776

The Corporation completed the acquisition of Peninsula Financial Corporation (“PFC”) on December 5, 2014, The First National Bank of Eagle River (“Eagle River”) on April 29, 2016, Niagara Bancorporation (“Niagara”) on August 31, 2016, First Federal of Northern Michigan Bancorp (“FFNM”) on May 18, 2018 and Lincoln Community Bank (“Lincoln”) on October 1, 2018. The PFC acquired impaired loans totaled $13.290 million, the Eagle River acquired impaired loans totaled $3.401 million, the Niagara acquired impaired loans totaled $2.105 million, the FFNM acquired impaired loans totaled $5.440 million, and the Lincoln acquired impaired loans totaled $1.901 million.

The table below details the outstanding balances of the PFC acquired portfolio and the fair value adjustments at acquisition date (dollars in thousands):

    

Acquired

    

Acquired

    

Acquired

Impaired

Non-impaired

Total

Loans acquired - contractual payments

$

13,290

$

53,849

$

67,139

Nonaccretable difference

 

(2,234)

 

 

(2,234)

Expected cash flows

 

11,056

 

53,849

 

64,905

Accretable yield

 

(744)

 

(2,100)

 

(2,844)

Carrying balance at acquisition date

$

10,312

$

51,749

$

62,061

The table below details the outstanding balances of the Eagle River acquired portfolio and the fair value adjustments at acquisition date (dollars in thousands):

    

Acquired

    

Acquired

    

Acquired

Impaired

Non-impaired

Total

Loans acquired - contractual payments

$

3,401

$

80,737

$

84,138

Nonaccretable difference

 

(1,172)

 

 

(1,172)

Expected cash flows

 

2,229

 

80,737

 

82,966

Accretable yield

 

(391)

 

(1,700)

 

(2,091)

Carrying balance at acquisition date

$

1,838

$

79,037

$

80,875

The table below details the outstanding balances of the Niagara acquired portfolio and the fair value adjustments at acquisition date (dollars in thousands):

    

Acquired

    

Acquired

    

Acquired

Impaired

Non-impaired

Total

Loans acquired - contractual payments

$

2,105

$

30,555

$

32,660

Nonaccretable difference

 

(265)

 

 

(265)

Expected cash flows

 

1,840

 

30,555

 

32,395

Accretable yield

 

(88)

 

(600)

 

(688)

Carrying balance at acquisition date

$

1,752

$

29,955

$

31,707

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Table of Contents

The table below details the outstanding balances of the FFNM acquired portfolio and the fair value adjustments at acquisition date (dollars in thousands):

    

Acquired

    

Acquired

    

Acquired

Impaired

Non-impaired

Total

Loans acquired - contractual payments

$

5,440

$

187,302

$

192,742

Nonaccretable difference

 

(2,100)

 

 

(2,100)

Expected cash flows

 

3,340

 

187,302

 

190,642

Accretable yield

 

(700)

 

(4,498)

 

(5,198)

Carrying balance at acquisition date

$

2,640

$

182,804

$

185,444

The table below details the outstanding balances of the Lincoln acquired portfolio and the fair value adjustments at acquisition date (dollars in thousands):

    

Acquired

    

Acquired

    

Acquired

Impaired

Non-impaired

Total

Loans acquired - contractual payments

$

1,901

$

37,700

$

39,601

Nonaccretable difference

 

(421)

 

 

(421)

Expected cash flows

 

1,480

 

37,700

 

39,180

Accretable yield

 

(140)

 

(493)

 

(633)

Carrying balance at acquisition date

$

1,340

$

37,207

$

38,547

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Table of Contents

The table below presents a rollforward of the accretable yield on acquired loans for the nine months ended September 30, 2020 (dollars in thousands):

PFC

Eagle River

    

Acquired

    

Acquired

    

Acquired

    

Acquired

    

Acquired

    

Acquired

Impaired

Non-impaired

Total

Impaired

Non-impaired

Total

Balance, December 31, 2019

$

105

$

$

105

$

209

$

$

209

Accretion

(202)

 

(202)

(104)

 

(104)

Reclassification from nonaccretable difference

151

151

78

78

Balance, September 30, 2020

$

54

$

$

54

$

183

$

$

183

Niagara

First Federal Northern Michigan

    

Acquired

    

Acquired

    

Acquired

    

Acquired

    

Acquired

    

Acquired

Impaired

Non-impaired

Total

Impaired

Non-impaired

Total

Balance, December 31, 2019

$

19

$

$

19

$

518

$

1,953

$

2,471

Accretion

(27)

 

(27)

(287)

(838)

 

(1,125)

Reclassification from nonaccretable difference

20

20

215

(15)

200

Balance, September 30, 2020

$

12

$

$

12

$

446

$

1,100

$

1,546

Lincoln Community Bank

Total

    

Acquired

    

Acquired

    

Acquired

Acquired

    

Acquired

    

Acquired

Impaired

Non-impaired

Total

Impaired

Non-impaired

Total

Balance, December 31, 2019

$

108

$

264

$

372

$

959

$

2,217

$

3,176

Accretion

(7)

(105)

 

(112)

(627)

(943)

 

(1,570)

Reclassification from nonaccretable difference

6

6

470

(15)

455

Balance, September 30, 2020

$

107

$

159

$

266

$

802

$

1,259

$

2,061

The table below presents a rollforward of the accretable yield on acquired loans for the nine months ended September 30, 2019 (dollars in thousands):

    

PFC

Eagle River

Acquired

Acquired

Acquired

Acquired

Acquired

Acquired

Impaired

    

Non-impaired

    

Total

    

Impaired

    

Non-impaired

    

Total

Balance, December 31, 2018

$

128

$

$

128

$

213

$

16

$

229

Accretion

(81)

 

(81)

(17)

(16)

 

(33)

Reclassification from nonaccretable difference

60

60

13

13

Balance, September 30, 2019

$

107

$

$

107

$

209

$

$

209

Niagara

First Federal Northern Michigan

Acquired

Acquired

Acquired

Acquired

Acquired

Acquired

Impaired

    

Non-impaired

    

Total

Impaired

    

Non-impaired

    

Total

Balance, December 31, 2018

$

26

$

69

$

95

$

571

$

3,446

$

4,017

Accretion

(14)

(69)

 

(83)

(145)

(1,157)

 

(1,302)

Reclassification from nonaccretable difference

11

11

109

109

Balance, September 30, 2019

$

23

$

$

23

$

535

$

2,289

$

2,824

Lincoln Community Bank

Total

Acquired

Acquired

Acquired

Acquired

Acquired

Acquired

Impaired

    

Non-impaired

    

Total

Impaired

    

Non-impaired

    

Total

Balance, December 31, 2018

$

140

$

442

$

582

$

1,078

$

3,973

$

5,051

Accretion

(109)

(138)

 

(247)

(366)

(1,380)

 

(1,746)

Reclassification from nonaccretable difference

82

82

275

275

Balance, September 30, 2019

$

113

$

304

$

417

$

987

$

2,593

$

3,580

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Table of Contents

Allowance for Loan Losses

An analysis of the allowance for loan losses for the nine months ended September 30, 2020 and September 30, 2019 is as follows (dollars in thousands):

September 30,

September 30,

    

2020

    

2019

    

Balance, January 1

$

5,308

$

5,183

Recoveries on loans previously charged off

 

240

 

199

Loans charged off

 

(316)

 

(424)

Provision

 

600

 

350

Balance at end of period

$

5,832

$

5,308

In the first nine months of 2020, net charge-offs were $76,000, compared to net charge-offs of $225,000 in the same period in 2019. In the first nine months of 2020, the Corporation recorded a provision for loan loss of $600,000 compared to a $350,000 provision for loan losses in the first nine months of 2019. The Corporation’s allowance for loan loss reserve policy calls for a measurement of the adequacy of the reserve at each quarter end. This process includes an analysis of the loan portfolio to take into account increases in loans outstanding and portfolio composition, historical loss rates, and specific reserve requirements of nonperforming loans.

A breakdown of the allowance for loan losses and recorded balances in loans at September 30, 2020 is as follows (dollars in thousands):

    

    

Commercial,

    

    

One to four

    

    

    

    

 

Commercial

financial and

Commercial

family residential

Consumer

real estate

agricultural

construction

real estate

construction

Consumer

Unallocated

Total

Three Months Ended September 30, 2020

Allowance for loan loss reserve:

Beginning balance ALLR

$

1,838

$

1,859

$

120

$

400

$

10

$

9

$

1,119

$

5,355

Charge-offs

 

(8)

(16)

 

(24)

Recoveries

 

7

1

79

4

10

 

101

Provision

 

28

(77)

(83)

(12)

5

539

 

400

Ending balance ALLR

$

1,873

$

1,783

$

116

$

384

$

10

$

8

$

1,658

$

5,832

Nine Months Ended September 30, 2020

Allowance for loan loss reserve:

Beginning balance ALLR

$

1,189

$

1,197

$

71

$

148

$

11

$

13

$

2,679

$

5,308

Charge-offs

 

(187)

(8)

(40)

(81)

 

(316)

Recoveries

 

98

1

80

15

46

 

240

Provision

 

586

772

(27)

261

(1)

30

(1,021)

 

600

Ending balance ALLR

$

1,873

$

1,783

$

116

$

384

$

10

$

8

$

1,658

$

5,832

At September 30, 2020

Loans:

Ending balance

$

499,793

$

326,771

$

39,162

$

237,336

$

21,688

$

19,575

$

$

1,144,325

Ending balance ALLR

 

(1,873)

 

(1,783)

 

(116)

(384)

 

(10)

 

(8)

 

(1,658)

 

(5,832)

Net loans

$

497,920

$

324,988

$

39,046

$

236,952

$

21,678

$

19,567

$

(1,658)

$

1,138,493

Ending balance ALLR:

Individually evaluated

$

564

$

847

$

$

$

$

$

$

1,411

Collectively evaluated

 

1,309

 

936

 

116

 

384

 

10

 

8

 

1,658

 

4,421

Total

$

1,873

$

1,783

$

116

$

384

$

10

$

8

$

1,658

$

5,832

Ending balance Loans:

Individually evaluated

$

2,349

$

1,483

$

$

$

$

$

$

3,832

Collectively evaluated

 

495,591

325,040

38,981

236,433

21,688

19,558

 

1,137,291

Acquired with deteriorated credit quality

1,853

248

181

903

17

3,202

Total

$

499,793

$

326,771

$

39,162

$

237,336

$

21,688

$

19,575

$

$

1,144,325

Impaired loans, by definition, are individually evaluated.

In the first nine months of 2020, the Corporation booked a provision for loan losses of $600,000 as a result of changes in environmental factors. Furthermore, a portion of the unallocated reserve was allocated due to a modification in the methodology for calculating the environmental factors.

