Independent Bank 10K 2019 Annual report | IBCP Filing

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Performance Graph		8
Selected Consolidated Financial Data		9
Management’s Discussion and Analysis of Financial Condition and Results of Operations		10
Management’s Annual Report on Internal Control Over Financial Reporting		32
Report of Independent Registered Public Accounting Firm		33
Consolidated Financial Statements		35
Notes to Consolidated Financial Statements		40
Quarterly Data		100

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PERFORMANCE GRAPH

The graph below compares the total returns (assuming reinvestment of dividends) of Independent Bank Corporation common stock, the NASDAQ Composite Index and the NASDAQ Bank Stock Index. The graph assumes $100 invested in Independent Bank Corporation common stock (returns based on stock prices per the NASDAQ) and each of the indices on December 31, 2014, and the reinvestment of all dividends during the periods presented. The performance shown on the graph is not necessarily indicative of future performance.

Independent Bank Corporation

	Period Ending
Index	12/31/14		12/31/15		12/31/16		12/31/17		12/31/18		12/31/19
Independent Bank Corporation		100.00		118.93		173.20		181.85		175.46		195.41
NASDAQ Composite		100.00		106.96		116.45		153.23		147.35		200.49
NASDAQ Bank		100.00		102.21		129.34		154.02		130.28		175.61

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SELECTED CONSOLIDATED FINANCIAL DATA

	Year Ended December 31,
	2019			2018			2017			2016			2015
	(Dollars in thousands, except per share amounts)
SUMMARY OF OPERATIONS
Interest income	$	148,928		$	130,773		$	98,309		$	86,523		$	80,842
Interest expense		26,347			17,491			9,123			6,882			5,856
Net interest income		122,581			113,282			89,186			79,641			74,986
Provision for loan losses		824			1,503			1,199			(1,309	)		(2,714	)
Net gains on securities		307			138			260			563			20
Net gain on branch sale		—			—			—			—			1,193
Other non-interest income		47,429			44,677			42,273			41,735			38,917
Non-interest expenses		111,733			107,461			92,082			90,347			88,450
Income before income tax		57,760			49,133			38,438			32,901			29,380
Income tax expense		11,325			9,294			17,963			10,135			9,363
Net income	$	46,435		$	39,839		$	20,475		$	22,766		$	20,017

PER COMMON SHARE DATA
Net income per common share
Basic	$	2.03		$	1.70		$	0.96		$	1.06		$	0.88
Diluted		2.00			1.68			0.95			1.05			0.86
Cash dividends declared and paid		0.72			0.60			0.42			0.34			0.26
Book value		15.58			14.38			12.42			11.71			11.28

SELECTED BALANCES
Assets	$	3,564,694		$	3,353,281		$	2,789,355		$	2,548,950		$	2,409,066
Loans		2,725,023			2,582,520			2,018,817			1,608,248			1,515,050
Allowance for loan losses		26,148			24,888			22,587			20,234			22,570
Deposits		3,036,727			2,913,428			2,400,534			2,225,719			2,085,963
Shareholders’ equity		350,169			338,994			264,933			248,980			251,092
Other borrowings		88,646			25,700			54,600			9,433			11,954
Subordinated debentures		39,456			39,388			35,569			35,569			35,569

SELECTED RATIOS
Net interest income to average interest earning assets		3.80	%		3.88	%		3.65	%		3.52	%		3.58	%
Net income to
Average shareholders' equity		13.63			12.38			7.82			9.21			7.89
Average assets		1.35			1.27			0.77			0.92			0.86
Average shareholders’ equity to average assets		9.90			10.27			9.88			9.98			10.93
Tier 1 capital to average assets		10.11			10.47			10.57			10.50			10.91
Non-performing loans to Portfolio Loans		0.35			0.33			0.39			0.75			0.70

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

Disclaimer Regarding Forward-Looking Statements. Statements in this report that are not statements of historical fact, including statements that include terms such as “will,” “may,” “should,” “believe,” “expect,” “forecast,” “anticipate,” “estimate,” “project,” “intend,” “likely,” “optimistic” and “plan” and statements about future or projected financial and operating results, plans, projections, objectives, expectations, and intentions, are forward-looking statements. Forward-looking statements include, but are not limited to, descriptions of plans and objectives for future operations, products or services; projections of our future revenue, earnings or other measures of economic performance; forecasts of credit losses and other asset quality trends; statements about our business and growth strategies; and expectations about economic and market conditions and trends. These forward-looking statements express our current expectations, forecasts of future events, or long-term goals. They are based on assumptions, estimates, and forecasts that, although believed to be reasonable, may turn out to be incorrect. Actual results could differ materially from those discussed in the forward-looking statements for a variety of reasons, including:

•

economic, market, operational, liquidity, credit, and interest rate risks associated with our business;

•

economic conditions generally and in the financial services industry, particularly economic conditions within Michigan and the regional and local real estate markets in which our bank operates;

•

the failure of assumptions underlying the establishment of, and provisions made to, our allowance for loan losses;

•

increased competition in the financial services industry, either nationally or regionally;

•

our ability to achieve loan and deposit growth;

•

volatility and direction of market interest rates;

•

the continued services of our management team; and

•

implementation of new legislation, which may have significant effects on us and the financial services industry.

This list provides examples of factors that could affect the results described by forward-looking statements contained in this report, but the list is not intended to be all-inclusive. The risk factors disclosed in Part I – Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2019, as updated by any new or modified risk factors disclosed in Part II – Item 1A of any subsequently filed Quarterly Report on Form 10-Q, include the known risks our management believes could materially affect the results described by forward-looking statements in this report. However, those risks may not be the only risks we face. Our results of operations, cash flows, financial position, and prospects could also be materially and adversely affected by additional factors that are not presently known to us, that we currently consider to be immaterial, or that develop after the date of this report. We cannot assure you that our future results will meet expectations. While we believe the forward-looking statements in this report are reasonable, you should not place undue reliance on any forward-looking statement. In addition, these statements speak only as of the date made. We do not undertake, and expressly disclaim, any obligation to update or alter any statements, whether as a result of new information, future events, or otherwise, except as required by applicable law.

Introduction. The following section presents additional information to assess the financial condition and results of operations of Independent Bank Corporation (“IBCP”), its wholly-owned bank, Independent Bank (the “Bank”), and their subsidiaries. This section should be read in conjunction with the consolidated financial statements and the supplemental financial data contained elsewhere in this annual report. We also encourage you to read our Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission (“SEC”). That report includes a list of risk factors that you should consider in connection with any decision to buy or sell our securities.

Overview. We provide banking services to customers located primarily in Michigan’s Lower Peninsula and have also opened two loan production offices in Ohio (Columbus and Fairlawn). A third Ohio loan production office is being opened in Toledo in March 2020. As a result, our success depends to a great extent upon the economic conditions in Michigan’s Lower Peninsula.

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Significant Developments. On December 22, 2017, “H.R. 1”, also known as the “Tax Cuts and Jobs Act” was signed into law. H.R.1, among other things, reduced the federal corporate income tax rate to 21%, effective January 1, 2018. As a result, we concluded that our deferred tax assets, net (“DTA”) had to be remeasured. Our DTA represents expected corporate tax benefits anticipated to be realized in the future. The reduction in the federal corporate income tax rate reduced these anticipated future benefits. The remeasurement of our DTA at December 31, 2017 resulted in a reduction of these net assets and a corresponding increase in income tax expense of $6.0 million that was recorded in the fourth quarter of 2017.

On December 4, 2017, we entered into an Agreement and Plan of Merger with TCSB Bancorp, Inc. (“TCSB”) (the “Merger Agreement”) providing for a business combination of IBCP and TCSB. On April 1, 2018, TCSB was merged with and into IBCP, with IBCP as the surviving corporation (the “Merger”). In connection with the Merger, on April 1, 2018, IBCP consolidated Traverse City State Bank, TCSB’s wholly-owned subsidiary bank, with and into Independent Bank (with Independent Bank as the surviving institution). See note #26.

It is against this backdrop that we discuss our results of operations and financial condition in 2019 as compared to earlier periods.

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RESULTS OF OPERATIONS

Summary. We recorded net income of $46.4 million, or $2.00 per diluted share, in 2019, net income of $39.8 million, or $1.68 per diluted share, in 2018, and net income of $20.5 million, or $0.95 per diluted share, in 2017. The 2019 and 2018 results include the benefit of a reduced federal income tax rate pursuant to H.R. 1 and the impact of the Merger and 2017 results include an additional $6.0 million ($0.28 per diluted share) of income tax expense related to the remeasurement of our DTA, both as described earlier under “Significant Developments.”

KEY PERFORMANCE RATIOS

	Year Ended December 31,
	2019			2018			2017
Net income to
Average shareholders' equity		13.63	%		12.38	%		7.82	%
Average assets		1.35			1.27			0.77
Net income per common share
Basic	$	2.03		$	1.70		$	0.96
Diluted		2.00			1.68			0.95

Net interest income. Net interest income is the most important source of our earnings and thus is critical in evaluating our results of operations. Changes in our net interest income are primarily influenced by our level of interest-earning assets and the income or yield that we earn on those assets and the manner and cost of funding our interest-earning assets. Certain macro-economic factors can also influence our net interest income such as the level and direction of interest rates, the difference between short-term and long-term interest rates (the steepness of the yield curve) and the general strength of the economies in which we are doing business. Finally, risk management plays an important role in our level of net interest income. The ineffective management of credit risk and interest-rate risk in particular can adversely impact our net interest income.

Net interest income totaled $122.6 million during 2019, compared to $113.3 million and $89.2 million during 2018 and 2017, respectively. The increase in net interest income in 2019 compared to 2018 primarily reflects a $302.1 million increase in average interest-earning assets that was partially offset by an eight basis point decrease in our tax equivalent net interest income as a percent of average interest-earning assets (the “net interest margin”).

The increase in net interest income in 2018 compared to 2017 reflects a $462.0 million increase in average interest-earning assets and a 23 basis point increase in our net interest margin.

The increase in average interest-earning assets during 2019 and 2018 primarily reflects the impact of the Merger as well as loan growth utilizing funds from increases in deposits. The decrease in the net interest margin during 2019 as compared to 2018 primarily reflects reductions in short-term interest rates during that year as well as a flattening of the yield curve. The increase in the net interest margin during 2018 as compared to 2017 primarily reflects increases in short-term interest rates during that year as well as the impact of the Merger.

2019 and 2018 interest income on loans includes $1.5 million and $1.7 million, respectively, of accretion of the discount recorded on the TCSB loans acquired in the Merger.

Our net interest income is also impacted by our level of non-accrual loans. Average non-accrual loans totaled $8.1 million, $8.4 million and $9.5 million in 2019, 2018 and 2017, respectively.