15

Table of Contents

A breakdown of the allowance for loan losses and recorded balances in loans at September 30, 2019 is as follows (dollars in thousands):

    

    

Commercial,

    

    

One to four

    

    

    

    

 

Commercial

financial and

Commercial

family residential

Consumer

 

real estate

agricultural

construction

real estate

construction

Consumer

Unallocated

Total

 

Three Months Ended September 30, 2019

Allowance for loan loss reserve:

Beginning balance ALLR

$

1,208

$

861

$

77

$

228

$

5

$

10

$

2,917

$

5,306

Charge-offs

 

(7)

 

 

(19)

 

 

(52)

 

 

(78)

Recoveries

 

17

 

1

 

2

 

 

10

 

 

30

Provision

 

(6)

326

 

 

(29)

 

6

 

207

 

(454)

 

50

Ending balance ALLR

$

1,212

$

1,187

$

78

$

182

$

11

$

175

$

2,463

$

5,308

Nine Months Ended September 30, 2019

Allowance for loan loss reserve:

Beginning balance ALLR

$

1,682

$

648

$

101

$

199

$

6

$

8

$

2,539

$

5,183

Charge-offs

 

(27)

(103)

(139)

(155)

(424)

Recoveries

 

151

4

2

13

29

199

Provision

 

(594)

638

(25)

109

5

293

(76)

350

Ending balance ALLR

$

1,212

$

1,187

$

78

$

182

$

11

$

175

$

2,463

$

5,308

At September 30, 2019

Loans:

Ending balance

$

508,332

$

209,872

$

34,511

$

268,333

$

18,680

$

20,214

$

$

1,059,942

Ending balance ALLR

 

(1,212)

(1,187)

 

(78)

 

(182)

 

(11)

 

(175)

 

(2,463)

 

(5,308)

Net loans

$

507,120

$

208,685

$

34,433

$

268,151

$

18,669

$

20,039

$

(2,463)

$

1,054,634

Ending balance ALLR:

Individually evaluated

$

490

$

773

$

$

$

$

$

$

1,263

Collectively evaluated

 

722

 

414

 

78

 

182

 

11

 

175

 

2,463

 

4,045

Total

$

1,212

$

1,187

$

78

$

182

$

11

$

175

$

2,463

$

5,308

Ending balance Loans:

Individually evaluated

$

2,474

$

3,642

$

361

$

$

$

$

$

6,477

Collectively evaluated

 

503,669

 

204,023

 

33,773

 

267,342

 

18,680

 

20,185

 

 

1,047,672

Acquired with deteriorated credit quality

2,189

2,207

377

991

29

5,793

Total

$

508,332

$

209,872

$

34,511

$

268,333

$

18,680

$

20,214

$

$

1,059,942

As part of the management of the loan portfolio, risk ratings are assigned to all commercial loans. Through the loan review process, ratings are modified as believed to be appropriate to reflect changes in the credit. Our ability to manage credit risk depends in large part on our ability to properly identify and manage problem loans.

To do so, we operate a credit risk rating system under which our credit management personnel assign a credit risk rating to each loan at the time of origination and review loans on a regular basis to determine each loan’s credit risk rating on a scale of 1 through 8, with higher scores indicating higher risk. The credit risk rating structure used is shown below.

In the context of the credit risk rating structure, the term Classified is defined as a problem loan which may or may not be in a nonaccrual status, dependent upon current payment status and collectability.

Strong (1)

Borrower is not vulnerable to sudden economic or technological changes. They have “strong” balance sheets and are within an industry that is very typical for our markets or type of lending culture. Borrowers also have “strong” financial and cash flow performance and excellent collateral (low loan to value or readily available to liquidate collateral) in conjunction with an impeccable repayment history.

Good (2)

Borrower shows limited vulnerability to sudden economic change. These borrowers have “above average” financial and cash flow performance and a very good repayment history. The balance sheet of the company is also very good as compared to peer and the company is in an industry that is familiar to our markets or our type of lending. The collateral securing the deal is also very good in terms of its type, loan to value, and other relevant characteristics.

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Average (3)

Borrower is typically a well-seasoned business, however may be susceptible to unfavorable changes in the economy, and could be somewhat affected by seasonal factors. The borrowers within this category exhibit financial and cash flow performance that appear “average” to “slightly above average” when compared to peer standards and they show an adequate payment history. Collateral securing this type of credit is good, exhibiting above average loan to values, and other relevant characteristics.

Acceptable (4)

A borrower within this category exhibits financial and cash flow performance that appear adequate and satisfactory when compared to peer standards and they show a satisfactory payment history. The collateral securing the request is within supervisory limits and overall is acceptable. Borrowers rated acceptable could also be newer businesses that are typically susceptible to unfavorable changes in the economy, and more than likely could be affected by seasonal factors.

Acceptable Watch (44)

The borrower may have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Acceptable Watch assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. Examples of this type of credit include a start-up company fully based on projections, a documentation issue that needs to be corrected or a general market condition that the borrower is working through to get corrected.

Substandard (6)

Substandard loans are classified assets exhibiting a number of well-defined weaknesses that jeopardize normal repayment. The assets are no longer adequately protected due to declining net worth, lack of earning capacity, or insufficient collateral offering the distinct possibility of the loss of a portion of the loan principal. Loans classified as substandard clearly represent troubled and deteriorating credit situations requiring constant supervision.

Doubtful (7)

Loans in this category exhibit the same, if not more pronounced weaknesses used to describe the substandard credit. Loans are frozen with collection improbable. Such loans are not yet rated as Charge-off because certain actions may yet occur which would salvage the loan.

Charge-off/Loss (8)

Loans in this category are largely uncollectible and should be charged against the loan loss reserve immediately.

General Reserves:

For loans with a credit risk rating of 44 or better and any loans with a risk rating of 6 or 7 not considered impaired, reserves are established based on the type of loan collateral, if any, and the assigned credit risk rating.

Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogenous loans based on historical loss experience, and consideration of current environmental factors and economic trends, all of which may be susceptible to significant change.

Using a historical average loss by loan type as a base, each loan graded as higher risk is assigned a specific percentage. The residential real estate and consumer loan portfolios are assigned a loss percentage as a homogenous group. If, however, on an individual loan the projected loss based on collateral value and payment histories is in excess of the computed allowance, the allocation is increased for the higher anticipated loss. These computations provide the basis for the allowance for loan losses as recorded by the Corporation.

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Below is a breakdown of loans by risk category as of September 30, 2020 (dollars in thousands):

(1)

(2)

(3)

(4)

(44)

(6)

(7)

Rating

    

Strong

    

Good

    

Average

    

Acceptable

    

Acceptable Watch

    

Substandard

    

Doubtful

    

Unassigned

    

Total

Commercial real estate

$

8,802

$

12,059

$

215,700

$

255,094

$

3,619

$

4,519

$

$

$

499,793

Commercial, financial and agricultural

 

163,512

 

6,470

57,288

 

93,980

 

707

 

4,814

 

 

 

326,771

Commercial construction

 

 

40

 

19,063

 

16,671

 

600

 

385

 

 

2,403

 

39,162

One-to-four family residential real estate

 

 

2,167

 

5,617

 

17,889

 

372

2,356

 

208,935

 

237,336

Consumer construction

 

 

 

 

 

 

21,688

 

21,688

Consumer

 

 

91

152

 

498

 

 

76

 

18,758

 

19,575

Total loans

$

172,314

$

20,827

$

297,820

$

384,132

$

5,298

$

12,150

$

$

251,784

$

1,144,325

At September 30, 2020, $152.410 million of Paycheck Protection Program (“PPP”) loans are included with a risk rating of “1” in the Commercial, financial and agricultural category.

Below is a breakdown of loans by risk category as of December 31, 2019 (dollars in thousands):

(1)

(2)

(3)

(4)

(44)

(6)

(7)

Rating

    

Strong

    

Good

    

Average

    

Acceptable

    

Acceptable Watch

    

Substandard

    

Doubtful

    

Unassigned

    

Total

Commercial real estate

$

9,979

$

17,516

$

228,962

$

248,177

$

4,468

$

5,292

$

$

$

514,394

Commercial, financial and agricultural

 

15,126

 

4,510

 

70,748

 

115,229

 

930

 

4,480

 

 

 

211,023

Commercial construction

 

 

292

 

6,390

 

28,893

 

400

 

607

 

 

3,525

 

40,107

One-to-four family residential real estate

 

40

 

2,145

 

4,937

 

15,168

 

634

 

2,632

 

 

228,362

 

253,918

Consumer construction

 

 

 

 

 

 

 

 

18,096

 

18,096

Consumer

 

 

158

 

250

 

640

 

 

41

 

 

20,149

 

21,238

Total loans

$

25,145

$

24,621

$

311,287

$

408,107

$

6,432

$

13,052

$

$

270,132

$

1,058,776

Impaired Loans

Impaired loans are those which are contractually past due 90 days or more as to interest or principal payments, on nonaccrual status, or loans, the terms of which have been renegotiated to provide a reduction or deferral on interest or principal.

Loans are considered impaired when, based on current information and events, it is probable the Corporation will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

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The following is a summary of impaired loans and their effect on interest income (dollars in thousands):

Impaired Loans

Impaired Loans

Total

Unpaid

Related

with No Related

with Related

Impaired

Principal

Allowance for

    

Allowance

    

Allowance

    

Loans

    

Balance

    

Loan Losses

September 30, 2020

Commercial real estate

$

1,853

$

2,349

$

4,202

$

7,201

$

564

Commercial, financial and agricultural

 

248

 

1,483

 

1,731

 

4,395

 

847

Commercial construction

 

181

 

 

181

 

703

 

One to four family residential real estate

 

903

 

 

903

 

2,701

 

Consumer construction

 

 

 

 

 

Consumer

 

17

 

 

17

 

20

 

Total

$

3,202

$

3,832

$

7,034

$

15,020

$

1,411

December 31, 2019

Commercial real estate

$

4,318

$

2,374

$

6,692

$

7,937

$

497

Commercial, financial and agricultural

 

2,354

 

1,475

 

3,829

 

4,892

 

770

Commercial construction

 

373

 

 

373

 

386

 

One to four family residential real estate

 

1,920

 

 

1,920

 

2,881

 

Consumer construction

 

 

 

 

 

Consumer

 

9

 

 

9

 

33

 

Total

$

8,974

$

3,849

$

12,823

$

16,129

$

1,267

Individually Evaluated Impaired Loans

September 30, 2020

December 31, 2019

    

Average

Interest Income

    

Average

    

Interest Income

Balance for

Recognized for

Balance for

Recognized for

the Period

the Period

the Period

the Period

Commercial real estate

$

7,564

$

202

$

8,374

$

301

Commercial, financial and agricultural

1,426

11

1,144

2

Commercial construction

553

22

396

One to four family residential real estate

3,419

106

3,508

219

Consumer construction

Consumer

38

1

44

2

Total

$

13,000

$

342

$

13,466

$

524

A summary of past due loans at September 30, 2020 and December 31, 2019 is as follows (dollars in thousands):

September 30,

December 31,

 

2020

2019

 

30-89 days

    

90+ days

    

    

    

    

30-89 days

    

90+ days

    

    

    

 

Past Due

Past Due

Past Due

Past Due

 

(accruing)

(accruing)

Nonaccrual

Total

(accruing)

(accruing)

Nonaccrual

Total

 

 

Commercial real estate

$

975

$

$

680

$

1,655

$

1,055

$

$

671

$

1,726

Commercial, financial and agricultural

 

9,989

842

 

10,831

 

829

 

 

527

 

1,356

Commercial construction

 

156

46

 

202

 

59

 

 

105

 

164

One to four family residential real estate

 

663

3,790

 

4,453

 

4,357

 

11

 

3,850

 

8,218

Consumer construction

 

 

 

 

 

 

Consumer

 

109

56

 

165

 

83

 

 

19

 

102

Total past due loans

$

11,892

$

$

5,414

$

17,306

$

6,383

$

11

$

5,172

$

11,566

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Troubled Debt Restructuring

Troubled debt restructurings (“TDR”) are determined on a loan-by-loan basis. Generally restructurings are related to interest rate reductions, loan term extensions and short term payment forbearance as a means to maximize collectability of troubled credits. If a portion of the TDR loan is uncollectible (including forgiveness of principal), the uncollectible amount will be charged off against the allowance at the time of the restructuring. In general, a borrower must make at least six consecutive timely payments before the Corporation would consider a return of a restructured loan to accruing status in accordance with FDIC guidelines regarding restoration of credits to accrual status. More recent regulatory guidelines and accounting standards indicate that loan modifications or forbearances related to the COVID-19 pandemic will generally not be considered TDRs.

The Corporation has, in accordance with generally accepted accounting principles and applicable accounting standard updates, evaluated all loan modifications to determine the fair value impact of the underlying asset. The carrying amount of the loan is compared to the expected payments to be received, discounted at the loan’s original rate, or for collateral dependent loans, to the fair value of the collateral.

There were 4 TDRs that occurred during the nine months ended September 30, 2020 and 4 TDRs during the nine months ended September 30, 2019. The three restructured loans as of September 30, 2020, included only modifications to the repayment schedules. The balance of these restructured loans pre-modification was $.568 million. Post-modification balances as of September 30, 2020 were $.540 million. The three TDRs are not COVID-19 related.

Insider Loans

The Bank, in the ordinary course of business, grants loans to the Corporation’s executive officers and directors, including their families and firms in which they are principal owners. Activity in such loans is summarized below (dollars in thousands):

    

Nine Months Ended

Nine Months Ended

    

September 30,

September 30,

2020

    

2019

Loans outstanding, January 1

$

12,196

$

9,817

New loans

 

 

1,872

Net activity on revolving lines of credit

 

(752)

 

954

Change in status of insiders

(285)

Repayment

 

(134)

 

(673)

Loans outstanding at end of period

$

11,310

$

11,685

There were no loans to related parties classified substandard as of September 30, 2020 or September 30, 2019. In addition to the outstanding balances above, there were unfunded commitments of $.752 million to related parties at September 30, 2020.

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6.

GOODWILL AND OTHER INTANGIBLE ASSETS

The Corporation through the acquisition of Peninsula in 2014, Eagle River and Niagara in 2016, and FFNM and Lincoln in 2018, has recorded goodwill and core deposit intangibles as presented below (dollars in thousands):

Deposit Based

Goodwill

Intangible

    

Balance

    

Initial Balance

    

Peninsula

 

$

3,805

 

$

1,206

Eagle River

 

1,839

 

 

993

Niagara

 

50

 

 

300

FFNM

12,628

2,894

Lincoln

1,252

1,353

Total

$

19,574

$

6,746

Deposit Based

Amortization Expense

Intangible

for the

Future Annual

September 30, 2020

nine months ended

Amortization

Balance

    

September 30, 2020

Expense

Peninsula

$

503

 

$

90

$

121

Eagle River

 

554

 

 

74

 

99

Niagara

 

178

 

 

23

 

30

FFNM

2,219

217

290

Lincoln

1,083

102

135

Total

$

4,537

$

506

$

675

Deposit Based

Intangible

2019

December 31, 2019

Amortization

Balance

    

Expense

Peninsula

$

594

 

$

121

Eagle River

 

629

 

 

99

Niagara

 

200

 

 

30

FFNM

2,436

299

Lincoln

1,184

128

Total

$

5,043

$

677

The deposit based intangible asset is reported net of accumulated amortization at $4.537 million at September 30, 2020. Amortization expense in the first nine months of 2020 is $.506 million. Amortization expense for the next five years is expected to be at $.675 million per year.

The Corporation, in accordance with GAAP, evaluates goodwill annually for impairment. As a result of the current economic uncertainty and volatility surrounding COVID-19, the Corporation performed an interim analysis during the third quarter of 2020. The Corporation determined that there is currently no impairment of its goodwill.

7.

SERVICING RIGHTS

Mortgage Loans

Mortgage servicing rights (“MSRs”) are recorded when loans are sold in the secondary market with servicing retained. As of September 30, 2020, the Corporation had obligations to service approximately $218.009 million of residential first mortgage loans. The valuation of MSRs is based upon the net present value of the projected revenues over the expected life of the loans being serviced, as reduced by estimated internal costs to service these loans. On a quarterly basis, management evaluates the MSRs for impairment. The key economic assumptions used in determining the fair value of the MSRs include an annual constant prepayment speed of 17.09% and a discount rate of 7.75% as of September 30, 2020.

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The following table summarizes MSRs capitalized and amortized (dollars in thousands) for the nine month periods ending September 30, 2020 and September 30, 2019:

September 30,

September 30,

    

2020

    

2019

    

Balance at beginning of period

$

1,499

$

1,144

Additions from loans sold with servicing retained

500

Amortization

 

(105)

 

(105)

Balance at end of period

$

1,394

$

1,539

Balance of loan servicing portfolio

$

218,009

$

260,905

Mortgage servicing rights as % of portfolio

.64%

.59%

Fair value of servicing rights

1,746

2,283

Commercial Loans

The Corporation periodically retains the servicing on certain commercial loans that have been sold. These loans were originated and underwritten under the SBA and USDA government guarantee programs, in which the guaranteed portion of the loan was sold to a third party with servicing retained. The balance of these sold loans with servicing retained at September 30, 2020 was approximately $52 million. The Corporation valued these servicing rights at $165,000 as of September 30, 2020 and at $27,000 as of September 30, 2019. This valuation was established in consideration of the discounted cash flow of net expected servicing income over the life of the loans.

8.

BORROWINGS

Borrowings consist of the following at September 30, 2020 and December 31, 2019 (dollars in thousands):

    

September 30,

December 31,

    

2020

    

2019

    

Federal Home Loan Bank fixed rate advances

$

63,181

$

64,148

USDA Rural Development note

 

324

 

403

$

63,505

$

64,551

The Federal Home Loan Bank borrowings bear a weighted average rate of 1.67% and mature at various dates through 2026. They are collateralized at September 30, 2020 by the following: a collateral agreement on the Corporation’s one to four family residential real estate loans with a book value of approximately $56.314 million; mortgage related and municipal securities with an amortized cost and estimated fair value of $22.324 million and $22.979 million, respectively; and Federal Home Loan Bank stock owned by the Bank totaling $4.924 million. Prepayment of the advances is subject to the provisions and conditions of the credit policy of the Federal Home Loan Bank of Indianapolis in effect as of September 30, 2020.

The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), created the Paycheck Protection Program to support lending to small businesses that have been affected by the disruption caused by COVID-19. The Federal Reserve created the Paycheck Protection Program Lending Facility (PPPLF) to offer a source of liquidity to the financial institution lenders who lend to small businesses through the Small Business Administration’s (SBA) Paycheck Protection Program. The PPPLF bears an interest rate of 0.35% and is collateralized by the PPP loans pledged. There were no PPP loans pledged as of September 30, 2020 as the PPPLF was repaid during the third quarter of 2020.

The Corporation currently has one correspondent banking borrowing relationship. As of September 30, 2020 the relationship consisted of a $15.0 million revolving line of credit, which had no balance. The line of credit bears an interest rate of LIBOR plus 2.00%, with a floor rate of 3.00% and a ceiling of 22%. The line of credit expires April 30, 2022. LIBOR at September 30, 2020 was 0.23%. This relationship is secured by all of the outstanding mBank stock.

The USDA Rural Development borrowing bears an interest rate of 1.00% and matures in August, 2024. It is collateralized by an assignment of a demand deposit account held by the Corporation’s wholly owned subsidiary, First Rural Relending, in the amount of $.374 million, and guaranteed by the Corporation.

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9.

DEFINED BENEFIT PENSION PLAN

The Corporation acquired the Peninsula Financial Corporation noncontributory defined benefit pension plan in 2014. Effective December 31, 2005, the plan was amended to freeze participation in the plan; therefore, no additional employees are eligible to become participants in the plan. The benefits are based on years of service and the employee’s compensation at the time of retirement. The Plan was amended effective December 31, 2010, to freeze benefit accrual for all participants. Expected contributions to the Plan in 2020 are $139,000.

The anticipated distributions over the next five years and through December 31, 2029 are detailed in the table below (dollars in thousands):

2020

    

$

131

 

2021

 

129

2022

 

137

2023

 

143

2024

 

141

2025-2029

 

869

Total

$

1,550

The Corporation receives a valuation of the Plan annually. As such, at September 30, 2020, the plan’s assets had a fair value of $2.259 million and the Corporation had a net unfunded liability of $1.188 million. The accumulated benefit obligation at September 30, 2020 was $3.447 million.

Assumptions in the actuarial valuation are:

    

2020

    

2019

 

Weighted average discount rate

2.92%

4.02%

Rate of increase in future compensation levels

 

N/A

N/A

Expected long-term rate of return on plan assets

8.00%

8.00%

The expected long-term rate of return on plan assets reflects management’s expectations of long-term average rates of return on funds invested to provide for benefits included in the projected benefit obligation. The expected return is based on the outlook for inflation, fixed income returns and equity returns, while also considering historical returns, asset allocation and investment strategy. The discount rate assumption is based on investment yields available on AA rated long-term corporate bonds.

The primary investment objective is to maximize growth of the pension plan assets to meet the projected obligations to the beneficiaries over a long period of time, and to do so in a manner that is consistent with the Corporation’s risk tolerance. The intention of the plan sponsor is to invest the plan assets in mutual funds with the following asset allocation; which was in place at both September 30, 2020 and December 31, 2019.

    

Target

    

Actual

 

Allocation 

Allocation

Equity securities

 

50% to 70%

60%

Fixed income securities

 

30% to 50%

40%

10.

STOCK COMPENSATION PLANS

Restricted Stock Awards

The Corporation’s restricted stock awards are service-based and awarded based on performance. Each award has a vesting period of four years. Compensation expense is recognized on a straight-line basis over the vesting period. Shares are subject to certain restrictions and risk of forfeiture by the participants.

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The Corporation has historically granted RSAs to members of the Board of Directors and management. Awards granted are set to vest equally over their award terms and are issued at no cost to the recipient. The table below summarizes each of the grant awards:

Market Value at

Date of Award

    

Units Granted

    

grant date

    

Vesting Term

February, 2017

28,427

13.39

4 years

February, 2018

18,643

16.30

4 years

April, 2018

8,000

16.00

Immediate

February, 2019

27,790

15.70

4 years

October, 2019

8,000

15.40

Immediate

February, 2020

132,000

15.46

4 years

In the first nine months of 2020, the Corporation issued 25,521 shares of its common stock for vested RSAs. In the first nine months of 2019, the Corporation issued 27,967 shares of its common stock for vested RSAs.

A summary of changes in our nonvested shares for the period follows:

    

    

Weighted Average

 

Number

Grant Date

Outstanding

Fair Value

 

Nonvested balance at January 1, 2020

 

69,145

$

14.52

Granted during the period

 

132,000

 

15.46

Vested during the period

 

(25,521)

 

14.99

Nonvested balance at September 30, 2020

 

175,624

$

15.16

11.

INCOME TAXES

The Corporation has reported deferred tax assets of $1.758 million at September 30, 2020.

A valuation allowance is provided against deferred tax assets when it is more likely than not that some or all of the deferred tax asset will not be realized.  The Corporation, as of September 30, 2020 had a net operating loss carryforwards for tax purposes of approximately $10.2 million. As a result of the repeal of the corporate alternative minimum tax in the Tax Cuts and Jobs Act, any outstanding alternative minimum tax credits are believed to be utilized or refundable as of September 30, 2020. There are $1.3 million of alternative minimum tax credits, classified as a current tax receivable as of September 30, 2020.  A portion of the NOL and credit carryforwards are subject to the limitations for utilization as set forth in Section 382 of the Internal Revenue Code.  The annual limitation is $2.0 million for the NOL and the equivalent value of tax credits, which is approximately $.420 million.  These limitations for use were established in conjunction with the recapitalization of the Corporation in December 2004.  The Corporation will continue to evaluate the future benefits from these carryforwards in order to determine if any adjustment to the deferred tax asset is warranted.

The Corporation recognized a federal income tax expense of approximately $2.613 million for the nine months ended September 30, 2020 and $2.806 million for the nine months ended September 30, 2019.  

12.

FAIR VALUE MEASUREMENTS

Fair value estimates, methods, and assumptions are set forth below for the Corporation’s financial instruments.

Cash, cash equivalents, and interest-bearing deposits - The carrying values approximate the fair values for these assets.

Securities - Fair values are based on quoted market prices where available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Federal Home Loan Bank stock – Federal Home Loan Bank stock is carried at cost, which is its redeemable value and approximates its fair value, since the market for this stock is limited.

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Table of Contents

Loans - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, residential mortgage, and other consumer. The fair value of loans is calculated by discounting scheduled cash flows using discount rates reflecting the credit and interest rate risk inherent in the loan.

The methodology in determining fair value of nonaccrual loans is to average them into the blended interest rate at 0% interest. This has the effect of decreasing the carrying amount below the risk-free rate amount and, therefore, discounts the estimated fair value.