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AVERAGE BALANCES AND RATES

	2019							2018							2017
	Average Balance		Interest		Rate			Average Balance		Interest		Rate			Average Balance		Interest		Rate
	(Dollars in thousands)
ASSETS
Taxable loans	$	2,713,690	$	133,574		4.92	%	$	2,418,421	$	116,634		4.82	%	$	1,845,661	$	84,169		4.56	%
Tax-exempt loans⁽¹⁾		7,937		391		4.93			6,118		292		4.77			3,199		172		5.38
Taxable securities		397,598		11,842		2.98			394,160		10,874		2.76			485,343		10,928		2.25
Tax-exempt securities⁽¹⁾		52,324		1,683		3.22			67,574		2,192		3.24			86,902		3,063		3.52
Interest bearing cash		48,023		818		1.70			32,593		371		1.14			37,119		264		0.71
Other investments		18,359		1,043		5.68			16,936		920		5.43			15,543		836		5.38
Interest earning assets		3,237,931		149,351		4.61			2,935,802		131,283		4.48			2,473,767		99,432		4.02
Cash and due from banks		37,575							33,384							31,980
Other assets, net		164,726							162,750							144,442
Total assets	$	3,440,232						$	3,131,936						$	2,650,189
LIABILITIES
Savings and interest-
bearing checking	$	1,453,061		10,228		0.70		$	1,218,243		4,696		0.39		$	1,052,215		1,530		0.15
Time deposits		655,718		13,197		2.01			632,330		9,782		1.55			502,284		5,245		1.04
Other borrowings		77,254		2,922		3.78			79,519		3,013		3.79			74,876		2,348		3.14
Interest bearing liabilities		2,186,033		26,347		1.21			1,930,092		17,491		0.91			1,629,375		9,123		0.56
Non-interest bearing deposits		867,314							846,718							728,208
Other liabilities		46,153							33,354							30,838
Shareholders’ equity		340,732							321,772							261,768
Total liabilities and shareholders’ equity	$	3,440,232						$	3,131,936						$	2,650,189
Net interest income			$	123,004						$	113,792						$	90,309
Net interest income as a percent of average interest earning assets						3.80	%						3.88	%						3.65	%

(1)

Interest on tax-exempt loans and securities is presented on a fully tax equivalent basis assuming a marginal tax rate of 21% in 2019 and 2018 and 35% in 2017.

RECONCILIATION OF NET INTEREST MARGIN, FULLY TAXABLE EQUIVALENT (“FTE”)

	Year Ended December 31,
	2019			2018			2017
	(Dollars in thousands)
Net interest income	$	122,581		$	113,282		$	89,186
Add: taxable equivalent adjustment		423			510			1,123
Net interest income - taxable equivalent	$	123,004		$	113,792		$	90,309
Net interest margin (GAAP)		3.79	%		3.85	%		3.61	%
Net interest margin (FTE)		3.80	%		3.88	%		3.65	%

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CHANGE IN NET INTEREST INCOME

	2019 compared to 2018									2018 compared to 2017
	Volume			Rate			Net			Volume			Rate			Net
	(In thousands)
Increase (decrease) in interest income⁽¹⁾
Taxable loans	$	14,491		$	2,449		$	16,940		$	27,388		$	5,077		$	32,465
Tax-exempt loans⁽²⁾		89			10			99			141			(21	)		120
Taxable securities		96			872			968			(2,263	)		2,209			(54	)
Tax-exempt securities⁽²⁾		(491	)		(18	)		(509	)		(641	)		(230	)		(871	)
Interest bearing cash		218			229			447			(35	)		142			107
Other investments		80			43			123			76			8			84
Total interest income		14,483			3,585			18,068			24,666			7,185			31,851
Increase (decrease) in interest expense⁽¹⁾
Savings and interest bearing checking		1,047			4,485			5,532			276			2,890			3,166
Time deposits		374			3,041			3,415			1,587			2,950			4,537
Other borrowings		(86	)		(5	)		(91	)		153			512			665
Total interest expense		1,335			7,521			8,856			2,016			6,352			8,368
Net interest income	$	13,148		$	(3,936	)	$	9,212		$	22,650		$	833		$	23,483

(1)

The change in interest due to changes in both balance and rate has been allocated to change due to balance and change due to rate in proportion to the relationship of the absolute dollar amounts of change in each.

(2)

Interest on tax-exempt loans and securities is presented on a fully tax equivalent basis assuming a marginal tax rate of 21% in 2019 and 2018 and 35% in 2017.

COMPOSITION OF AVERAGE INTEREST EARNING ASSETS AND INTEREST BEARING LIABILITIES

	Year Ended December 31,
	2019			2018			2017
As a percent of average interest earning assets
Loans		84.1	%		82.6	%		74.7	%
Other interest earning assets		15.9			17.4			25.3
Average interest earning assets		100.0	%		100.0	%		100.0	%
Savings and interest-bearing checking		44.9	%		41.5	%		42.5	%
Time deposits		20.3			21.5			20.3
Other borrowings		2.3			2.7			3.1
Average interest bearing liabilities		67.5	%		65.7	%		65.9	%
Earning asset ratio		94.1	%		93.7	%		93.3	%
Free-funds ratio⁽¹⁾		32.5			34.3			34.1

(1)

Average interest earning assets less average interest bearing liabilities divided by average interest earning assets.

Provision for loan losses. The provision for loan losses was an expense of $0.8 million, $1.5 million and $1.2 million in 2019, 2018 and 2017, respectively. The provision reflects our assessment of the allowance for loan losses taking into consideration factors such as loan mix, levels of non-performing and classified loans and loan net charge-offs. While we use relevant information to recognize losses on loans, additional provisions for related losses may be necessary based on changes in economic conditions, customer circumstances and other credit risk factors. See “Portfolio Loans and asset quality” for a discussion of the various components of the allowance for loan losses and their impact on the provision for loan losses.

Non-interest income. Non-interest income is a significant element in assessing our results of operations. Non-interest income totaled $47.7 million during 2019 compared to $44.8 million and $42.5 million during 2018 and

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2017, respectively. We adopted Financial Accounting Standards Board Accounting Standards Update 2014-09 “Revenue from Contracts with Customers (Topic 606)” (“ASU 2014-09”) on January 1, 2018, using the modified retrospective method. Although ASU 2014-09 did not have any impact on our January 1, 2018 shareholders’ equity or 2019 or 2018 net income, it did result in a classification change in non-interest income and non-interest expense as compared to 2017. Specifically, in 2019, interchange income and interchange expense each increased by $1.9 million and in 2018, interchange income and interchange expense each increased by $1.5 million, due to classification changes under ASU 2014-09 (also see note #25 to our Consolidated Financial Statements).

NON-INTEREST INCOME

	Year Ended December 31,
	2019			2018		2017
	(In thousands)
Service charges on deposit accounts	$	11,208		$	12,258	$	12,673
Interchange income		10,297			9,905		8,023
Net gains on assets
Mortgage loans		19,978			10,597		11,762
Securities		307			138		260
Mortgage loan servicing, net		(3,336	)		3,157		1,647
Investment and insurance commissions		1,658			1,971		1,968
Bank owned life insurance		1,111			970		1,061
Other		6,513			5,819		5,139
Total non-interest income	$	47,736		$	44,815	$	42,533

Service charges on deposit accounts totaled $11.2 million in 2019, as compared to $12.3 million in 2018 and $12.7 million during 2017. These yearly variations primarily reflect declines in non-sufficient funds fees.

Interchange income totaled $10.3 million in 2019 compared to $9.9 million in 2018 and $8.0 million in 2017. The increases in 2019 and 2018 as compared to 2017, are primarily due to the aforementioned impact of ASU 2014-09 as well as increased transaction volume.

We realized net gains of $20.0 million on mortgage loans during 2019, compared to $10.6 million and $11.8 million during 2018 and 2017 respectively. Mortgage loan activity is summarized as follows:

MORTGAGE LOAN ACTIVITY

	Year Ended December 31,
	2019			2018			2017
	(Dollars in thousands)
Mortgage loans originated	$	1,011,141		$	807,408		$	871,222
Mortgage loans sold⁽¹⁾		738,910			491,798			423,327
Net gains on mortgage loans		19,978			10,597			11,762
Net gains as a percent of mortgage loans sold (“Loan Sales Margin”)		2.70	%		2.15	%		2.78	%
Fair value adjustments included in the Loan Sales Margin		0.22			(0.02	)		(0.07	)

(1)

2019 includes the sale of $50.5 million of portfolio residential fixed and adjustable mortgage loans to other institutions and securitization of $65.1 million of portfolio residential fixed rate loans. 2018 includes the sale of $27.6 million of portfolio residential fixed and adjustable rate portfolio mortgage loans to another financial institution and securitization of $10.9 million of portfolio residential fixed rate loans.

The increase in mortgage loan originations, sales and net gains in 2019 as compared to 2018 and 2017 is due primarily to lower interest rates that resulted in increased mortgage loan refinance activity. In addition, a solid housing market has resulted in strong purchase money mortgage origination volume. However, higher interest rates during 2018, reduced mortgage loan refinance volume during that year on an industry-wide basis.

The volume of loans sold is dependent upon our ability to originate mortgage loans as well as the demand for fixed-rate obligations and other loans that we choose to not put into portfolio because of our established interest-rate risk parameters. (See “Portfolio Loans and asset quality.”) Net gains on mortgage loans are also dependent upon

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economic and competitive factors as well as our ability to effectively manage exposure to changes in interest rates and thus can often be a volatile part of our overall revenues.

Net gains as a percentage of mortgage loans sold (our “Loan Sales Margin”) are impacted by several factors including competition and the manner in which the loan is sold. Net gains on mortgage loans are also impacted by recording fair value accounting adjustments. Excluding these fair value accounting adjustments, the Loan Sales Margin would have been 2.48% in 2019, 2.17% in 2018 and 2.85% in 2017. The higher Loan Sales Margin in 2019 and 2017, as compared to 2018, was principally due to more favorable competitive conditions including wider primary-to-secondary market pricing spreads for much of each of those years. In 2018, our Loan Sales Margin contracted due to competitive factors. In general, as overall industry-wide mortgage loan origination levels drop, pricing becomes more competitive. The changes in the fair value accounting adjustments are primarily due to changes in the amount of commitments to originate mortgage loans for sale during each period. In addition, in 2018, we recorded a loss on mortgage loans of $0.25 million in the fourth quarter on the pending sale of approximately $41.5 million of portfolio mortgage loans. These loans were classified as held for sale at December 31, 2018, and carried at the lower of cost or fair value. This sale closed on January 30, 2019.

We generated net gains on securities of $0.31 million, $0.14 million and $0.26 million in 2019, 2018 and 2017, respectively. These net gains were due to the sales of securities and changes in the fair value of equity/trading securities as outlined in the table below. We recorded no net impairment losses in 2019, 2018 or 2017 for other than temporary impairment of securities available for sale.

GAINS AND LOSSES ON SECURITIES

	Year Ended December 31,
	Proceeds		Gains⁽¹⁾		Losses⁽²⁾		Net
	(In thousands)
2019	$	68,716	$	415	$	108	$	307
2018		48,736		336		198		138
2017		17,308		263		3		260

(1)

Gains in 2019 and 2017 include $0.166 million and $0.045 million, respectively related to equity securities at fair value. Gains in 2018 include $0.144 million related to the sale of 1,000 VISA Class B shares.

(2)

Losses in 2018 include $0.062 million related to equity securities at fair value.