Impaired loans are measured at the estimated fair value of the expected future cash flows at the loan’s effective interest rate or the fair value of the collateral for loans which are collateral dependent. Therefore, the carrying values of impaired loans approximate the estimated fair values for these assets.

Deposits - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits and savings, is equal to the amount payable on demand at the reporting date. The fair value of time deposits is based on the discounted value of contractual cash flows applying interest rates currently being offered on similar time deposits.

Borrowings - Rates currently available for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt. The fair value of borrowed funds due on demand is the amount payable at the reporting date.

Accrued interest - The carrying amount of accrued interest approximates fair value.

Off-balance-sheet instruments - The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the current interest rates, and the present creditworthiness of the counterparties. Since the differences in the current fees and those reflected to the off-balance-sheet instruments at year-end are immaterial, no amounts for fair value are presented.

The following table presents information for financial instruments at September 30, 2020 and December 31, 2019 (dollars in thousands):

September 30, 2020

December 31, 2019

    

Level in Fair

    

Carrying

    

Estimated

    

Carrying

    

Estimated

 

Value Hierarchy

Amount

Fair Value

Amount

Fair Value

Financial assets:

Cash and cash equivalents

 

Level 1

$

173,769

$

173,769

$

49,826

$

49,826

Interest-bearing deposits

 

Level 2

 

5,367

5,367

 

10,295

 

10,295

Securities available for sale

 

Level 2

 

105,488

105,488

 

106,569

 

106,569

Securities available for sale

Level 3

1,342

1,342

1,403

1,403

Federal Home Loan Bank stock

 

Level 2

 

4,924

4,924

 

4,924

 

4,924

Net loans

 

Level 3

 

1,138,493

1,140,659

 

1,053,468

 

1,055,985

Accrued interest receivable

 

Level 3

 

4,443

4,443

 

3,751

 

3,751

Total financial assets

$

1,433,826

$

1,435,992

$

1,230,236

$

1,232,753

Financial liabilities:

Deposits

 

Level 2

$

1,280,887

$

1,281,656

$

1,075,677

$

1,044,267

Borrowings

 

Level 2

 

63,505

61,740

 

64,551

 

64,403

Accrued interest payable

 

Level 3

 

450

450

 

569

 

569

Total financial liabilities

$

1,344,842

$

1,343,846

$

1,140,797

$

1,109,239

Limitations - Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Corporation’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Corporation’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of

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significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on-and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial assets or liabilities include premises and equipment, other assets, and other liabilities. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

The following is information about the Corporation’s assets and liabilities measured at fair value on a recurring basis at September 30, 2020, and the valuation techniques used by the Corporation to determine those fair values.

Level 1:

In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that the Corporation has the ability to access.

Level 2:

Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3:

Level 3 inputs are unobservable inputs, including inputs available in situations where there is little, if any, market activity for the related asset or liability.

The fair value of all investment securities at September 30, 2020 and December 31, 2019 were based on level 2 and level 3 inputs. There are no other assets or liabilities measured on a recurring basis at fair value. For additional information regarding investment securities, please refer to “Note 4 - Investment Securities.”

The table below shows investment securities measured at fair value on a recurring basis (dollars in thousands):

Quoted Prices

Significant

Significant

Total (Gains)

Total (Gains)

in Active Markets

Other Observable

Unobservable

Losses for

Losses for

Balance at

for Identical Assets

Inputs

Inputs

Three Months Ended

Nine Months Ended

(dollars in thousands)

  

September 30, 2020

  

(Level 1)

  

(Level 2)

  

(Level 3)

  

September 30, 2020

    

September 30, 2020

Assets

Corporate

$

21,232

$

$

20,732

$

500

$

$

US Agencies

9,615

9,615

US Agencies - MBS

32,497

32,497

Obligations of state and political subdivisions

43,486

42,644

842

$

106,830

$

    

    

Quoted Prices

    

Significant

    

Significant

    

in Active Markets

Other Observable

Unobservable

Total (Gains) Losses for

Balance at

for Identical Assets

Inputs

Inputs

Twelve months ended

(dollars in thousands)

December 31, 2019

(Level 1)

(Level 2)

(Level 3)

December 31, 2019

Assets

Corporate

$

20,938

$

$

20,438

$

500

$

US Agencies

14,496

14,496

US Agencies - MBS

34,526

34,526

Obligations of state and political subdivisions

38,012

37,024

903

$

107,972

$

The Corporation had no Level 3 assets or liabilities measured at fair value on a recurring basis as of September 30, 2020, or December 31, 2019 other than as described above.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Corporation’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability.

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The Corporation also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets include certain impaired loans and other real estate owned. The Corporation has estimated the fair values of these assets using Level 3 inputs, specifically discounted cash flow projections.

Assets Measured at Fair Value on a Nonrecurring Basis at September 30, 2020

Quoted Prices

Significant

Significant

Total (Gains)

Total (Gains)

in Active Markets

Other Observable

Unobservable

Losses for

Losses for

Balance at

for Identical Assets

Inputs

Inputs

Three Months Ended

Nine Months Ended

(dollars in thousands)

    

September 30, 2020

    

(Level 1)

    

(Level 2)

    

(Level 3)

    

September 30, 2020

    

September 30, 2020

 

Assets

Impaired loans

$

7,034

$

$

$

7,034

$

$

58

Other real estate owned

1,851

1,851

(21)

10

$

(21)

68

Assets Measured at Fair Value on a Nonrecurring Basis at December 31, 2019

    

    

Quoted Prices

    

Significant

    

Significant

    

 

in Active Markets

Other Observable

Unobservable

Total Losses for

 

Balance at

for Identical Assets

Inputs

Inputs

Twelve months ended

 

(dollars in thousands)

December 31, 2019

(Level 1)

(Level 2)

(Level 3)

December 31, 2019

 

Assets

Impaired loans

$

12,823

$

$

$

12,823

$

280

Other real estate held for sale

 

2,194

2,194

212

$

492

Impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Corporation estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals).

13.

SHAREHOLDERS’ EQUITY

The Corporation currently has one active share repurchase program and one repurchase program that has since expired. All share repurchase programs are conducted under authorizations by the Board of Directors. Under the now expired program, the Corporation repurchased 1,661 shares in 2020, 14,000 shares in 2016, 102,455 shares in 2015, 13,700 shares in 2014 and 55,594 shares in 2013. The share repurchases were conducted under Board authorizations made and publicly announced of $.600 million on February 27, 2013, $.600 million on December 17, 2013 and an additional $.750 million on April 28, 2015.

On August 28, 2019, the Corporation, under the authorization of the Board of Directors announced a new common stock repurchase program. Under the Repurchase Program, the Company is authorized to repurchase up to approximately 5% of the Company’s outstanding common stock, and has no expiration date. During the first nine months of 2020, the Corporation repurchased 238,983 shares under this plan. As a result of the pandemic, the Corporation has temporarily paused its repurchase activity.

Total shares repurchased under stock repurchase plans in the first nine months of 2020 were 240,644.

14.COMMITMENTS, CONTINGENCIES AND CREDIT RISK

Financial Instruments With Off-Balance-Sheet Risk

The Corporation is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby

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letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

The Corporation’s exposure to credit loss, in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit, is represented by the contractual amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. These commitments are as follows (dollars in thousands):

    

September 30,

December 31,

2020

    

2019

    

Commitments to extend credit:

Variable rate

$

113,982

$

106,278

Fixed rate

 

77,073

 

50,796

Standby letters of credit - Variable rate

 

8,075

 

5,441

Credit card commitments - Fixed rate

 

6,828

 

5,841

$

205,958

$

168,356

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The commitments are structured to allow for 100% collateralization on all standby letters of credit.

Credit card commitments are commitments on credit cards issued by the Corporation’s subsidiary and serviced by other companies. These commitments are unsecured.

Legal Proceedings and Contingencies

In the normal course of business, the Corporation is involved in various legal proceedings. For an expanded discussion on the Corporation’s legal proceedings, see Part II, Item 1, “Legal Proceedings” in this report.

Concentration of Credit Risk

The Bank grants commercial, residential, agricultural, and consumer loans throughout Michigan and Northeastern Wisconsin. The Bank’s most prominent concentration in the loan portfolio relates to commercial real estate loans to operators of nonresidential buildings. This concentration at September 30, 2020 represents $136.372 million, or 15.75%, compared to $141.965 million, or 18.54%, of the commercial loan portfolio on December 31, 2019. The remainder of the commercial loan portfolio is diversified in such categories as hospitality and tourism, real estate agents and managers, new car dealers, gas stations and convenience stores, petroleum, forestry, agriculture and construction. Due to the diversity of the Bank’s locations, the ability of debtors of residential and consumer loans to honor their obligations is not tied to any particular economic sector.

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MACKINAC FINANCIAL CORPORATION

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward Looking Statements/Risk Factors

This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Corporation intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and is including this statement for purposes of these safe harbor provisions. Forward-looking statements which are based on certain assumptions and describe future plans, strategies, or expectations of the Corporation, are generally identifiable by use of the words “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project”, or similar expressions. The Corporation’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could cause actual results to differ from the results in forward-looking statements include, but are not limited to:

RISK FACTORS

Risks Related to our Lending and Credit Activities

The outbreak of the COVID-19 pandemic, including the severity, magnitude, duration and businesses’ and governments’ responses thereto, may have a negative impact on the Corportion’s operations and personnel, as well as on activity and demand across the customers it serves.

Our business may be adversely affected by conditions in the financial markets and economic conditions generally, as our borrowers’ ability to repay loans and the value of the collateral securing our loans decline.

Weakness in the markets for residential or commercial real estate, including the secondary residential mortgage loan markets, could reduce our net income and profitability.

As a community banking organization, the Corporation’s success depends upon local and regional economic conditions and the Corporation has different lending risks than larger banks.

We manage our credit exposure through careful monitoring of loan applicants and loan concentrations in particular industries and through loan approval and review procedures. We have established an evaluation process designed to determine the adequacy of our allowance for loan losses. While this evaluation process uses historical and other objective information, the classification of loans and the establishment of loan losses is estimated based on experience, judgment and expectations regarding borrowers and economic conditions, as well as regulator judgments. We can make no assurance that our loan loss reserves will be sufficient to absorb future loan losses or prevent a material adverse effect on our business, profitability or financial condition.

Our allowance for loan losses may be insufficient.

Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, and other factors, both within and outside of our control, may require an increase in our allowance for loan losses.

Risks Related to Our Operations

We are subject to interest rate risk.

Our earnings and cash flows are largely dependent upon our net interest income, which is the difference between interest income on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. There are many factors which influence interest rates that are beyond our control, including but not limited to general economic conditions and governmental policy, in particular, the policies of the FRB.

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Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition.

We may not realize the expected benefits of our acquisitions of First Federal of Northern Michigan or Lincoln Community Bank.

Our controls and procedures may fail or be circumvented.

Impairment of deferred income tax assets could require charges to earnings, which could result in an adverse impact on our results of operations.

In assessing the realizability of deferred income tax assets, management considers whether it is more likely than not that some allowance requires management to evaluate all available evidence, both negative and positive. Positive evidence necessary to overcome the negative evidence includes whether future taxable income in sufficient amounts and character within the carry back and carry forward periods is available under the tax law, including the use of tax planning strategies. When negative evidence (e.g. cumulative losses, history of operating loss or tax credit carry forwards expiring unused) exists, more positive evidence than negative evidence will be necessary. At September 30, 2020, net deferred tax assets were approximately $1.758 million. If a valuation allowance becomes necessary with respect to such balance, it could have a material adverse effect on our business, results of operations and financial condition.

Our information systems may experience an interruption or breach in security.

Risks Related to Legal and Regulatory Compliance

We operate in a highly regulated environment, which could increase our cost structure or have other negative impacts on our operations.

Strategic Risks

Maintaining or increasing our market share may depend on lowering prices and market acceptance of new products and services.