Mortgage loan servicing, net, generated a loss of $3.3 million and earnings of $3.2 million and $1.6 million in 2019, 2018 and 2017, respectively. This activity is summarized in the following table:

MORTGAGE LOAN SERVICING ACTIVITY

	2019			2018			2017
	(In thousands)
Mortgage loan sevicing:
Revenue, net	$	6,196		$	5,480		$	4,391
Fair value change due to price		(6,408	)		191			(718	)
Fair value change due to pay-downs		(3,124	)		(2,514	)		(2,026	)
Total	$	(3,336	)	$	3,157		$	1,647

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Effective on January 1, 2017, we adopted the fair value accounting method for capitalized mortgage loan servicing rights. Activity related to capitalized mortgage loan servicing rights is as follows:

CAPITALIZED MORTGAGE LOAN SERVICING RIGHTS

	2019			2018			2017
	(In thousands)
Balance at January 1,	$	21,400		$	15,699		$	13,671
Change in accounting		—			—			542
Balance at January 1, as adjusted		21,400			15,699			14,213
Originated servicing rights capitalized		7,303			4,977			4,230
Servicing rights acquired		—			3,047			—
Change in fair value		(9,532	)		(2,323	)		(2,744	)
Balance at December 31,	$	19,171		$	21,400		$	15,699

At December 31, 2019, we were servicing approximately $2.58 billion in mortgage loans for others on which servicing rights have been capitalized. This servicing portfolio had a weighted average coupon rate of 4.22% and a weighted average service fee of approximately 25.8 basis points. Remaining capitalized mortgage loan servicing rights at December 31, 2019 totaled $19.2 million, representing approximately 74.3 basis points on the related amount of mortgage loans serviced for others.

Investment and insurance commissions totaled $1.7 million in 2019 as compared to $2.0 million in both 2018 and 2017. The lower level of revenue in 2019 as compared to the prior two years was due primarily to lower sales volumes reflecting, in part, changes in and newer personnel in certain markets.

We earned $1.1 million, $1.0 million and $1.1 million in 2019, 2018 and 2017, respectively, on our separate account bank owned life insurance principally as a result of increases in the cash surrender value. Our separate account is primarily invested in agency mortgage-backed securities and managed by a fixed income investment manager. The crediting rate (on which the earnings are based) reflects the performance of the separate account. The total cash surrender value of our bank owned life insurance was $55.7 million and $55.1 million at December 31, 2019 and 2018, respectively.

Other non-interest income totaled $6.5 million, $5.8 million and $5.1 million in 2019, 2018 and 2017, respectively. The increase in 2019 as compared to 2018 is due primarily to growth in fees related to interest rate swaps for commercial loan customers. The increase in 2018 as compared to 2017 is primarily due to increases in a variety of categories including: wire transfer fees, credit card interchange income, merchant processing fees, and income from a small business investment company.

Non-interest expense. Non-interest expense is an important component of our results of operations. We strive to efficiently manage our cost structure.

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Non-interest expense totaled $111.7 million in 2019, $107.5 million in 2018, and $92.1 million in 2017. Many of our components of non-interest expense increased in 2019 and 2018 as compared to 2017 due to the Merger. The components of non-interest expense are as follows:

NON-INTEREST EXPENSE

	Year ended December 31,
	2019			2018			2017
	(In thousands)
Compensation	$	41,719		$	37,878		$	35,397
Performance-based compensation		12,066			11,942			9,874
Payroll taxes and employee benefits		13,716			12,258			9,818
Compensation and employee benefits		67,501			62,078			55,089
Occupancy, net		9,013			8,912			8,102
Data processing		8,905			8,262			7,657
Furniture, fixtures and equipment		4,113			4,080			3,870
Interchange expense		3,215			2,702			1,156
Communications		2,947			2,848			2,684
Loan and collection		2,685			2,682			2,230
Advertising		2,450			2,155			1,905
Legal and professional		1,814			1,839			1,892
Amortization of intangible assets		1,089			969			346
FDIC deposit insurance		685			1,081			894
Supplies		638			689			666
Credit card and bank service fees		411			414			529
Costs related to unfunded lending commitments		246			171			475
Provision for loss reimbursement on sold loans		229			10			171
Net gains on other real estate and repossessed assets		(90	)		(672	)		(606	)
Merger related expenses		—			3,465			284
Other		5,882			5,776			4,738
Total non-interest expense	$	111,733		$	107,461		$	92,082

Compensation expense, which is primarily salaries, totaled $41.7 million, $37.9 million and $35.4 million in 2019, 2018 and 2017, respectively. The increases in 2019 and 2018 as compared to 2017 were primarily due to annual merit based salary increases, the Merger and additional staffing particularly in commercial lending and information technology (including data analytics).

Performance-based compensation expense totaled $12.1 million, $11.9 million and $9.9 million in 2019, 2018 and 2017, respectively. The increase in 2019 as compared to 2018 was primarily due to an increase in the employee stock ownership plan (“ESOP”) contribution accrual reflecting the aforementioned higher salaries. The increase in 2018 as compared to 2017 primarily related to the level of compensation under our Management Incentive Compensation Plan (“MICP”) based on our performance relative to plan targets and increased ESOP contributions.

We maintain performance-based compensation plans. In addition to commissions and cash incentive awards, such plans include an ESOP and a long-term equity based incentive plan. The amount of expense recognized in 2019, 2018 and 2017 for share-based awards under our long-term equity based incentive plan was $1.6 million, $1.5 million and $1.6 million, respectively. In each of those three years, the Board and Compensation Committee of the Board authorized the grant of restricted stock and performance share awards under the plan.

Payroll taxes and employee benefits expense totaled $13.7 million, $12.3 million and $9.8 million in 2019, 2018 and 2017, respectively. The increase in 2019 as compared to 2018 was primarily due to a $0.3 million increase in payroll taxes, a $0.5 million increase in health care insurance, a $0.2 million increase in 401(k) plan employer contributions and a $0.4 million increase in employee education and employee relations costs. The increase in 2018 as compared to 2017 was primarily due to a $0.5 million increase in payroll taxes, a $1.1 million increase in health care insurance and a $0.6 million increase in 401(k) plan employer contributions. A portion of the increases in 2019 and 2018 was due to the Merger. However, we maintain a self-insured health care plan (with an individual claim stop

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loss limit) and we experienced a significant rise in claims in 2019 and 2018 as compared to 2017. In 2018, we also increased the 401(k) employer match to 4% (from 3%) of an employee’s eligible compensation.

Occupancy expenses, net, totaled $9.0 million, $8.9 million and $8.1 million in 2019, 2018 and 2017, respectively. The increases in 2019 and 2018 as compared to 2017 were primarily due to additional locations acquired in the Merger and a few additional loan production offices that were opened during 2017.

Data processing expenses totaled $8.9 million, $8.3 million, and $7.7 million in 2019, 2018 and 2017, respectively. The increase in 2019 as compared to 2018 was primarily due to higher mobile banking activity and software costs for new applications in several departments. The increase in 2018 as compared to 2017 was primarily due to the Merger as well as higher mobile banking activity and software costs for new applications in several departments.

Furniture, fixtures and equipment expense totaled $4.1 million, $4.1 million, and $3.9 million in 2019, 2018 and 2017, respectively. The increases in 2019 and 2018 as compared to 2017 were primarily due to the Merger.

Interchange expense, which totaled $3.2 million, $2.7 million, and $1.2 million in 2019, 2018 and 2017, respectively, primarily represents fees paid to our core information systems processor and debit card licensor related to debit card and ATM transactions. The increases in 2019 and 2018 as compared to 2017 were due primarily to the impact of the implementation of ASU 2014-09 on January 1, 2018. Prior to 2018, certain processing costs were being netted against interchange income. As described above, under ASU 2014-09 these costs are no longer being netted against interchange income but instead are being reported as part of interchange expense. Increased debit card transaction volumes in 2019 and 2018 also contributed to the rise in this expense as well as the addition of a fraud detection service in early 2019.

Communications expense totaled $2.9 million, $2.8 million and $2.7 million in 2019, 2018 and 2017, respectively. The increases in 2019 and 2018 as compared to 2017 were primarily due to the Merger.

Loan and collection expenses reflect costs related to new lending activity as well as the management and collection of non-performing loans and other problem credits. These expenses totaled $2.7 million, $2.7 million and $2.2 million in 2019, 2018 and 2017, respectively. The reduced level of expense in 2017 primarily reflects a higher level of recoveries of previously incurred expenses related to the resolution and collection of non-performing or previously charged-off loans.

Advertising expense totaled $2.5 million, $2.2 million, and $1.9 million in 2019, 2018 and 2017, respectively. The increase in 2019 as compared to 2018 was primarily due to increased outdoor advertising (billboards). The increase in 2018 as compared to 2017 was primarily due to increased outdoor advertising (billboards) as well as the Merger.

Legal and professional fees totaled $1.8 million, $1.8 million, and $1.9 million in 2019, 2018 and 2017, respectively. The decreases in 2019 and 2018 as compared to 2017 were primarily due to lower consulting costs for certain deposit account programs.

The amortization of intangible assets primarily relates to the Merger (for 2019 and 2018) and branch acquisitions and the related amortization of the deposit customer relationship value, including core deposit value, which was acquired in connection with those transactions. We had remaining unamortized intangible assets of $5.3 million and $6.4 million at December 31, 2019 and 2018 respectively. See note #7 to the Consolidated Financial Statements for a schedule of future amortization of intangible assets.

FDIC deposit insurance expense totaled $0.7 million, $1.1 million, and $0.9 million in 2019, 2018 and 2017, respectively. The decrease in 2019 as compared to 2018 was primarily due to the use of our FDIC Small Bank Assessment Credit (the “Assessment Credit”) of approximately $0.7 million. We do not have any remaining Assessment Credit to apply against our 2020 FDIC deposit insurance expense. The increase in 2018 as compared to 2017 was primarily due to the Merger and growth in total assets.

Supplies expenses were relatively unchanged for all periods presented.

Credit card and bank service fees totaled $0.4 million, $0.4 million, and $0.5 million in 2019, 2018 and 2017, respectively. The declines in 2019 and 2018 compared to 2017 were primarily due to the sale of our payment plan processing business in May 2017.

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The changes in costs related to unfunded lending commitments are primarily impacted by changes in the amounts of such commitments to originate Portfolio Loans as well as (for commercial loan commitments) the grade (pursuant to our loan rating system) of such commitments.

The provision for loss reimbursement on sold loans was an expense of $0.23 million, $0.01 million and $0.17 million in 2019, 2018 and 2017, respectively. This provision represents our estimate of incurred losses related to mortgage loans that we have sold to investors (primarily Fannie Mae, Freddie Mac, Ginnie Mae and the Federal Home Loan Bank of Indianapolis). Since we sell mortgage loans without recourse, loss reimbursements only occur in those instances where we have breached a representation or warranty or other contractual requirement related to the loan sale. The reserve for loss reimbursements on sold mortgage loans totaled $0.88 million and $0.78 million at December 31, 2019 and 2018, respectively. This reserve is included in accrued expenses and other liabilities in our Consolidated Statements of Financial Condition. We believe that the amounts that we have accrued for incurred losses on sold mortgage loans are appropriate based upon our prior experience and other assumptions. However, future losses could exceed our current estimate.

Net gains on other real estate and repossessed assets represent the gain or loss on the sale or additional write downs on these assets subsequent to the transfer of the asset from our loan portfolio. This transfer occurs at the time we acquire the collateral that secured the loan. At the time of acquisition, the other real estate or repossessed asset is valued at fair value, less estimated costs to sell, which becomes the new basis for the asset. Any write-downs at the time of acquisition are charged to the allowance for loan losses. The net gains of $0.1 million in 2019 and $0.7 million in 2018 were primarily due to improved market conditions leading to better sales prices for both commercial and residential properties. The net gain of $0.6 million in 2017 was primarily due to the sale of a commercial property in the fourth quarter of that year.