Future growth or operating results may require us to raise additional capital but that capital may not be available.

Reputation Risks

Unauthorized disclosure of sensitive or confidential client or customer information, whether through a breach of our computer system or otherwise, could severely harm our business.

Liquidity Risks

We could experience an unexpected inability to obtain needed liquidity.

The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure, its ability to liquidate assets and its access to alternative sources of funds. We seek to ensure our funding needs are met by maintaining an appropriate level of liquidity through asset/liability management.

Risks Related to an Investment in Our Common Stock

Limited trading activity for shares of our common stock may contribute to price volatility.

Our securities are not an insured deposit.

You may not receive dividends on your investment in common stock.

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Our ability to pay dividends is dependent upon our receipt of dividends from the Bank, which is subject to regulatory restrictions. Such restrictions, which govern state-chartered banks, generally limit the payment of dividends on bank stock to the bank’s undivided profits after all payments of all necessary expenses, provided that the bank’s surplus equals or exceeds its capital.

These risks and uncertainties should be considered in evaluating forward-looking statements. Further information concerning the Corporation and its business, including additional factors that could materially affect the Corporation’s financial results, is included in the Corporation’s filings with the Securities and Exchange Commission. All forward-looking statements contained in this report are based upon information presently available and the Corporation assumes no obligation to update any forward-looking statements.

The following discussion covers results of operations, asset quality, financial position, liquidity, interest rate sensitivity, and capital resources for the periods indicated. The information included in this discussion is intended to assist readers in their analysis of, and should be read in conjunction with, the consolidated financial statements, the related notes, and other supplemental information presented elsewhere in this report. It should be noted that there may be non-GAAP disclosures presented within this discussion to further assist readers in their analysis of the financial condition of the Corporation. This discussion should also be read in conjunction with the consolidated financial statements and footnotes contained in the Corporation’s Annual Report and Form 10-K for the year-ended December 31, 2019. Throughout this discussion and elsewhere in this report, the term “Bank” refers to mBank, the principal banking subsidiary of the Corporation.

FINANCIAL OVERVIEW

The Corporation recorded third quarter 2020 net income of $3.324 million, or $.32 per share, compared to net income of $3.719 million, or $.35 per share, for the third quarter of 2019.

Weighted average shares outstanding for the three month period in 2020 totaled 10,533,589, compared to 10,740,712  shares in the same period of 2019.  

The net interest income and net interest margin for the third quarter of 2020 was $13.052 million, or 4.37%, compared to $13.324 million, or 4.39%, for the third quarter of 2019. Net interest income in the third quarter of 2020 was positively impacted by the recognition of $.700 million of fees generated by participation in the PPP loan program.

Total assets of the Corporation at September 30, 2020 were $1.523 billion, up by $202.848 million, or 15.37%, from the $1.320 billion in total assets reported at year-end 2019. A large portion of this increase is a result of participation in the Payment Protection Program, of which we have current loan balances of $152.410 million.

As of the end of the third quarter of 2020, the Corporation had experienced no material adverse systemic issues or material deterioration in its loan portfolio prior to the COVID-19 pandemic. At the onset of COVID-19, the Corporation began to actively work to identify potential heightened industry and consumer exposure within the portfolio based on its footprint. The Corporation does expect that COVID-19 will unavoidably impact many of its customer’s businesses and will be prepared to assist these customers with appropriate relief using the regulatory guidance provided, particularly for industries experiencing negative environmental factors and risk trends. The Corporation will continue to refine these measures and continually assess its financial reporting and loan loss reserves as the Corporation and its customers work through the pandemic crisis in the upcoming quarters.

In response to the COVID-19 pandemic and in accordance with ASC 350-20-35-3c, the Corporation performed a qualitative evaluation of its goodwill during the third quarter of 2020. The analysis included an assessment of financial performance based on (but not limited to) pre-provision earnings, prior period comparisons, and peer comparisons. Additional considerations were given to macroeconomic conditions, industry and market conditions, and cost factors, among others and the impact of future performance. The Corporation, when factoring in all considerations, believes it is more likely than not that its fair value exceeds book value and therefore, did not perform a full quantitative assessment over the fair value of the Corporation, at September 30, 2020. The Corporation, in accordance with the aforementioned ASC 350-20-35-3c, will complete its annual impairment test over goodwill, including both qualitative and quantitative measures.

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FINANCIAL CONDITION

Cash and Cash Equivalents

Cash and cash equivalents increased $123.943 million during the first nine months of 2020, compared to 2019 year end. See further discussion of the change in cash and cash equivalents in the Liquidity section of this Quarterly Report on Form 10-Q.

Investment Securities

Securities available for sale increased $1.142 million from December 31, 2019 to September 30, 2020, with the balance on September 30, 2020 totaling $106.830 million. Investment securities are increased or decreased as appropriate as a result of managing interest rate risk and liquidity. As of September 30, 2020, investment securities with an estimated fair value of $27.594 million were pledged against borrowings at the FHLB and certain customer relationships.

Loans

Through the first nine months of 2020, loan balances increased by $85.549 million from December 31, 2019 balances of $1.059 billion. During the first nine months of 2020, the Bank had total loan production of $291.621 million, exclusive of PPP loans, which included $155.179 million of secondary market loan production. This loan production, however, was partially offset by loan amortization and payoffs. When including the PPP loans, total production was $444.127 million, which includes $152.510 million of PPP loans.

Management believes a properly positioned loan portfolio provides the most attractive earning asset yield available to the Corporation and, with a diligent loan approval process and exception reporting, management can effectively manage the risk in the loan portfolio. Management intends to continue to pursue loan growth within its markets for mortgage, consumer, and commercial loan products while concentrating on loan quality, industry concentration issues, and competitive pricing. The Corporation is highly competitive in structuring loans to meet borrowing needs, while maintaining strong underwriting requirements.

Following is a summary of the loan portfolio at September 30, 2020 and December 31, 2019 (dollars in thousands):

September 30,

Percent of

December 31,

Percent of

   

2020

   

Total

   

2019

   

Total

 

Commercial real estate

 

$

499,793

 

43.67%

$

514,394

 

48.58%

Commercial, financial, and agricultural

 

326,771

 

28.56

 

211,023

 

19.93

Commercial construction

 

39,162

 

3.42

 

40,107

 

3.79

One to four family residential real estate

 

237,336

 

20.74

 

253,918

 

23.98

Consumer

 

19,575

 

1.71

 

21,238

 

2.01

Consumer construction

 

21,688

 

1.90

 

18,096

 

1.70

Total loans

 

$

1,144,325

 

100.00%

$

1,058,776

 

100.00%

Following is a table showing the significant industry types in the commercial loan portfolio as of September 30, 2020 and December 31, 2019 (dollars in thousands).

September 30, 2020

December 31, 2019

Outstanding

Percent of

Percent of

Outstanding

Percent of

Percent of

   

Balance

   

Loans

   

Capital

   

Balance

   

Loans

   

Capital

   

Real estate - operators of nonresidential buildings

136,372

15.75%

82.07%

141,965

18.54%

87.68%

Hospitality and tourism

100,524

11.61

60.50

97,721

12.77

60.35

Lessors of residential buildings

49,694

5.74

29.91

51,085

6.67

31.55

Gasoline stations and convenience stores

27,965

3.23

16.83

27,176

3.55

16.78

Logging

21,487

2.48

12.93

22,136

2.89

13.67

Commercial construction

39,162

4.52

23.57

40,107

5.24

24.77

Other

490,522

56.67

295.20

385,334

50.34

237.98

Total Commercial Loans

$

865,726

100.00%

$

765,524

100.00%

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Management recognizes that additional risks presented by concentration in certain segments of the portfolio. Management does not believe that its current portfolio composition has increased such risk related to any specific industry concentration as of September 30, 2020. The current concentration of commercial real estate-related loans represents a broad customer base composed of a high percentage of owner-occupied developments. The company will slow, and has slowed, growth and origination of certain industry concentrations where internal limits have been reached.

Our residential real estate portfolio predominantly includes one to four family adjustable rate mortgages that have repricing terms generally from one to three years, construction loans to individuals and bridge financing loans for qualifying customers. As of September 30, 2020, our residential loan portfolio totaled $259.024 million, or 22.64%, of our total outstanding loans.

Due to the seasonal nature of many of the Corporation’s commercial loan customers, our loan payment terms provide flexibility by structuring payments to coincide with our customers’ business cycles. The lending staff evaluates the collectability of past due loans based on documented collateral values and payment history. The Corporation discontinues the accrual of interest on loans when, in the opinion of management, there is an indication that the borrower may be unable to meet the payments as they become due. Upon such discontinuance, all unpaid accrued interest is reversed. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Credit Quality

The table below shows period end balances of nonperforming assets (dollars in thousands):

    

September 30,

    

December 31,

   

2020

2019

Nonperforming Assets:

Nonaccrual loans

$

5,414

$

5,172

Loans past due 90 days or more

 

 

11

Restructured loans on nonaccrual

 

 

Total nonperforming loans

 

5,414

 

5,183

Other real estate owned

 

1,851

 

2,194

Total nonperforming assets

$

7,265

$

7,377

Nonperforming loans as a % of loans

 

0.47%

0.49%

Nonperforming assets as a % of assets

 

0.48%

0.56%

Reserve for Loan Losses:

At period end

$

5,832

$

5,308

As a % of outstanding loans

 

.51%

.51%

As a % of nonperforming loans

 

107.72%

102.41%

As a % of nonaccrual loans

 

107.72%

102.63%

Texas Ratio

 

4.91%

4.41%

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The following ratios provide additional information relative to the Corporation’s credit quality (dollars in thousands):

At Period End

    

September 30, 2020

    

December 31, 2019

    

Total loans, at period end

$

1,144,325

1,058,776

Average loans for the period

$

1,116,617

$

1,047,439

For the Period Ended

Nine Months Ended

Twelve Months Ended

    

September 30, 2020

    

December 31, 2019

    

Net charge-offs during the period

$

76

260

Net charge-offs to average loans, annualized

.01%

.02%

Management seeks to address market issues, if any, impacting its loan customer base. In conjunction with the Corporation’s senior lending staff and bank regulatory examinations, management reviews the Corporation’s loans, related collateral evaluations, and the overall lending process. The Corporation also utilizes an outside loan consultant to perform a review of the loan portfolio. The opinion of this consultant upon completion of the 2019 independent review provided findings similar to management’s findings with respect to credit quality. In 2020, the Corporation is once again utilizing a consultant for loan review.

During the first nine months of 2020, the Corporation recorded a provision for loan losses of $600,000. As a result of COVID-19, the qualitative factors for economic conditions were adjusted within the allowance for loan losses calculation and methodology. The Corporation is not yet subject to the requirements of CECL and management will actively refine the provision and loan reserves as client impact and broader economic data from the pandemic become more clear in the fourth quarter and beyond.

During the first nine months of 2020, loan deferrals in response to COVID-19 amounted to approximately $220 million. Of this original amount, only approximately $30 million remain in deferral status, with the rest having returned to contractual obligations of either principal and interest or interest only, for a short period, as they come off full deferral in order to build up cash flow.

As of September 30, 2020, the allowance for loan losses represented .51% of total loans. The total coverage ratio (equivalent to ALLL plus remaining purchase accounting credit marks to total loans less PPP balances) is 1.04%. At September 30, 2020, the allowance included specific reserves in the amount of $1.411 million, as compared to specific reserves of $1.267 million at December 31, 2019. In management’s opinion, the allowance for loan losses is adequate to cover probable losses related to specifically identified loans, as well as probable losses inherent in the balance of the loan portfolio. Purchased impaired credits do not have an effect on the allowance for loan losses, unless they experience further deterioration subsequent to acquisition, in accordance with ASC 310-30.

As part of the process of resolving problem credits, the Corporation may acquire ownership of collateral which secured such credits. The Corporation carries this collateral in other real estate on the balance sheet.

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The following table represents the activity in other real estate for the periods indicated (dollars in thousands):

Nine Months Ended

Year Ended

    

September 30, 2020

    

December 31, 2019

    

Balance at beginning of period

$

2,194

$

3,119

Other real estate transferred from loans due to foreclosure

503

1,629

Proceeds from sale of other real estate

(833)

(1,329)

Transfer to premise and equipment

(1,013)

Writedowns on other real estate held for sale

(13)

(181)

Loss on other real estate held for sale

(31)

Balance at end of period

$

1,851

$

2,194

During the first nine months of 2020, the Corporation received real estate in lieu of loan payments of $.503 million. In determining the carrying value of other real estate held for sale, the Corporation generally starts with a third party appraisal of the underlying collateral and then deducts estimated selling costs to arrive at a net asset value. After the initial receipt, management periodically re-evaluates the recorded balances and records any additional reductions in the fair value as a write-down of other real estate held for sale.

Deposits

The Corporation had an increase in deposits in the first nine months of 2020. Total deposits increased by $205.210 million, or 19.08%, in the first nine months of 2020. The increase in deposits for the first nine months of 2020 is composed of a increase in core deposits of $190.782 million and an increase in noncore deposits of $14.428 million. Management utilizes brokered deposits as a funding source, which provides flexibility in managing interest rate risk for fixed rate longer term loan fundings.

Management continues to monitor existing deposit products in order to stay competitive, both as to terms and pricing, which will remain important as we move through the current rate cycle to protect our margin. This focus on deposits has become especially important with changing client banking habits and demographics, as well as customer desire for more electronic and mobile based banking products and services, particularly in light of the pandemic. It is the intent of management to focus on growing core deposit levels, the comparatively inexpensive core deposits, in relation to wholesale deposit sources, will continue to prove valuable as rates continue to increase.

The following table represents detail of deposits at the end of the periods indicated (dollars in thousands):

September 30,

December 31,

    

2020

    

% of Total

    

2019

    

% of Total

    

Noninterest bearing

$

432,390

33.75%

$

287,611

26.74%

NOW, money market, checking

417,508

32.60

373,165

34.69%

Savings

129,633

10.12

109,548

10.18%

Certificates of Deposit <$250,000

215,531

16.83

233,956

21.75%

Total core deposits

1,195,062

93.30

1,004,280

93.36%

Certificates of Deposit >$250,000

15,654

1.22

12,775

1.19%

Brokered CDs

70,171

5.48

58,622

5.45%

Total non-core deposits

85,825

6.70

71,397

6.64%

Total deposits

$

1,280,887

100.00%

$

1,075,677

100.00%

Borrowings

The Corporation also utilizes FHLB borrowings as a source of funding. At September 30, 2020, this source of funding totaled $63 million and the Corporation secured this funding by pledging loans and investments. The $63 million of

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Table of Contents

FHLB borrowings have a weighted average maturity of 2.14 years and a weighted average interest rate of 1.67% at September 30, 2020. The Corporation also has a USDA Rural Development loan held by its wholly owned subsidiary, First Rural Relending, that has an outstanding balance of $.403 million, with a fixed interest rate of 1% that matures in August 2024.

The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), created the Paycheck Protection Program to support lending to small businesses that have been affected by the disruption caused by COVID-19. The Federal Reserve created the Paycheck Protection Program Lending Facility (PPPLF) to offer a source of liquidity to the financial institution lenders who lend to small businesses through the Small Business Administration’s (SBA) Paycheck Protection Program. The PPPLF bears an interest rate of 0.35% and is collateralized by the PPP loans pledged. There were no PPP loans pledged as of September 30, 2020 as the balance was repaid in the third quarter of 2020.

The Corporation currently has one correspondent banking borrowing relationship. As of September 30, 2020 the relationship consisted of a $15.0 million revolving line of credit, which had no balance. The line of credit bears an interest rate of LIBOR plus 2.00%, with a floor rate of 3.00% and a ceiling of 22%. The line of credit expires April 30, 2022. LIBOR at September 30, 2020 was 0.23%. This relationship is secured by all of the outstanding mBank stock.

Shareholders’ Equity

Total shareholders’ equity increased $4.249 million from December 31, 2019 to September 30, 2020. Contributing to the change in shareholders’ equity was net income of $9.829 million, offset by a reduction for cash dividends on common stock of $4.425 million, an increase due to stock compensation of $.591 million, and an increase in the market value of securities of $.983 million and a decrease due to share repurchases of $2.729 million.

RESULTS OF OPERATIONS

Summary

The Corporation recorded first nine months of 2020 net income of $9.829 million, or $.93 per share, compared to net income of $10.555 million, or $.98 per share, for the first nine months of 2019.

Net Interest Income

Net interest income is the Corporation’s primary source of core earnings. Net interest income represents the difference between the average yield earned on interest earning assets and the average rate paid on interest bearing obligations. Net interest income is impacted by economic and competitive factors that influence rates, loan demand, and the availability of funding.

Net interest income and net interest margin on a fully taxable equivalent basis amounted to $41.265 million and 4.39% of average earning assets, respectively, in the first nine months of 2020, compared to $40.760 million and 4.63% of average earning assets, respectively, in the first nine months of 2019. Included in the net interest income for the first nine months of 2020 is $3.010 million of fee recognition on the PPP loans. The $3.01 million of fee recognition included $1.7 million to offset direct origination costs involved in the program, as well as $.700 million of accretion of the remaining deferred fees.

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Table of Contents

The following table presents the amount of interest income from average interest-earning assets and the yields earned on those assets, as well as the interest expense on average interest-bearing obligations and the rates paid on those obligations. All average balances are daily average balances.

Three Months Ended

 

2020-2019

 

Average Balances

Average Rates

Interest

Income/

Rate/

 

September 30,

Increase/

September 30,

September 30,

Expense

Volume

Rate

Volume

 

(dollars in thousands)

  

2020

  

2019

  

(Decrease)

  

2020

  

2019

  

2020

  

2019

  

Variance

  

Variance

  

Variance

  

Variance

 

 

Loans (1,2,3)

 

$

1,154,670

 

$

1,065,337

 

$

89,333

 

4.81%

5.56%

$

13,970

 

$

14,920

 

$

(950)

 

$

1,248

 

$

(1,990)

 

$

(208)

Taxable securities

 

82,492

 

94,821

 

(12,329)

 

2.51

2.82

 

520

 

675

 

(155)

 

(88)

 

(75)

8

Nontaxable securities (2)

 

23,739

 

14,114

 

9,625

 

3.05

2.67

 

182

 

95

 

87

 

65

 

13

9

Federal funds sold

 

30,189

 

13,515

 

16,674

 

.10

1.24

 

8

 

42

 

(34)

 

52

 

(38)

(48)

Other interest-earning assets

 

12,012

 

16,994

 

(4,982)

 

3.67

8.45

 

111

 

362

 

(251)

 

(106)

 

(208)

63

Total earning assets

 

1,303,102

 

1,204,781

 

98,321

 

4.52

5.30

 

14,791

 

16,094

 

(1,303)

 

1,171

 

(2,298)

 

(176)

Reserve for loan losses

 

(5,393)

 

(5,279)

 

(114)

Cash and due from banks

 

147,763

 

67,280

 

80,483

Fixed Assets

 

25,696

 

23,561

 

2,135

Other Real Estate

 

2,027

 

2,634

 

(607)

Other assets

 

62,933

 

61,243

 

1,690

Total assets

 

$

1,536,128

 

$

1,354,220

 

$

181,908

NOW and money market deposits

 

$

300,922

 

$

253,154

 

$

47,768

 

.20

.48

$

152

 

$

306

 

$

(154)

 

$

58

 

$

(177)

 

$

(35)

Interest checking

 

102,786

 

106,367

 

(3,581)

 

.03

 

.12

 

8

 

32

 

(24)

 

(1)

 

(24)

 

1

Savings deposits

 

127,406

 

110,741

 

16,665

 

.25

 

.63

 

79

 

177

 

(98)

 

27

 

(108)

 

(17)

Certificates of deposit

 

238,471

 

267,904

 

(29,433)

 

1.46

 

1.93

 

875

 

1,302

 

(427)

 

(143)

 

(315)

 

31

Brokered deposits

 

77,939

 

101,914

 

(23,975)

 

1.22

 

2.52

 

239

 

647

 

(408)

 

(152)

 

(333)

 

77

Borrowings

 

88,682

 

54,786

 

33,896

 

1.27

 

1.75

 

283

 

242

 

41

 

149

 

(67)

 

(41)

Total interest-bearing liabilities

 

936,206

 

894,866

 

41,340

 

.70

 

1.20

 

1,636

 

2,706

 

(1,070)

 

(62)

 

(1,024)

 

16

Demand deposits

 

422,134

 

284,354

 

137,780

Other liabilities

 

12,338

 

15,547

 

(3,209)

Shareholders’ equity

 

165,450

 

159,453

 

5,997

Total liabilities and shareholders’ equity

 

$

1,536,128

 

$

1,354,220

 

$

181,908

Rate spread

 

3.82%

4.10%

Net interest margin/revenue

 

4.02%

4.41%

$

13,155

 

$

13,388

 

$

(233)

 

$

1,233

 

$

(1,274)

 

$

(192)

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Table of Contents

Nine Months Ended

2020-2019

Average Balances

Average Rates

Interest

Income/

Rate/

September 30,

Increase/

September 30,

September 30,

Expense

Volume

Rate

Volume

(dollars in thousands)

    

2020

    

2019

    

(Decrease)

    

2020

    

2019

    

2020

    

2019

    

Variance

    

Variance

    

Variance

    

Variance

 

Loans (1,2,3)

$

1,116,617

$

1,041,991

$

74,626

5.31%

5.81%

$

44,466

$

45,277

$

(811)

$

3,246

(3,782)

(275)

Taxable securities

87,476

95,798

(8,322)

2.60

2.89

1,700

2,073

(373)

(180)

(213)

20

Nontaxable securities (2)

20,938

15,292

5,646

3.01

2.76

472

316

156

117

28

11

Federal funds sold

16,670

5,145

11,525

.14

1.39

17

54

(37)

121

(49)

(109)

Other interest-earning assets

13,373

17,543

(4,170)

4.96

8.40

497

1102

(605)

(262)

(451)

108

Total earning assets

1,255,074

1,175,769

79,305

5.02

5.59

47,152

48,822

(1,670)

3,042

(4,467)

(245)

Reserve for loan losses

(5,323)

(5,237)

(86)

Cash and due from banks

113,477

76,951

36,526

Fixed Assets

25,048

23,196

1,852

Other Real Estate

2,156

2,503

(347)

Other assets

61,874

60,552

1,322

Total assets

$

1,452,306

$

1,333,734

$

118,572

NOW and money market deposits

$

289,830

$

251,319

$

38,511

.27

0.53

$

578

$

1001

$

(423)

$

154

(501)

(76)

Interest checking

98,255

110,042

(11,787)

.04

.17

33

137

(104)

(15)

(100)

11

Savings deposits

118,696

110,546

8,150

.48

.49

430

403

27

30

(3)

Certificates of deposit

240,350

261,430

(21,080)

1.66

1.87

2,991

3,665

(674)

(296)

(415)

37

Brokered deposits

87,469

116,053

(28,584)

1.46

2.45

954

2,128

(1,174)

(525)

(864)

215

Borrowings

93,083

53,150

39,933

1.29

1.83

901

728

173

547

(214)

(160)

Total interest-bearing liabilities

927,683

902,540

25,143

.85

1.19

5,887

8,062

(2,175)

(105)

(2,097)

27

Demand deposits

351,044

260,194

90,850

Other liabilities

10,059

14,435

(4,376)

Shareholders’ equity

163,520

156,565

6,955

Total liabilities and shareholders’ equity

$

1,452,306

$

1,333,734

$

118,572

Rate spread

4.17%

4.36%

Net interest margin/revenue

4.39%

4.63%

$

41,265

$

40,760

$

505

$

3,147

$

(2,370)

$

(272)

(1)For purposes of these computations, nonaccruing loans are included in the daily average loan amounts outstanding.
(2)The amount of interest income on loans and nontaxable securities has been adjusted to a tax equivalent basis, using a 21% tax rate.
(3)Interest income on loans includes fees.