Merger related expenses totaled $3.5 million and $0.3 million in 2018 and 2017, respectively. These expenses included our investment banking fees, certain accounting and legal costs, various contract termination fees, data processing conversion costs, payments made on officer change-in-control contracts, and employee severance costs.

Other non-interest expenses totaled $5.9 million, $5.8 million, and $4.7 million in 2019, 2018 and 2017, respectively. The increases in 2019 and 2018 as compared to 2017 was due to increases in several expense categories, including: directors’ fees (a new director was added in 2018), travel and entertainment expenses (in part due to the Merger), debit card and check fraud losses and certain outsourcing costs related to mortgage lending.

Income tax expense. We recorded an income tax expense of $11.3 million, $9.3 million and $18.0 million in 2019, 2018 and 2017, respectively. 2019 and 2018 reflect a lower corporate federal income tax rate and 2017 includes an additional $6.0 million of income tax expense related to the remeasurement of our DTA, both as described earlier under “Significant Developments.”

Our actual federal income tax expense is different than the amount computed by applying our statutory federal income tax rate to our pre-tax income primarily due to tax-exempt interest income, share based compensation and tax-exempt income from the increase in the cash surrender value on life insurance (and for 2017, the remeasurement of our DTA as well).

We assess whether a valuation allowance should be established against our DTA based on the consideration of all available evidence using a “more likely than not” standard. The ultimate realization of this asset is primarily based on generating future income. We concluded at December 31, 2019 and 2018 that the realization of substantially all of our DTA continues to be more likely than not.

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FINANCIAL CONDITION

Summary. Our total assets increased to $3.56 billion at December 31, 2019, compared to $3.35 billion at December 31, 2018, primarily due to growth in securities available for sale and loans.

Loans, excluding loans held for sale (“Portfolio Loans”), totaled $2.73 billion at December 31, 2019, an increase of 5.5% from $2.58 billion at December 31, 2018. (See “Portfolio Loans and asset quality”). The increase in Portfolio Loans during the last few years is part of our overall strategy to grow revenues, earnings and improve our operating leverage by increasing our loans to deposits ratio. The expansion of our mortgage banking operations is part of this strategy along with continuing to increase our commercial and consumer installment lending.

Deposits totaled $3.04 billion at December 31, 2019, compared to $2.91 billion at December 31, 2018. The $123.3 million increase in total deposits during the period reflects growth in reciprocal deposits.

Securities. We maintain diversified securities portfolios, which include obligations of U.S. government- sponsored agencies, securities issued by states and political subdivisions, residential and commercial mortgage- backed securities, asset-backed securities, corporate securities, trust preferred securities and foreign government securities (that are denominated in U.S. dollars). We regularly evaluate asset/liability management needs and attempt to maintain a portfolio structure that provides sufficient liquidity and cash flow. Except as discussed below, we believe that the unrealized losses on securities available for sale are temporary in nature and are expected to be recovered within a reasonable time period. We believe that we have the ability to hold securities with unrealized losses to maturity or until such time as the unrealized losses reverse. (See “Asset/liability management.”) Securities available for sale increased by $90.5 million during 2019, reflecting the deployment of a portion of the funds generated from the growth in deposits and borrowings.

Our portfolio of securities available for sale is reviewed quarterly for impairment in value. In performing this review, management considers (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) the impact of changes in market interest rates on the market value of the security, and (4) an assessment of whether we intend to sell, or it is more likely than not that we will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. For securities that do not meet these recovery criteria, the amount of impairment recognized in earnings is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income (loss). We recorded no net impairment losses related to other than temporary impairment on securities available for sale in 2019, 2018 or 2017.

SECURITIES

	Amortized Cost		Unrealized				Fair Value
	Amortized Cost		Gains		Losses		Fair Value
	(In thousands)
Securities available for sale
December 31, 2019	$	513,668	$	5,782	$	1,050	$	518,400
December 31, 2018		433,224		1,520		6,818		427,926

Portfolio Loans and asset quality. In addition to the communities served by our Bank branch and loan production office network, our principal lending markets also include nearby communities and metropolitan areas. Subject to established underwriting criteria, we also may participate in commercial lending transactions with certain non-affiliated banks and make whole loan purchases from other financial institutions.

The senior management and board of directors of our Bank retain authority and responsibility for credit decisions and we have adopted uniform underwriting standards. Our loan committee structure and the loan review process attempt to provide requisite controls and promote compliance with such established underwriting standards. However, there can be no assurance that our lending procedures and the use of uniform underwriting standards will prevent us from incurring significant credit losses in our lending activities.

We generally retain loans that may be profitably funded within established risk parameters. (See “Asset/liability management.”) As a result, we may hold adjustable-rate conventional and fixed rate jumbo mortgage loans as Portfolio Loans, while 15- and 30-year fixed-rate non-jumbo mortgage loans are generally sold to mitigate exposure to changes in interest rates. (See “Non-interest income.”) Due primarily to the expansion of our mortgage-banking activities and a change in mix in our mortgage loan originations, we are now originating and putting into Portfolio

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Loans more fixed rate mortgage loans compared to past periods. These fixed rate mortgage loans generally have terms from 15 to 30 years, do not have prepayment penalties and expose us to more interest rate risk. To date, our interest rate risk profile has not changed significantly. However, we are carefully monitoring this change in the composition of our Portfolio Loans and the impact of potential future changes in interest rates on our changes in market value of portfolio equity and changes in net interest income. (See “Asset/liability management.”). As a result, we have added and may continue to add some longer-term borrowings, may utilize derivatives (interest rate swaps and interest rate caps) to manage interest rate risk and may continue to sell certain fixed rate and adjustable rate jumbo or other mortgage loans in the future. In 2019, we sold or securitized $75.0 million (excludes the $41.7 million discussed below) of fixed and adjustable rate portfolio mortgage loans. In 2018, we sold $27.6 million of fixed and adjustable rate portfolio mortgage loans. In addition, in the fourth quarter of 2018 we reclassified $41.7 million (fair value of $41.5 million) of adjustable rate portfolio mortgage loans to held for sale. These loans (which totaled $40.6 million at the time of sale) were sold to another financial institution on a servicing released basis on January 30, 2019. All of these loan sales/securitizations were non-recourse (other than standard representations and warranties) and were executed primarily for asset/liability management purposes.

LOAN PORTFOLIO COMPOSITION

	December 31,
	2019		2018
	(In thousands)
Real estate⁽¹⁾
Residential first mortgages	$	843,746	$	811,719
Residential home equity and other junior mortgages		166,735		177,574
Construction and land development		249,747		180,286
Other⁽²⁾		693,580		707,347
Consumer		448,297		379,607
Commercial		318,504		319,058
Agricultural		4,414		6,929
Total loans	$	2,725,023	$	2,582,520

(1)

Includes both residential and non-residential commercial loans secured by real estate.

(2)

Includes loans secured by multi-family residential and non-farm, non-residential property.

NON-PERFORMING ASSETS⁽¹⁾

	December 31,
	2019			2018			2017
	(Dollars in thousands)
Non-accrual loans	$	10,178		$	9,029		$	8,184
Loans 90 days or more past due and still accruing interest		—			5			—
Sub total		10,178			9,034			8,184
Less: Government guaranteed loans		646			460			255
Total non-performing loans		9,532			8,574			7,929
Other real estate and repossessed assets		1,865			1,299			1,643
Total non-performing assets	$	11,397		$	9,873		$	9,572

As a percent of Portfolio Loans
Non-performing loans		0.35	%		0.33	%		0.39	%
Allowance for loan losses		0.96			0.96			1.12
Non-performing assets to total assets		0.32			0.29			0.34
Allowance for loan losses as a percent of non-performing loans		274.32			290.27			284.87

(1)

Excludes loans classified as “troubled debt restructured” that are performing and vehicle service contract counterparty receivables, net.

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TROUBLED DEBT RESTRUCTURINGS

	December 31, 2019
	Commercial		Retail⁽¹⁾			Total
	(In thousands)
Performing TDR's	$	7,974	$	39,601		$	47,575
Non-performing TDR's⁽²⁾		540		2,607	⁽³⁾		3,147
Total	$	8,514	$	42,208		$	50,722

	December 31, 2018
	Commercial		Retail⁽¹⁾			Total
	(In thousands)
Performing TDR's	$	6,460	$	46,627		$	53,087
Non-performing TDR's⁽²⁾		74		2,884	⁽³⁾		2,958
Total	$	6,534	$	49,511		$	56,045

(1)

Retail loans include mortgage and installment loan portfolio segments.

(2)

Included in non-performing loans table above.

(3)

Also includes loans on non-accrual at the time of modification until six payments are received on a timely basis.

Non-performing loans totaled $9.5 million, $8.6 million and $7.9 million at December 31, 2019, 2018 and 2017, respectively. The increase in 2019 as compared to 2018 was primarily in the residential mortgage loan portfolio segment that was partially offset by the pay-off or liquidation of non-performing commercial loans. The increase in 2018 as compared to 2017 is primarily due to an increase in non-performing commercial loans. In general, stable economic conditions in our market areas, as well as our collection and resolution efforts, have resulted in relatively low levels of non-performing loans the last few years. However, we are still experiencing some loan defaults, particularly related to commercial loans secured by income-producing property and mortgage loans secured by resort/vacation property.

Non-performing loans exclude performing loans that are classified as troubled debt restructurings (“TDRs”). Performing TDRs totaled $47.6 million, or 1.7% of total Portfolio Loans, and $53.1 million, or 2.1% of total Portfolio Loans, at December 31, 2019 and 2018, respectively. The decrease in the amount of performing TDRs during 2019 reflects a decline in mortgage loan TDRs due primarily to payoffs and amortization.

ORE and repossessed assets totaled $1.9 million at December 31, 2019, compared to $1.3 million at December 31, 2018. The increase in ORE during 2019 primarily reflects the addition of a $0.6 million commercial office building located in Grand Rapids, Michigan in the second quarter.

We will place a loan that is 90 days or more past due on non-accrual, unless we believe the loan is both well secured and in the process of collection. Accordingly, we have determined that the collection of the accrued and unpaid interest on any loans that are 90 days or more past due and still accruing interest is probable.

ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES

	December 31,
	2019		2018		2017
	(In thousands)
Specific allocations	$	6,155	$	6,310	$	6,839
Other adversely rated commercial loans		2,502		1,861		1,228
Historical loss allocations		8,764		7,792		7,125
Additional allocations based on subjective factors		8,727		8,925		7,395
Total	$	26,148	$	24,888	$	22,587

Some loans will not be repaid in full. Therefore, an allowance for loan losses (“AFLL”) is maintained at a level which represents our best estimate of losses incurred. In determining the AFLL and the related provision for loan losses, we consider four principal elements: (i) specific allocations based upon probable losses identified during the

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review of the loan portfolio, (ii) allocations established for other adversely rated commercial loans, (iii) allocations based principally on historical loan loss experience, and (iv) additional allowances based on subjective factors, including local and general economic business factors and trends, portfolio concentrations and changes in the size and/or the general terms of the loan portfolios.