The Corporation continues to reprice a significant portion of its loan portfolio. Management has been diligent when repricing maturing or new loans in establishing interest rate floors in order to maintain our interest rate spread. The Corporation is anticipating some margin pressure in future periods as we continue to see extremely competitive pricing on new and renewable loans.

Provision for Loan Losses

The Corporation records a provision for loan losses when it believes it is necessary to adjust the allowance for loan losses to maintain an adequate level after considering factors such as loan charge-offs and recoveries, changes in identified levels of risk in the loan portfolio, changes in the mix of loans in the portfolio, loan growth, and other economic factors. During the third quarter of 2020, the Corporation recorded a loan loss provision of $400,000 compared to $50,000 in the third quarter of 2019. This increase was precautionary given the COVID-19 conditions and not due to any increase in loan loss activity or increased risk within the portfolio. During the first nine months of 2020, the Corporation recorded a loan loss provision of $600,000, compared to $350,000 in the first nine months of 2019. There were net charge-offs of $76,000 in the first nine months of 2020, compared to net charge-offs of $225,000 for the same period in 2019. There was no provision for loan losses for acquired loans as a result of acquisition fair value adjustments.

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Table of Contents

Other Income

Other income was $7.420 million in the first nine months of 2020, compared to $4.105 million in the same period in 2019. The increase year over year was largely a result of increased income from loans sold in the secondary market and loans sold to the SBA. Management continues to evaluate deposit products and services for ways to better serve its customer base and also enhance service fee income through a broad array of products that price services based on income contribution and cost attributes.

The following table details other income for the three and nine months ended September 30, 2020 and 2019 (dollars in thousands):

Three Months Ended

Nine Months Ended

September 30,

September 30,

Increase/(Decrease)

Increase/(Decrease)

    

2020

    

2019

    

Dollars

    

Percent

    

2020

    

2019

    

Dollars

    

Percent

 

Deposit service fees

 

$

260

 

$

383

 

$

(123)

 

-32.11%

$

900

 

$

1,197

 

$

(297)

 

-24.81%

Income from loans sold in the secondary market

 

1,968

 

586

 

1,382

 

235.84

4,018

 

1,253

 

2,765

 

220.67

SBA/USDA loan sale gains

 

476

 

496

 

(20)

 

(4.03)

1,460

 

650

 

810

 

124.62

Net mortgage servicing (amortization) income

 

247

 

238

 

9

 

3.78

640

 

486

 

154

 

58.47

Other noninterest income

 

165

 

175

 

(10)

 

(5.71)

 

402

 

519

 

(117)

 

(22.54)

Total other income

 

$

3,116

 

$

1,878

 

$

1,238

 

65.92%

$

7,420

 

$

4,105

 

$

3,315

 

80.76%

Other Expense

For the first nine months of 2020, the Corporation recorded other expenses of $35.285 million, compared to $30.951 million in 2019, an increase of $4.334 million. The increase in salaries and benefits was largely a result of personnel expenses incurred with participation in the PPP loan program and other general related pandemic expenses, and other customary operating expenses related to our efforts to ensure our platform infrastructure keeps pace with our growing asset base and the associated regulatory and risk management needs.

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Table of Contents

The following table details other expense for the three and nine months ended September 30, 2020 and 2019 (dollars in thousands):

Three Months Ended

Nine Months Ended

 

September 30,

September 30,

 

Increase/(Decrease)

Increase/(Decrease)

 

    

2020

    

2019

    

Dollars

    

Percentage

    

2020

    

2019

    

Dollars

    

Percentage

 

 

Salaries and employee benefits

 

$

6,487

 

$

5,669

 

$

818

 

14.43%

$

19,547

 

$

16,615

 

$

2,932

 

17.65%

Occupancy

 

1,163

 

987

 

176

 

17.83

 

3,295

 

3,072

 

223

 

7.26

Furniture and equipment

 

846

 

768

 

78

 

10.16

 

2,452

 

2,209

 

243

 

11.00

Data processing

 

801

 

785

 

16

 

2.04

 

2,478

 

2,202

 

276

 

12.53

Advertising

 

168

 

203

 

(35)

 

(17.24)

 

692

 

726

 

(34)

 

(4.68)

Professional service fees

 

474

 

536

 

(62)

 

(11.57)

 

1,546

 

1,517

 

29

 

1.91

Loan origination expenses and deposit and card related fees

 

413

 

314

 

99

 

31.53

 

1,200

 

677

 

523

 

77.25

Writedowns and losses on other real estate held for sale

 

(21)

 

(24)

 

3

 

(12.50)

 

13

 

77

 

(64)

 

(83.12)

FDIC insurance assessment

 

135

 

(141)

 

276

 

(195.74)

 

450

 

70

 

380

 

542.86

Communications

 

248

 

221

 

27

 

12.22

 

685

 

681

 

4

 

0.59

Other

 

847

 

1,125

 

(278)

 

(24.71)

 

2,927

 

3,105

 

(178)

 

(5.73)

Total other expense

 

$

11,561

 

$

10,443

 

$

1,118

 

10.71%

$

35,285

 

$

30,951

 

$

4,334

 

14.00%

Federal Income Taxes

The Corporation recognized a federal income tax expense for the nine months ended September 30, 2020 of $2.613 million, compared to $2.806 million a year earlier.

The Corporation has reported deferred tax assets of $1.758 million at September 30, 2020. A valuation allowance is provided against deferred tax assets when it is more likely than not that some or all of the deferred tax asset will not be realized. As of September 30, 2020, the Corporation had a net operating loss carryforwards for tax purposes of approximately $10.2 million. As a result of the repeal of the corporate alternative minimum tax in the Tax Cuts and Jobs Act, any outstanding alternative minimum tax credits are believed to be utilized or refundable as of September 30, 2020. There are $1.3 million of alternative minimum tax credits classified as a current tax receivable at September 30, 2020. A portion of the NOL and credit carryforwards are subject to the limitations for utilization as set forth in Section 382 of the Internal Revenue Code. The annual limitation is $2.0 million for the NOL and the equivalent value of tax credits, which is approximately $.420 million. These limitations for use were established in conjunction with the recapitalization of the Corporation in December 2004. The Corporation will continue to evaluate the future benefits from these carryforwards in order to determine if any adjustment to the deferred tax asset is warranted.

LIQUIDITY

We define liquidity as the ability to generate cash at a reasonable cost to fulfill lending commitments and support asset growth, while satisfying the withdrawal demands of customers and making payments on any existing borrowing commitments. The Bank’s principal sources of liquidity are core deposits and loan and investment payments and prepayments. Providing a secondary source of liquidity is the available for sale investment portfolio, FHLB borrowings and brokered deposits. As a final source of liquidity, the Bank can exercise existing credit arrangements.

Current balance sheet liquidity consists of $173.769 million in cash and cash equivalents and $79.236 million of unpledged investment securities. Although current liquidity is deemed adequate, management has the ability to increase on hand liquidity by acquiring brokered CDs in order to fund any anticipated loan growth.

During the first nine months of 2020, the Corporation increased cash and cash equivalents by $123.943 million. The management of bank liquidity for funding of loans and deposit maturities and withdrawals includes monitoring projected loan fundings and scheduled prepayments and deposit maturities within a 30 day period, a 30- to 90- day period and from 90 days until the end of the year. This funding forecast model is completed weekly.

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Table of Contents

The Corporation’s primary source of liquidity on a stand-alone basis is dividends from the Bank. During the first nine months of 2020, the Bank paid dividends of $8.0 million to the Corporation. Bank capital remains strong and above the “well-capitalized” level for regulatory purposes as of September 30, 2020. The Corporation also has a line of credit with a correspondent bank that had borrowing availability at September 30, 2020 of $15 million. The Corporation’s current plan for dividends from the Bank are dependent upon the profitability of the Bank, growth of assets at the Bank and the level of capital needed to stay “adequately capitalized.” The Corporation will continue to explore opportunities for longer term sources of liquidity and permanent equity to support projected asset growth.

Liquidity is managed by the Corporation through its Asset and Liability Committee (“ALCO”). The ALCO Committee meets regularly to discuss asset and liability management in order to address liquidity and funding needs to provide a process to seek the best alternatives for investments of assets, funding costs, and risk management. The liquidity position of the Bank is managed daily, thus enabling the Bank to adapt its position according to market fluctuations. Core deposits are important in maintaining a strong liquidity position as they represent a stable and relatively low cost source of funds. The Bank’s liquidity is best illustrated by the mix in the Bank’s core and noncore funding dependence ratio, which explains the degree of reliance on noncore liabilities to fund long-term assets.

Core deposits are herein defined as demand deposits, NOW (negotiable order withdrawals), money markets, savings and certificates of deposit under $250,000. Noncore funding consists of certificates of deposit greater than $250,000, brokered deposits, and FHLB, Farmers’ Home Administration and other borrowings. At September 30, 2020, the Bank’s core deposits in relation to total funding were 88.90% compared to 87.60% at December 31, 2019. These ratios indicate that at September 30, 2020, that the Bank had slightly increased its reliance on noncore deposits and borrowings to fund the Bank’s long-term assets, namely loans and investments. This decrease is the direct result of the Bank taking precautionary measures to augment its cash position at the onset of the COVID-19 pandemic. The Bank believes that by maintaining adequate volumes of short-term investments and implementing competitive pricing strategies on deposits, it can ensure adequate liquidity to support future growth. The Bank also has correspondent lines of credit available to meet unanticipated short-term liquidity needs. As of September 30, 2020, the Bank had $106 million of unsecured lines available and additional funding sources available if secured. The Bank believes that its liquidity position remains sufficient to meet both present and future financial obligations and commitments, events or uncertainties that have resulted or are reasonably likely to result in material changes with respect to the Bank’s liquidity, including any additional liquidity pressure that may stem from the effects of the COVID-19 pandemic.

From a long-term perspective, the Corporation’s strategy is to increase core deposits in the Corporation’s local markets. Management continually evaluates deposit products it offers in order to remain competitive in its goal of increasing core deposits. The Corporation also has the ability to augment local deposit growth efforts with wholesale CD funding.

REGULATORY CAPITAL

The Corporation is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory—and possibly additional discretionary—actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation must meet specific capital guidelines that involve quantitative measures of the Corporation’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Corporation’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Corporation to maintain minimum amounts and ratios (set forth in the table below) of total, Tier 1 capital and Common Equity Tier 1 Capital to risk-weighted assets and of Tier 1 capital to average assets. Management has determined that, as of September 30, 2020, the Corporation is well-capitalized.

In order to be “well-capitalized” under the current guidelines, a depository institution must maintain a Common Equity Tier 1 Capital ratio of 6.5% or more; an Additional Tier 1 Capital ratio of 8% or more; a Total Capital ratio of 10% or more; and a leverage ratio of 5% or more.

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Table of Contents

The Corporation’s and the Bank’s actual capital and ratios compared to generally applicable regulatory requirements as of September 30, 2020 are as follows (dollars in thousands):

Actual

Adequacy Purposes

Well-Capitalized

 

    

Amount

    

Ratio

    

Amount

    

Ratio

    

Amount

    

Ratio

 

Total capital to risk weighted assets:

Consolidated

 

$

144,532

14.5%

> 

$

79,782

> 

8.0%

> 

$

N/A

> 

N/A

mBank

 

$

141,164

14.2%

> 

$

79,768

> 

8.0%

> 

$

99,710

> 

10.0%

Tier 1 capital to risk weighted assets:

Consolidated

 

$

138,700

13.9%

> 

$

59,836

> 

6.0%

> 

$

N/A

> 

N/A

mBank

 

$

135,373

13.6%

> 

$

59,826

> 

6.0%

> 

$

79,768

> 

8.0%

Common equity Tier 1 capital to risk weighted assets

Consolidated

 

$

138,700

13.9%

> 

$

44,877

> 

4.5%

> 

$

N/A

> 

N/A

mBank

 

$

135,373

13.6%

> 

$

44,869

> 

4.5%

> 

$

64,811

> 

6.5%

Tier 1 capital to average assets:

Consolidated

 

$

138,700

9.2%

> 

$

60,306

> 

4.0%

> 

$

N/A

> 

N/A

mBank

 

$

135,373

9.0%

> 

$

60,152

> 

4.0%

> 

$

75,190

> 

5.0%

Regulatory capital is not the same as shareholders’ equity reported in the accompanying condensed consolidated financial statements. Certain assets cannot be considered assets for regulatory purposes, such as acquisition intangibles and noncurrent deferred tax benefits.