The first AFLL element (specific allocations) reflects our estimate of probable incurred losses based upon our systematic review of specific loans. These estimates are based upon a number of factors, such as payment history, financial condition of the borrower, discounted collateral exposure and discounted cash flow analysis. Impaired commercial, mortgage and installment loans are allocated AFLL amounts using this first element. The second AFLL element (other adversely rated commercial loans) reflects the application of our commercial loan rating system. This rating system is similar to those employed by state and federal banking regulators. Commercial loans that are rated below a certain predetermined classification are assigned a loss allocation factor for each loan classification category that is based upon a historical analysis of both the probability of default and the expected loss rate (“loss given default”). The lower the rating assigned to a loan or category, the greater the allocation percentage that is applied. The third AFLL element (historical loss allocations) is determined by assigning allocations to higher rated (“non-watch credit”) commercial loans using a probability of default and loss given default similar to the second AFLL element and to homogenous mortgage and installment loan groups based upon borrower credit score and portfolio segment. For homogenous mortgage and installment loans a probability of default for each homogenous pool is calculated by way of credit score migration. Historical loss data for each homogenous pool coupled with the associated probability of default is utilized to calculate an expected loss allocation rate. The fourth AFLL element (additional allocations based on subjective factors) is based on factors that cannot be associated with a specific credit or loan category and reflects our attempt to ensure that the overall AFLL appropriately reflects a margin for the imprecision necessarily inherent in the estimates of expected credit losses. We consider a number of subjective factors when determining this fourth element, including local and general economic business factors and trends, portfolio concentrations and changes in the size, mix and the general terms of the overall loan portfolio.

No allowance for loan losses was brought forward on any of the TCSB loans acquired in the Merger as any credit deterioration evident in the loans was included in the determination of the fair value of the loans at the acquisition date. An allowance for loan losses is being established for any subsequent credit deterioration or adverse changes in expected cash flows.

Increases in the AFLL are recorded by a provision for loan losses charged to expense. Although we periodically allocate portions of the AFLL to specific loans and loan portfolios, the entire AFLL is available for incurred losses. We generally charge-off commercial, homogenous residential mortgage and installment loans when they are deemed uncollectible or reach a predetermined number of days past due based on product, industry practice and other factors. Collection efforts may continue and recoveries may occur after a loan is charged against the AFLL. While we use relevant information to recognize losses on loans, additional provisions for related losses may be necessary based on changes in economic conditions, customer circumstances and other credit risk factors.

The AFLL increased $1.26 million to $26.15 million at December 31, 2019 from $24.89 million at December 31, 2018 and was equal to 0.96% of total Portfolio Loans at both December 31, 2019 and 2018.

During the first quarter of 2019, we deployed a third-party software solution (we previously used spreadsheet software) to assist in the determination of our AFLL. This new third-party software has also assisted us in moving to the expected loss framework that we implemented on January 1, 2020. Although the use of this new third-party software did not have any material impact on our overall AFLL, it did result in some classification shifts from the AFLL related to subjective factors into the AFLL related to historical losses as the new software model allowed us to capture longer historical look-back periods (previously this was being captured in the subjective portion of the AFLL).

Two of the four components of the AFLL outlined above increased during 2019. The AFLL related to specific loans decreased $0.2 million during 2019 due primarily to a $2.6 million decline in the amount of such loans. The AFLL related to other adversely rated commercial loans increased $0.6 million during 2019, primarily due to an increase in the balance of such loans included in this component to $54.4 million at December 31, 2019 from $44.7 million at December 31, 2018. The increase in other adversely rated commercial loans was primarily in early watch credit categories and these loans are largely performing. We do not believe that we will experience any

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significant loan losses as a result of this rise in other adversely rated commercial loans. The AFLL related to historical losses increased $1.0 million during 2019, and the AFLL related to subjective factors decreased $0.2 million during 2019, due in part to the classification shifts discussed above, as well as loan growth, for the AFLL related to historical losses.

By comparison, three of the four components of the allowance for loan losses outlined above increased during 2018. The allowance for loan losses related to specific loans decreased $0.5 million in 2018 due primarily to a decline in the balance of individually impaired loans and charge-offs. The allowance for loan losses related to other adversely rated commercial loans increased $0.6 million in 2018 primarily due to an increase in the balance of such loans included in this component to $44.7 million at December 31, 2018 from $27.2 million at December 31, 2017. The allowance for loan losses related to historical losses increased $0.7 million during 2018 due principally to loan growth. The allowance for loan losses related to subjective factors increased $1.5 million during 2018 primarily due to loan growth.

ALLOWANCE FOR LOSSES ON LOANS AND UNFUNDED COMMITMENTS

	2019					2018					2017
	Loan Losses			Unfunded Commitments		Loan Losses			Unfunded Commitments		Loan Losses			Unfunded Commitments
	(Dollars in thousands)
Balance at beginning of year	$	24,888		$	1,296	$	22,587		$	1,125	$	20,234		$	650
Additions (deductions)
Provision for loan losses		824			—		1,503			—		1,199			—
Recoveries credited to allowance		3,961			—		4,622			—		4,205			—
Loans charged against the allowance		(3,525	)		—		(3,824	)		—		(3,051	)		—
Additions included in non-interest expense		—			246		—			171		—			475
Balance at end of year	$	26,148		$	1,542	$	24,888		$	1,296	$	22,587		$	1,125
Net loans charged against the allowance to average Portfolio Loans		(0.02	)%				(0.03	)%				(0.06	)%

In 2019, 2018 and 2017, we recorded loan net recoveries of $0.4 million, $0.8 million and $1.2 million, respectively. These net recoveries primarily reflect reduced levels of non-performing loans, improvement in collateral liquidation values and on-going collection efforts on previously charged-off loans.

Deposits and borrowings. Historically, the loyalty of our customer base has allowed us to price deposits competitively, contributing to a net interest margin that compares favorably to our peers. However, we still face a significant amount of competition for deposits within many of the markets served by our branch network, which limits our ability to materially increase deposits without adversely impacting the weighted-average cost of core deposits.

To attract new core deposits, we have implemented various account acquisition strategies as well as branch staff sales training. Account acquisition initiatives have historically generated increases in customer relationships. Over the past several years, we have also expanded our treasury management products and services for commercial businesses and municipalities or other governmental units and have also increased our sales calling efforts in order to attract additional deposit relationships from these sectors. We view long-term core deposit growth as an important objective. Core deposits generally provide a more stable and lower cost source of funds than alternative sources such as short-term borrowings. (See “Liquidity and capital resources.”)

Deposits totaled $3.04 billion and $2.91 billion at December 31, 2019 and 2018, respectively. The $123.3 million increase in deposits during 2019 is due to growth in reciprocal deposits. Reciprocal deposits totaled $431.0 million and $182.1 million at December 31, 2019 and 2018, respectively. These deposits represent demand, money market and time deposits from our customers that have been placed through Promontory Interfinancial Network’s Insured Cash Sweep^® service and Certificate of Deposit Account Registry Service^®. These services allow our customers to access multi-million dollar FDIC deposit insurance on deposit balances greater than the standard FDIC insurance maximum. The significant increase in reciprocal deposits is due in part to an automated sweep capability we introduced in mid-2018 as well as the marketing and sales efforts of our treasury management team.

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We cannot be sure that we will be able to maintain our current level of core deposits. In particular, those deposits that are uninsured may be susceptible to outflow. At December 31, 2019, we had an estimated $532.9 million of uninsured deposits. A reduction in core deposits would likely increase our need to rely on wholesale funding sources.

We have also implemented strategies that incorporate using federal funds purchased, other borrowings and Brokered CDs to fund a portion of our interest-earning assets. The use of such alternate sources of funds supplements our core deposits and is also a part of our asset/liability management efforts. Other borrowings, comprised primarily of federal funds purchased and advances from the Federal Home Loan Bank (the “FHLB”), totaled $88.6 million and $25.7 million at December 31, 2019 and 2018, respectively.

As described above, we utilize wholesale funding, including federal funds purchased, FHLB borrowings and Brokered CDs to augment our core deposits and fund a portion of our assets. At December 31, 2019, our use of such wholesale funding sources (including reciprocal deposits) amounted to approximately $709.7 million, or 22.7% of total funding (deposits and total borrowings, excluding subordinated debentures). Because wholesale funding sources are affected by general market conditions, the availability of such funding may be dependent on the confidence these sources have in our financial condition and operations. The continued availability to us of these funding sources is not certain, and Brokered CDs may be difficult for us to retain or replace at attractive rates as they mature. Our liquidity may be constrained if we are unable to renew our wholesale funding sources or if adequate financing is not available in the future at acceptable rates of interest or at all. Our financial performance could also be affected if we are unable to maintain our access to funding sources or if we are required to rely more heavily on more expensive funding sources. In such case, our net interest income and results of operations could be adversely affected.

We have historically employed derivative financial instruments to manage our exposure to changes in interest rates. During 2019, 2018 and 2017, we entered into $74.5 million, $23.9 million and $39.1 million (original aggregate notional amounts), respectively, of interest rate swaps with commercial loan customers, which were offset with interest rate swaps that the Bank entered into with a broker-dealer. We recorded $0.94 million, $0.46 million and $0.41 million of fee income related to these transactions during 2019, 2018 and 2017, respectively. Also in 2018 and 2017, we entered into (notional amounts): $10.0 million and $15.0 million, respectively, of pay fixed interest rate swaps and $105.0 million and $45.0 million, respectively, of interest rate caps. These swaps and caps are hedging short-term wholesale funding.

Liquidity and capital resources. Liquidity risk is the risk of being unable to timely meet obligations as they come due at a reasonable funding cost or without incurring unacceptable losses. Our liquidity management involves the measurement and monitoring of a variety of sources and uses of funds. Our Consolidated Statements of Cash Flows categorize these sources and uses into operating, investing and financing activities. We primarily focus our liquidity management on maintaining adequate levels of liquid assets (primarily funds on deposit with the FRB and certain investment securities) as well as developing access to a variety of borrowing sources to supplement our deposit gathering activities and provide funds for purchasing investment securities or originating Portfolio Loans as well as to be able to respond to unforeseen liquidity needs.

Our primary sources of funds include our deposit base, secured advances from the FHLB, federal funds purchased borrowing facilities with other commercial banks, and access to the capital markets (for Brokered CDs).

At December 31, 2019, we had $501.6 million of time deposits that mature in the next 12 months. Historically, a majority of these maturing time deposits are renewed by our customers. Additionally, $2.43 billion of our deposits at December 31, 2019, were in account types from which the customer could withdraw the funds on demand. Changes in the balances of deposits that can be withdrawn upon demand are usually predictable and the total balances of these accounts have generally grown or have been stable over time as a result of our marketing and promotional activities. However, there can be no assurance that historical patterns of renewing time deposits or overall growth or stability in deposits will continue in the future.

We have developed contingency funding plans that stress test our liquidity needs that may arise from certain events such as an adverse change in our financial metrics (for example, credit quality or regulatory capital ratios). Our liquidity management also includes periodic monitoring that measures quick assets (defined generally as highly liquid or short-term assets) to total assets, short-term liability dependence and basic surplus (defined as quick assets less volatile liabilities to total assets). Policy limits have been established for our various liquidity measurements and are monitored on a quarterly basis. In addition, we also prepare cash flow forecasts that include a variety of different scenarios.

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We believe that we currently have adequate liquidity at our Bank because of our cash and cash equivalents, our portfolio of securities available for sale, our access to secured advances from the FHLB, and our ability to issue Brokered CDs.

We also believe that the available cash on hand at the parent company (including time deposits) of approximately $20.5 million as of December 31, 2019, provides sufficient liquidity resources at the parent company to meet operating expenses, to make interest payments on the subordinated debentures and to pay a cash dividend on our common stock for the foreseeable future.

In the normal course of business we enter into certain contractual obligations. Such obligations include requirements to make future payments on debt and lease arrangements, contractual commitments for capital expenditures, and service contracts. The table below summarizes our significant contractual obligations at December 31, 2019.

CONTRACTUAL COMMITMENTS⁽¹⁾

	1 Year or Less		1-3 Years		3-5 Years		After 5 Years		Total
	(In thousands)
Time deposit maturities	$	501,609	$	87,327	$	20,156	$	445	$	609,537
FHLB advances		28,645		4,995		—		30,000		63,640
Subordinated debentures		—		—		—		39,456		39,456
Operating lease obligations		1,681		2,740		1,988		2,792		9,201
Purchase obligations⁽²⁾		3,088		8,872		9,720		21,060		42,740
Total	$	535,023	$	103,934	$	31,864	$	93,753	$	764,574

(1)

Excludes approximately $0.4 million of accrued tax and interest relative to uncertain tax benefits due to the high degree of uncertainty as to when, or if, those amounts would be paid.

(2)

Includes contracts with a minimum annual payment of $1.0 million and are not cancellable within one year.

Effective management of capital resources is critical to our mission to create value for our shareholders. In addition to common stock, our capital structure also currently includes cumulative trust preferred securities.

CAPITALIZATION

	December 31,
	2019			2018
	(In thousands)
Subordinated debentures	$	39,456		$	39,388
Amount not qualifying as regulatory capital		(1,224	)		(1,224	)
Amount qualifying as regulatory capital		38,232			38,164
Shareholders’ equity
Common stock		352,344			377,372
Retained earnings (accumulated deficit)		1,611			(28,270	)
Accumulated other comprehensive loss		(3,786	)		(10,108	)
Total shareholders’ equity		350,169			338,994
Total capitalization	$	388,401		$	377,158

We currently have four special purpose entities with $39.5 million of outstanding cumulative trust preferred securities. These special purpose entities issued common securities and provided cash to our parent company that in turn issued subordinated debentures to these special purpose entities equal to the trust preferred securities and common securities. The subordinated debentures represent the sole asset of the special purpose entities. The common securities and subordinated debentures are included in our Consolidated Statements of Financial Condition.

The FRB has issued rules regarding trust preferred securities as a component of the Tier 1 capital of bank holding companies. The aggregate amount of trust preferred securities (and certain other capital elements) is limited to 25 percent of Tier 1 capital elements, net of goodwill (net of any associated deferred tax liability). The amount of

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trust preferred securities and certain other elements in excess of the limit can be included in Tier 2 capital, subject to restrictions. Although the Dodd-Frank Act further limited Tier 1 treatment for trust preferred securities, those new limits did not apply to our outstanding trust preferred securities. Further, the New Capital Rules grandfathered the treatment of our trust preferred securities as qualifying regulatory capital.

Common shareholders’ equity increased to $350.2 million at December 31, 2019 from $339.0 million at December 31, 2018, due primarily to our net income and a decline in our accumulated other comprehensive loss that were partially offset by share repurchases and by dividends that we paid. Our tangible common equity (“TCE”) totaled $316.5 million and $304.3 million, respectively, at those same dates. Our ratio of TCE to tangible assets was 8.96% and 9.17% at December 31, 2019 and 2018, respectively. TCE and the ratio of TCE to tangible assets are non-GAAP measures. TCE represents total common equity less intangible assets.

In December and January 2018, our Board of Directors authorized the 2019 and 2018 share repurchase plans, respectively. Under the original terms of these share repurchase plans, we were authorized to buy back up to 5% of our outstanding common stock. In June 2019, our Board of Directors supplemented the 2019 share repurchase plan and authorized the repurchase of up to 300,000 additional common shares. These share repurchase plans expired on December 31, 2019 and 2018, respectively. We repurchased 1,204,688 shares during 2019 at an average cost of $21.82 per share. We repurchased 587,969 shares during 2018 (all in the fourth quarter) at an average cost of $21.57 per share.

In December 2019, our Board of Directors authorized the 2020 share repurchase plan. Under the terms of the 2020 share repurchase plan, we are authorized to buy back up to 1,120,000 shares, or approximately 5%, of our outstanding common stock. This repurchase plan commenced on January 1, 2020, and is expected to last through December 31, 2020.

We pay a quarterly cash dividend on our common stock. The annual total dividends paid were $0.72, $0.60 and $0.42 per share for 2019, 2018 and 2017, respectively. We generally favor a dividend payout ratio between 30% and 50% of net income.

As of December 31, 2019 and 2018, our Bank (and holding company) continued to meet the requirements to be considered “well-capitalized” under federal regulatory standards (also see note #20 to the Consolidated Financial Statements).

Asset/liability management. Interest-rate risk is created by differences in the cash flow characteristics of our assets and liabilities. Options embedded in certain financial instruments, including caps on adjustable-rate loans as well as borrowers’ rights to prepay fixed-rate loans, also create interest-rate risk.

Our asset/liability management efforts identify and evaluate opportunities to structure our statement of financial condition in a manner that is consistent with our mission to maintain profitable financial leverage within established risk parameters. We evaluate various opportunities and alternate asset/liability management strategies carefully and consider the likely impact on our risk profile as well as the anticipated contribution to earnings. The marginal cost of funds is a principal consideration in the implementation of our asset/liability management strategies, but such evaluations further consider interest-rate and liquidity risk as well as other pertinent factors. We have established parameters for interest-rate risk. We regularly monitor our interest-rate risk and report at least quarterly to our board of directors.

We employ simulation analyses to monitor our interest-rate risk profile and evaluate potential changes in our net interest income and market value of portfolio equity that result from changes in interest rates. The purpose of these simulations is to identify sources of interest-rate risk inherent in our Consolidated Statements of Financial Condition. The simulations do not anticipate any actions that we might initiate in response to changes in interest rates and, accordingly, the simulations do not provide a reliable forecast of anticipated results. The simulations are predicated on immediate, permanent and parallel shifts in interest rates and generally assume that current loan and deposit pricing relationships remain constant. The simulations further incorporate assumptions relating to changes in customer behavior, including changes in prepayment rates on certain assets and liabilities.

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CHANGES IN MARKET VALUE OF PORTFOLIO EQUITY AND NET INTEREST INCOME

Change in Interest Rates	Market Value of Portfolio Equity⁽¹⁾		Percent Change			Net Interest Income⁽²⁾		Percent Change
	(Dollars in thousands)
December 31, 2019
200 basis point rise	$	472,500		1.13	%	$	123,900		1.23	%
100 basis point rise		478,800		2.48			123,300		0.74
Base-rate scenario		467,200		—			122,400		—
100 basis point decline		412,100		(11.79	)		118,100		(3.51	)

December 31, 2018
200 basis point rise	$	481,100		(3.37	)%	$	126,200		3.27	%
100 basis point rise		495,400		(0.50	)		124,800		2.13
Base-rate scenario		497,900		—			122,200		—
100 basis point decline		482,800		(3.03	)		119,600		(2.13	)

(1)

Simulation analyses calculate the change in the net present value of our assets and liabilities, including debt and related financial derivative instruments, under parallel shifts in interest rates by discounting the estimated future cash flows using a market-based discount rate. Cash flow estimates incorporate anticipated changes in prepayment speeds and other embedded options.

(2)

Simulation analyses calculate the change in net interest income under immediate parallel shifts in interest rates over the next twelve months, based upon a static Consolidated Statement of Financial Condition, which includes debt and related financial derivative instruments, and do not consider loan fees.

Accounting Standards Update. See note #1 to the Consolidated Financial Statements included elsewhere in this report for details on recently issued accounting pronouncements and their impact on our financial statements.

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FAIR VALUATION OF FINANCIAL INSTRUMENTS

Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) topic 820 - “Fair Value Measurements and Disclosures” (“FASB ASC topic 820”) defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

We utilize fair value measurements to record fair value adjustments to certain financial instruments and to determine fair value disclosures. FASB ASC topic 820 differentiates between those assets and liabilities required to be carried at fair value at every reporting period (“recurring”) and those assets and liabilities that are only required to be adjusted to fair value under certain circumstances (“nonrecurring”). Equity securities, securities available for sale, loans held for sale, derivatives and capitalized mortgage loan servicing rights are financial instruments recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other financial assets on a nonrecurring basis, such as loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or fair value accounting or write-downs of individual assets. See note #21 to the Consolidated Financial Statements for a complete discussion on our use of fair valuation of financial instruments and the related measurement techniques.

LITIGATION MATTERS

We are involved in various litigation matters in the ordinary course of business. At the present time, we do not believe any of these matters will have a significant impact on our consolidated financial position or results of operations. The aggregate amount we have accrued for losses we consider probable as a result of these litigation matters is immaterial. However, because of the inherent uncertainty of outcomes from any litigation matter, we believe it is reasonably possible we may incur losses in addition to the amounts we have accrued. At this time, we estimate the maximum amount of additional losses that are reasonably possible is insignificant. However, because of a number of factors, including the fact that certain of these litigation matters are still in their early stages, this maximum amount may change in the future.

The litigation matters described in the preceding paragraph primarily include claims that have been brought against us for damages, but do not include litigation matters where we seek to collect amounts owed to us by third parties (such as litigation initiated to collect delinquent loans). These excluded, collection-related matters may involve claims or counterclaims by the opposing party or parties, however we have excluded such matters from the disclosure contained in the preceding paragraph in all cases where we believe the possibility of us paying damages to any opposing party is remote.

CRITICAL ACCOUNTING POLICIES

Our accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Accounting and reporting policies for the allowance for loan losses and capitalized mortgage loan servicing rights are deemed critical since they involve the use of estimates and require significant management judgments. Application of assumptions different than those that we have used could result in material changes in our financial position or results of operations.

Our methodology for determining the allowance and related provision for loan losses is described above in “Portfolio Loans and asset quality.” In particular, this area of accounting requires a significant amount of judgment because a multitude of factors can influence the ultimate collection of a loan or other type of credit. It is extremely difficult to precisely measure the amount of probable incurred losses in our loan portfolio. We use a rigorous process to attempt to accurately quantify the necessary allowance and related provision for loan losses, but there can be no assurance that our modeling process will successfully identify all of the probable incurred losses in our loan portfolio. As a result, we could record future provisions for loan losses that may be significantly different than the levels that we recorded in prior periods. In June 2016, the FASB issued ASU No. 2016-13 “Financial Instruments – Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”). See note #1 to the Consolidated Financial Statements for a description of our implementation of ASU 2016-13. In particular, since ASU 2016-13 requires a current expected (rather than incurred) credit loss model, our provision for loan losses may be more volatile in future periods.

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At December 31, 2019 and 2018, we had approximately $19.2 million and $21.4 million, respectively, of mortgage loan servicing rights capitalized on our Consolidated Statements of Financial Condition. There are several critical assumptions involved in establishing the value of this asset including estimated future prepayment speeds on the underlying mortgage loans, the interest rate used to discount the net cash flows from the mortgage loan servicing, the estimated amount of ancillary income that will be received in the future (such as late fees) and the estimated cost to service the mortgage loans. We believe the assumptions that we utilize in our valuation are reasonable based upon accepted industry practices for valuing mortgage loan servicing rights and represent neither the most conservative or aggressive assumptions.

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MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER
FINANCIAL REPORTING

The management of Independent Bank Corporation is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control system was designed to provide reasonable assurance to us and the board of directors regarding the preparation and fair presentation of published financial statements.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

We assessed the effectiveness of our internal control over financial reporting as of December 31, 2019. In making this assessment, we used the criteria established in the 2013 Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on our assessment, management has concluded that as of December 31, 2019, the Company’s internal control over financial reporting was effective to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.