MACKINAC FINANCIAL CORPORATION

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISK

In general, the Corporation attempts to manage interest rate risk by investing in a variety of assets which afford it an opportunity to reprice assets and increase interest income at a rate equal to or greater than the interest expense associated with repricing liabilities.

Interest rate risk is the exposure of the Corporation to adverse movements in interest rates. The Corporation derives its income primarily from the excess of interest collected on its interest-earning assets over the interest paid on its interest-bearing obligations. The rates of interest the Corporation earns on its assets and owes on its obligations generally are established contractually for a period of time. Since market interest rates change over time, the Corporation is exposed to lower profitability if it cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excess levels of interest rate risk could pose a significant threat to the Corporation’s earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to the Corporation’s safety and soundness.

Loans are the Corporation’s most significant earning asset. Management offers commercial and real estate loans priced at interest rates which fluctuate with various indices such as the prime rate or rates paid on various government issued securities. In addition, the Corporation prices the majority of its fixed rate loans so it has an opportunity to reprice the loan within 12 to 60 months.

As of September 30, 2020, the Corporation had established interest rate floors on approximately $89.317 million of its variable rate commercial loans. Historically these interest rate floors would result in a “lag” on the repricing of these variable rate loans when and if interest rates increased in future periods. However, the majority of these loans have surpassed their floors and will now reprice with each interest rate move.

The Corporation also has $106.830 million of securities providing for scheduled monthly principal and interest payments as well as unanticipated prepayments of principal as of September 30, 2020. These cash flows are then reinvested into other earning assets at current market rates. The Corporation also has federal funds sold to correspondent banks as well as other interest-bearing deposits with correspondent banks. These funds are generally repriced on a daily basis.

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The Corporation offers deposit products with a variety of terms ranging from deposits whose interest rates can change on a weekly basis to certificates of deposit with repricing terms of up to five years. Longer term deposits generally include penalty provisions for early withdrawal.

Management can mitigate interest rate risk by managing the maturity periods of securities purchased, selling securities available for sale, and borrowing funds with targeted maturity periods, among other strategies. Also, the rate of interest rate changes can impact the actions taken since the rate environment affects borrowers and depositors differently.

Exposure to interest rate risk is reviewed on a regular basis. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect of interest rate changes on net interest income and to structure the composition of the balance sheet to minimize interest rate risk and at the same time maximize income.

Management realizes certain interest rate risks are inherent in the business of banking and that the goal is to identify and minimize the risks. Tools used by management include maturity and repricing analysis and interest rate sensitivity analysis. The Bank has regular asset/liability meetings with an outside consultant to review its current position and strategize about future opportunities on risks relative to pricing and positioning of assets and liabilities.

The difference between repricing assets and liabilities for a specific period is referred to as the gap. An excess of repricable assets over liabilities is referred to as a positive gap. An excess of repricable liabilities over assets is referred to as a negative gap. The cumulative gap is the summation of the gap for all periods to the end of the period for which the cumulative gap is being measured.

Assets and liabilities scheduled to reprice are reported in the following time frames. Those instruments with a variable interest rate tied to an index and considered immediately repricable are reported in the 1- to 90-day time frame. The estimates of principal amortization and prepayments are assigned to the following time frames.

The following is the Corporation’s repricing opportunities at September 30, 2020 (dollars in thousands):

    

1-90

    

91-365

    

>1-5

    

Over 5

    

 

Days

Days

Years

Years

Total

 

Interest-earning assets:

Loans

$

287,114

387,484

457,561

12,166

$

1,144,325

Securities

 

19,752

10,901

44,387

31,790

 

106,830

Other (1)

 

7,374

490

2,427

 

10,291

Total interest-earning assets

 

314,240

 

398,875

 

504,375

 

43,956

 

1,261,446

Interest-bearing obligations:

NOW, money market, savings and interest checking

 

547,141

 

547,141

Time deposits

 

42,110

100,370

88,026

679

 

231,185

Brokered CDs

 

28,326

28,494

13,351

 

70,171

Borrowings

 

35,098

25,407

3,000

 

63,505

Total interest-bearing obligations

 

617,577

 

163,962

 

126,784

 

3,679

 

912,002

Gap

$

(303,337)

$

234,913

$

377,591

$

40,277

$

349,444

Cumulative gap

$

(303,337)

$

(68,424)

$

309,167

$

349,444

(1)Includes Federal Home Loan Bank Stock.

The above analysis indicates that at September 30, 2020, the Corporation had a cumulative liability sensitivity gap position of $68.424 million within the one-year time frame. The Corporation’s cumulative liability sensitive gap suggests that if market interest rates were to increase in the next twelve months, the Corporation has the potential to earn

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less net interest income. This is because more liabilities would reprice at higher rates than assets. Conversely, if market interest rates decrease in the next twelve months, the above gap position suggests the Corporation’s net interest income would increase. A limitation of the traditional gap analysis is that it does not consider the timing or magnitude of non-contractual repricing or expected prepayments. In addition, the gap analysis treats savings, NOW, and money market accounts as repricing within 90 days, while experience suggests that these categories of deposits are actually comparatively resistant to rate sensitivity.

At December 31, 2019, the Corporation had a cumulative liability sensitivity gap position of $46.031 million within the one-year time frame.

The borrowings in the gap analysis include $63 million of FHLB advances that have a weighted average maturity of 2.14 years and a weighted average rate of 1.67%.

The Corporation’s primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk and foreign exchange risk. The Corporation has no market risk sensitive instruments held for trading purposes. The Corporation has limited agricultural-related loan assets and therefore has minimal significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates are assumed to be insignificant.

Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. The Corporation’s interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems, and internal controls are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, the Corporation assesses the existing and potential future effects of changes in interest rates on its financial condition, including capital adequacy, earnings, liquidity, and asset quality.

In addition to changes in interest rates, the level of future net interest income is also dependent on a number of variables, including: the growth, composition and levels of loans, deposits, and other earning assets and interest-bearing obligations, and economic and competitive conditions; potential changes in lending, investing, and deposit strategies; customer preferences; and other factors.

FOREIGN EXCHANGE RISK

In addition to managing interest rate risk, management also actively manages risk associated with foreign exchange. The Corporation has decided to curtail its foreign exchange services for customers, and accordingly, management believes the exposure to short-term foreign exchange risk is minimal.

OFF-BALANCE-SHEET RISK

Derivative financial instruments include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. The Corporation currently does not enter into futures, forwards, swaps, or options. However, the Corporation is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit and involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the condensed consolidated balance sheets. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower if deemed necessary by the Corporation. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions.

Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Corporation until the instrument is exercised.

IMPACT OF INFLATION AND CHANGING PRICES

The accompanying condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and results of operations in

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historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Corporation’s operations. Nearly all the assets and liabilities of the Corporation are financial, unlike industrial or commercial companies. As a result, the Corporation’s performance is directly impacted by changes in interest rates, which are indirectly influenced by inflationary expectations. The Corporation’s ability to match the interest sensitivity of its financial assets to the interest sensitivity of its financial liabilities tends to minimize the effect of changes in interest rates on the Corporation’s performance. Changes in interest rates do not necessarily move to the same extent as changes in the price of goods and services.

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Table of Contents

MACKINAC FINANCIAL CORPORATION

ITEM 4 CONTROLS AND PROCEDURES

As of September 30, 2020, we carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934. Our management, which includes our principal executive officer and our principal financial officer, does not expect that our disclosure controls and procedures will prevent all errors and all fraud.

A control system, no matter how well conceived and operated, can provide only reasonable, but not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints; additionally, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Corporation have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is also based, in part, upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate due to changes in conditions; also the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Our principal executive officer and principal accounting officer have concluded, based on our evaluation of our disclosure controls and procedures, that our disclosure controls and procedures, as defined under Rule 13a-15 of the Securities Exchange Act of 1934, are effective as of September 30, 2020.

Changes in Internal Control Over Financial Reporting

There were no changes in the Corporation’s internal control over financial reporting that occurred during the quarter ended September 30, 2020 that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

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MACKINAC FINANCIAL CORPORATION

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The Corporation and its subsidiaries are subject to routine litigation incidental to the business of banking. Although the results of litigation and claims cannot be predicted, management believes there are no legal proceedings, the outcome of which, if determined adversely to the Corporation, would individually or in the aggregate be reasonably expected to have a material adverse effect on the Corporation’s results of operations.

Item 1A. Risk Factors

There have been no material changes to the Corporation’s risk factors contained in its Annual Report on Form 10-K for the year ended December 31, 2019 and its Quarterly Report on Form 10-Q for the three months ended March 31, 2020.

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

On August 28, 2019, the Corporation, under the authorization of the Board of Directors announced a common stock repurchase program (“the Repurchase Program”). Under the Repurchase Program, the Company is authorized to repurchase up to approximately 5% of the Corporation’s outstanding common stock. The Repurchase Program has no expiration date.

    

    

    

Total number of

    

 

shares purchased

Maximum

 

as part of a

number of

 

publically

shares that

Total number of

Average price

announced

may yet be

 

Period of purchases

shares purchased

paid per share

plan or program

purchased

 

January 1, 2020 to January 31, 2020

 

 

$

 

 

537,036

February 1, 2020 to February 29, 2020

 

3,626

 

$

14.89

 

3,626

 

533,410

March 1, 2020 to March 31, 2020

237,018

$

11.28

237,018

296,392

April 1, 2020 to April 30, 2020

$

296,392

May 1, 2020 to May 31, 2020

$

296,392

June 1, 2020 to June 30, 2020

$

296,392

July 1, 2020 to July 31, 2020

$

296,392

August 1, 2020 to August 31, 2020

$

296,392

September 1, 2020 to September 30, 2020

 

 

$

 

 

296,392

Total First Nine Months 2020

 

240,644

 

$

11.34

 

240,644

Item 6. Exhibits

(a)

Exhibits:

Exhibit 31.1

Rule 13a-14(a) Certification of Chief Executive Officer.

Exhibit 31.2

Rule 13a-14(a) Certification of Chief Financial Officer.

Exhibit 32.1

Section 1350 Certification of Chief Executive Officer.

Exhibit 32.2

Section 1350 Certification of Chief Financial Officer.

101.INS

Inline XBRL Instance Document* - The instance document does not appear in the interactive data file because its XBRL tags are embedded within the inline XBRL document.

101.SCH

Inline XBRL Taxonomy Extension Schema Document*

101.CAL

Inline XBRL Taxonomy Calculation Linkbase Document*

101.DEF

Inline XBRL Taxonomy Definition Document*

101.LAB

Inline XBRL Taxonomy Label Linkbase Document*

101.PRE

Inline XBRL Taxonomy Presentation Linkbase Document*

104

Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101)*

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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.

MACKINAC FINANCIAL CORPORATION

                         (Registrant)

Date:     November 9, 2020

By:

/s/ Paul D. Tobias

PAUL D. TOBIAS,

CHAIRMAN AND CHIEF EXECUTIVE OFFICER

(principal executive officer)

By:

/s/ Jesse A. Deering

JESSE A. DEERING

EVP/CHIEF FINANCIAL OFFICER

(principal financial and accounting officer)

49