There were no changes in our internal control over financial reporting during the quarter ended December 31, 2019, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Our independent registered public accounting firm has issued an audit report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2019. Their report immediately follows our report.


William B. Kessel	Stephen A. Erickson
President and Chief Executive Officer	Executive Vice President and Chief Financial Officer

Independent Bank Corporation March 6, 2020

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Shareholders and the Board of Directors of Independent Bank Corporation
Grand Rapids, Michigan

Opinions on the Financial Statements and Internal Control over Financial Reporting

We have audited the accompanying consolidated statements of financial condition of Independent Bank Corporation (the “Corporation”) as of December 31, 2019 and 2018, the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2019, and the related notes (collectively referred to as the “financial statements”). We also have audited the Corporation’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control – Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Corporation as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2019 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control – Integrated Framework: (2013) issued by COSO.

Basis for Opinions

The Corporation’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Corporation’s financial statements and an opinion on the Corporation’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (“PCAOB”) and are required to be independent with respect to the Corporation in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.

Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

Definition and Limitations of Internal Control Over Financial Reporting

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

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Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

We have served as the Corporation’s auditor since 2005.

Grand Rapids, Michigan
March 6, 2020

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CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

	December 31,
	2019			2018
	(In thousands, except share amounts)
ASSETS
Cash and due from banks	$	53,295		$	23,350
Interest bearing deposits		12,009			46,894
Cash and Cash Equivalents		65,304			70,244
Interest bearing deposits - time		350			595
Equity securities at fair value		—			393
Securities available for sale		518,400			427,926
Federal Home Loan Bank and Federal Reserve Bank stock, at cost		18,359			18,359
Loans held for sale, carried at fair value		69,800			44,753
Loans held for sale, carried at lower of cost or fair value		—			41,471
Loans
Commercial		1,166,695			1,144,481
Mortgage		1,098,911			1,042,890
Installment		459,417			395,149
Total Loans		2,725,023			2,582,520
Allowance for loan losses		(26,148	)		(24,888	)
Net Loans		2,698,875			2,557,632
Other real estate and repossessed assets, net		1,865			1,299
Property and equipment, net		38,411			38,777
Bank-owned life insurance		55,710			55,068
Deferred tax assets, net		2,072			5,779
Capitalized mortgage loan servicing rights		19,171			21,400
Other intangibles		5,326			6,415
Goodwill		28,300			28,300
Accrued income and other assets		42,751			34,870
Total Assets	$	3,564,694		$	3,353,281

LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits
Non-interest bearing	$	852,076		$	879,549
Savings and interest-bearing checking		1,186,745			1,194,865
Reciprocal		431,027			182,072
Time		376,877			385,981
Brokered time		190,002			270,961
Total Deposits		3,036,727			2,913,428
Other borrowings		88,646			25,700
Subordinated debentures		39,456			39,388
Accrued expenses and other liabilities		49,696			35,771
Total Liabilities		3,214,525			3,014,287

Commitments and contingent liabilities

Shareholders’ Equity
Preferred stock, no par value, 200,000 shares authorized; none issued or outstanding		—			—
Common stock, no par value, 500,000,000 shares authorized; issued and outstanding: 22,481,643 shares at December 31, 2019 and 23,579,725 shares at December 31, 2018		352,344			377,372
Retained earnings (accumulated deficit)		1,611			(28,270	)
Accumulated other comprehensive loss		(3,786	)		(10,108	)
Total Shareholders’ Equity		350,169			338,994
Total Liabilities and Shareholders’ Equity	$	3,564,694		$	3,353,281

See accompanying notes to consolidated financial statements

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CONSOLIDATED STATEMENTS OF OPERATIONS

	Year Ended December 31,
	2019			2018			2017
	(In thousands, except per share amounts)
INTEREST INCOME
Interest and fees on loans	$	133,883		$	116,865		$	84,281
Interest on securities
Taxable		11,842			10,874			10,928
Tax-exempt		1,342			1,743			2,000
Other investments		1,861			1,291			1,100
Total Interest Income		148,928			130,773			98,309
INTEREST EXPENSE
Deposits		23,425			14,478			6,775
Other borrowings and subordinated debentures		2,922			3,013			2,348
Total Interest Expense		26,347			17,491			9,123
Net Interest Income		122,581			113,282			89,186
Provision for loan losses		824			1,503			1,199
Net Interest Income After Provision for Loan Losses		121,757			111,779			87,987
NON-INTEREST INCOME
Service charges on deposit accounts		11,208			12,258			12,673
Interchange income		10,297			9,905			8,023
Net gains on assets
Mortgage loans		19,978			10,597			11,762
Securities		307			138			260
Mortgage loan servicing, net		(3,336	)		3,157			1,647
Other		9,282			8,760			8,168
Total Non-interest Income		47,736			44,815			42,533
NON-INTEREST EXPENSE
Compensation and employee benefits		67,501			62,078			55,089
Occupancy, net		9,013			8,912			8,102
Data processing		8,905			8,262			7,657
Furniture, fixtures and equipment		4,113			4,080			3,870
Interchange expense		3,215			2,702			1,156
Communications		2,947			2,848			2,684
Loan and collection		2,685			2,682			2,230
Advertising		2,450			2,155			1,905
Legal and professional		1,814			1,839			1,892
FDIC deposit insurance		685			1,081			894
Net gains on other real estate and repossessed assets		(90	)		(672	)		(606	)
Merger related expense		—			3,465			284
Other		8,495			8,029			6,925
Total Non-interest Expense		111,733			107,461			92,082
Income Before Income Tax		57,760			49,133			38,438
Income tax expense		11,325			9,294			17,963
Net Income	$	46,435		$	39,839		$	20,475
Net income per common share
Basic	$	2.03		$	1.70		$	0.96
Diluted	$	2.00		$	1.68		$	0.95

See accompanying notes to consolidated financial statements

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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

	Year Ended December 31,
	2019			2018			2017
	(In thousands)
Net income	$	46,435		$	39,839		$	20,475
Other comprehensive income (loss)
Securities available for sale
Unrealized gain (loss) arising during period		10,235			(4,594	)		4,065
Change in unrealized gains and losses for which a portion of other than temporary impairment has been recognized in earnings		(65	)		(53	)		186
Reclassification adjustments for gains included in earnings		(140	)		(56	)		(215	)
Unrealized gains (losses) recognized in other comprehensive income (loss) on securities available for sale		10,030			(4,703	)		4,036
Income tax expense (benefit)		2,106			(988	)		1,413
Unrealized gains (losses) recognized in other comprehensive income (loss) on securities available for sale, net of tax		7,924			(3,715	)		2,623
Derivative instruments
Unrealized gains (losses) arising during period		(1,603	)		(262	)		324
Reclassification adjustment for (income) expense recognized in earnings		(425	)		(237	)		18
Unrealized gains (losses) recognized in other comprehensive income (loss) on derivative instruments		(2,028	)		(499	)		342
Income tax expense (benefit)		(426	)		(105	)		120
Unrealized gains (losses) recognized in other comprehensive income (loss) on derivative instruments, net of tax		(1,602	)		(394	)		222
Other comprehensive income (loss)		6,322			(4,109	)		2,845
Comprehensive income	$	52,757		$	35,730		$	23,320

See accompanying notes to consolidated financial statements

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CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

	Common Stock			Retained Earnings (Accumulated Deficit)			Accumulated Other Comprehensive Loss			Total Shareholders’ Equity
	(Dollars in thousands, except per share amounts)
Balances at January 1, 2017	$	323,745		$	(65,605	)	$	(8,808	)	$	249,332
Net income for 2017		—			20,475			—			20,475
Cash dividends declared, $.42 per share		—			(8,960	)		—			(8,960	)
Issuance of 27,046 shares of common stock		72			—			—			72
Share based compensation (issuance of 71,256 shares of common stock)		1,748			—			—			1,748
Share based compensation withholding obligation (withholding of 22,525 shares of common stock)		(579	)		—			—			(579	)
Reclassification of certain deferred tax effects		—			36			(36	)		—
Other comprehensive income		—			—			2,845			2,845
Balances at December 31, 2017		324,986			(54,054	)		(5,999	)		264,933
Net income for 2018		—			39,839			—			39,839
Cash dividends declared, $.60 per share		—			(14,055	)		—			(14,055	)
Repurchase of 587,969 shares of common stock		(12,681	)		—			—			(12,681	)
Acquistion of TCSB Bancorp, Inc.		64,536			—			—			64,536
Issuance of 152,549 shares of common stock		267			—			—			267
Share based compensation (issuance of 80,028 shares of common stock)		1,731			—			—			1,731
Share based compensation withholding obligation (withholding of 108,185 shares of common stock)		(1,467	)		—			—			(1,467	)
Other comprehensive loss		—			—			(4,109	)		(4,109	)
Balances at December 31, 2018		377,372			(28,270	)		(10,108	)		338,994
Net income for 2019		—			46,435			—			46,435
Cash dividends declared, $.72 per share		—			(16,554	)		—			(16,554	)
Repurchase of 1,204,688 shares of common stock		(26,284	)		—			—			(26,284	)
Issuance of 71,799 shares of common stock		284			—			—			284
Share based compensation (issuance of 92,275 shares of common stock)		1,854			—			—			1,854
Share based compensation withholding obligation (withholding of 57,468 shares of common stock)		(882	)		—			—			(882	)
Other comprehensive income		—			—			6,322			6,322
Balances at December 31, 2019	$	352,344		$	1,611		$	(3,786	)	$	350,169

See accompanying notes to consolidated financial statements

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CONSOLIDATED STATEMENTS OF CASH FLOWS

	Year Ended December 31,
	2019			2018			2017
	(In thousands)
Net Income	$	46,435		$	39,839		$	20,475
ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH FROM OPERATING ACTIVITIES
Proceeds from the sale of equity securities at fair value		560			—			—
Proceeds from sales of loans held for sale		642,537			463,699			434,682
Disbursements for loans held for sale		(647,606	)		(457,077	)		(426,410	)
Provision for loan losses		824			1,503			1,199
Deferred income tax expense		1,088			9,294			16,009
Deferred loan fees and costs		(2,936	)		(4,044	)		(5,159	)
Net depreciation, amortization of intangible assets and premiums and accretion of discounts on securities, loans and interest bearing deposits - time		6,059			6,033			6,957
Net gains on mortgage loans		(19,978	)		(10,597	)		(11,762	)
Net gains on securities		(307	)		(138	)		(260	)
Net gains on other real estate and repossessed assets		(90	)		(672	)		(606	)
Share based compensation		1,854			1,731			1,748
Increase in accrued income and other assets		(6,573	)		(4,890	)		(3,708	)
Increase in accrued expenses and other liabilities		12,113			240			5,442
Total Adjustments		(12,455	)		5,082			18,132
Net Cash From Operating Activities		33,980			44,921			38,607
CASH FLOW USED IN INVESTING ACTIVITIES
Proceeds from the sale of securities available for sale		68,716			48,736			17,308
Proceeds from maturities, prepayments and calls of securities available for sale		153,938			160,627			173,723
Purchases of securities available for sale		(237,672	)		(103,493	)		(100,584	)
Proceeds from the sale of interest bearing deposits - time		—			2,474			—
Proceeds from the maturity of interest bearing deposits - time		250			3,728			2,850
Purchase of Federal Reserve Bank stock		—			(2,038	)		—
Net increase in portfolio loans (loans originated, net of principal payments)		(215,276	)		(344,330	)		(406,859	)
Proceeds from the sale of portfolio loans		50,516			27,658			—
Cash received in the acquisition of TCSB Bancorp Inc.		—			23,516			—
Cash received from the sale of Mepco Finance Corporation assets, net		—			—			33,446
Proceeds from the collection of vehicle service contract counterparty receivables		512			511			528
Proceeds from the sale of other real estate and repossessed assets		1,766			2,526			5,703
Proceeds from bank-owned life insurance		470			474			523
Proceeds from the sale of property and equipment		74			106			26
Capital expenditures		(4,936	)		(3,862	)		(4,242	)
Net Cash Used in Investing Activities		(181,642	)		(183,367	)		(277,578	)
CASH FLOW FROM FINANCING ACTIVITIES
Net increase in total deposits		123,299			225,185			174,815
Net increase (decrease) in other borrowings		25,002			(6,600	)		6,754
Proceeds from Federal Home Loan Bank advances		111,000			1,272,000			622,000
Payments of Federal Home Loan Bank advances		(73,143	)		(1,308,697	)		(583,587	)
Dividends paid		(16,554	)		(14,055	)		(8,960	)
Proceeds from issuance of common stock		284			267			72
Repurchase of common stock		(26,284	)		(12,681	)		—
Share based compensation withholding obligation		(882	)		(1,467	)		(579	)
Net Cash From Financing Activities		142,722			153,952			210,515
Net Increase (Decrease) in Cash and Cash Equivalents		(4,940	)		15,506			(28,456	)
Cash and Cash Equivalents at Beginning of Year		70,244			54,738			83,194
Cash and Cash Equivalents at End of Year	$	65,304		$	70,244		$	54,738
Cash paid during the year for
Interest	$	26,697		$	16,737		$	9,163
Income taxes		9,534			120			1,970
Operating leases		2,201			—			—
Transfers to other real estate and repossessed assets		2,242			1,510			1,735
Transfer of mortgage loans to held for sale		36,622			41,471			—
Securitization of portfolio loans		65,070			10,869			—
Right of use assets obtained in exchange for lease obligations		9,906			—			—
Purchase of securities available for sale and interest bearing deposits - time not yet settled		—			—			1,000
Common stock and stock options issued in TCSB Bancorp, Inc. acquisition		—			64,536			—

See accompanying notes to consolidated financial statements

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – ACCOUNTING POLICIES

The accounting and reporting policies and practices of Independent Bank Corporation and subsidiaries (“IBCP”) conform to accounting principles generally accepted in the United States of America and prevailing practices within the banking industry. Our critical accounting policies include the determination of the allowance for loan losses (“AFLL”) and the valuation of capitalized mortgage loan servicing rights. We are required to make material estimates and assumptions that are particularly susceptible to changes in the near term as we prepare the consolidated financial statements and report amounts for each of these items. Actual results may vary from these estimates.

Our subsidiary, Independent Bank (“Bank”), transacts business in the single industry of commercial banking. Our Bank’s activities cover traditional phases of commercial banking, including checking and savings accounts, commercial lending, direct and indirect consumer financing and mortgage lending. Our principal markets are the rural and suburban communities across Lower Michigan and Ohio that are served by our Bank’s branches and loan production offices. Through April, 2017 we also purchased payment plans from companies (which we referred to as “counterparties”) that provided vehicle service contracts and similar products to consumers, through our wholly owned subsidiary, Mepco Finance Corporation (“Mepco”) which was sold effective May 1, 2017. See note #27. At December 31, 2019, 71.7% of our Bank’s loan portfolio was secured by real estate.

PRINCIPLES OF CONSOLIDATION — The consolidated financial statements include the accounts of Independent Bank Corporation and its subsidiaries. The income, expenses, assets and liabilities of the subsidiaries are included in the respective accounts of the consolidated financial statements, after elimination of all intercompany accounts and transactions.

STATEMENTS OF CASH FLOWS — For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, interest bearing deposits and federal funds sold. Generally, federal funds are sold for one-day periods. We report net cash flows for customer loan and deposit transactions and for short-term borrowings.

INTEREST BEARING DEPOSITS — Interest bearing deposits consist of overnight deposits with the Federal Reserve Bank.

INTEREST BEARING DEPOSITS - TIME — Interest bearing deposits - time consist of deposits with original maturities of 3 months or more. All of these deposits are FDIC insured.

LOANS HELD FOR SALE — Mortgage loans originated and intended for sale in the secondary market are carried at fair value. Fair value adjustments, as well as realized gains and losses, are recorded in current earnings. Certain portfolio loans were reclassified to held for sale as of December 31, 2018, were carried at the lower of cost or fair value on an aggregate loan basis and were sold during the first quarter of 2019.

OPERATING SEGMENTS — While chief decision-makers monitor the revenue streams of our various products and services, operations are managed and financial performance is evaluated as one single unit. Discrete financial information is not available other than on a consolidated basis for material lines of business.

CAPITALIZED MORTGAGE LOAN SERVICING RIGHTS — During the first quarter of 2017, we adopted the fair value method of accounting for our capitalized mortgage loan servicing rights pursuant to Financial Accounting Standards Board (“FASB”) Accounting Standards Codification topic 860 – “Transfers and Servicing”. Prior to January 1, 2017, we were accounting for our capitalized mortgage loan servicing rights under the amortization method. We adopted the fair value method using a modified retrospective adjustment to beginning accumulated deficit.

We recognize as separate assets the rights to service mortgage loans for others. The fair value of capitalized mortgage loan servicing rights has been determined based upon fair value indications for similar servicing. Under the fair value method we measure capitalized mortgage loan servicing rights at fair value at each reporting date and report changes in fair value of capitalized mortgage loan servicing rights in earnings in the period in which the changes occur and are included in mortgage loan servicing, net in the Consolidated Statements of Operations. The fair values of capitalized mortgage loan servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.

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Mortgage loan servicing income is recorded for fees earned for servicing loans previously sold. The fees are generally based on a contractual percentage of the outstanding principal and are recorded as income when earned. Mortgage loan servicing fees, excluding fair value changes of capitalized mortgage loan servicing rights, totaled $6.2 million, $5.5 million and $4.4 million for the years ended December 31, 2019, 2018 and 2017, respectively. Late fees and ancillary fees related to loan servicing are not material.

TRANSFERS OF FINANCIAL ASSETS — Transfers of financial assets are accounted for as sales when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from us, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and we do not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

SECURITIES — We classify our securities as equity, trading, held to maturity or available for sale. Equity securities are investments in certain preferred stocks and are reported at fair value with realized and unrealized gains and losses included in earnings. Trading securities are bought and held principally for the purpose of selling them in the near term and are reported at fair value with realized and unrealized gains and losses included in earnings. We did not have any trading securities at December 31, 2019 and 2018. Securities held to maturity represent those securities for which we have the positive intent and ability to hold until maturity and are reported at cost, adjusted for amortization of premiums and accretion of discounts computed on the level-yield method. We did not have any securities held to maturity at December 31, 2019 and 2018. Securities available for sale represent those securities not classified as equity, trading or held to maturity and are reported at fair value with unrealized gains and losses, net of applicable income taxes reported in other comprehensive income (loss).

We evaluate securities for other than temporary impairment (“OTTI”) at least on a quarterly basis and more frequently when economic or market conditions warrant such an evaluation. In performing this evaluation, management considers (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) the impact of changes in market interest rates on the market value of the security and (4) an assessment of whether we intend to sell, or it is more likely than not that we will be required to sell a security in an unrealized loss position before recovery of its amortized cost basis. For securities that do not meet the aforementioned recovery criteria, the amount of impairment recognized in earnings is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income (loss). The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.

Gains and losses realized on the sale of securities available for sale are determined using the specific identification method and are recognized on a trade-date basis.

FEDERAL HOME LOAN BANK (“FHLB”) STOCK — Our Bank subsidiary is a member of the FHLB system. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income in interest income-other investments on the Consolidated Statements of Operations.

FEDERAL RESERVE BANK (“FRB”) STOCK — Our Bank subsidiary is a member of its regional Federal Reserve Bank. FRB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income in interest income-other investments on the Consolidated Statements of Operations.

LOAN REVENUE RECOGNITION — Interest on loans is accrued based on the principal amounts outstanding. In general, the accrual of interest income is discontinued when a loan becomes 90 days past due for commercial loans and installment loans and when a loan misses four consecutive payments for mortgage loans and the borrower’s capacity to repay the loan and collateral values appear insufficient for each loan class. However, loans may be placed on non-accrual status regardless of whether or not such loans are considered past due if, in management’s opinion, the borrower is unable to meet payment obligations as they become due or as required by regulatory provisions. All interest accrued but not received for all loans placed on non-accrual is reversed from interest income. Payments on such loans are generally applied to the principal balance until qualifying to be returned to accrual status. A non-accrual loan may be restored to accrual status when interest and principal payments are current and the loan

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

appears otherwise collectible. Delinquency status for all classes in the commercial and installment loan segments is based on the actual number of days past due as required by the contractual terms of the loan agreement while delinquency status for mortgage loan segment classes is based on the number of payments past due.

Certain loan fees and direct loan origination costs are deferred and recognized as an adjustment of yield generally over the contractual life of the related loan. Fees received in connection with loan commitments are deferred until the loan is advanced and are then recognized generally over the contractual life of the loan as an adjustment of yield. Fees on commitments that expire unused are recognized at expiration. Fees received for letters of credit are recognized as revenue over the life of the commitment.

PAYMENT PLAN RECEIVABLE REVENUE RECOGNITION — Payment plan receivables were acquired by Mepco at a discount which was accreted into interest income – interest and fees on loans in the Consolidated Statements of Operations over the life of the receivable computed on a level-yield method.

ALLOWANCE FOR LOAN LOSSES — Portfolios are disaggregated into segments for purposes of determining the allowance for loan losses (“AFLL”) which include commercial, mortgage and installment loans. These segments are further disaggregated into classes for purposes of monitoring and assessing credit quality based on certain risk characteristics. Classes within the commercial loan segment include (i) commercial and industrial and (ii) commercial real estate. Classes within the mortgage loan segment include (i) 1-4 family owner occupied - jumbo, (ii) 1-4 family owner occupied - non-jumbo, (iii) 1-4 family non-owner occupied (iv) 1-4 family - 2nd lien and (v) resort lending. Classes within the installment loan segment include (i) boat lending, (ii) recreational vehicle lending, and (iii) other. Commercial loans are subject to adverse market conditions which may impact the borrower’s ability to make repayment on the loan or could cause a decline in the value of the collateral that secures the loan. Mortgage and installment loans are subject to adverse employment conditions in the local economy which could increase default rates. In addition, mortgage loans and real estate based installment loans are subject to adverse market conditions which could cause a decline in the value of collateral that secures the loan. For an analysis of the AFLL by portfolio segment and credit quality information by class, see note #4.

Some loans will not be repaid in full. Therefore, an AFLL is maintained at a level which represents our best estimate of losses incurred. In determining the AFLL and the related provision for loan losses, we consider four principal elements: (i) specific allocations based upon probable losses identified during the review of the loan portfolio, (ii) allocations established for other adversely rated commercial loans, (iii) allocations based principally on historical loan loss experience, and (iv) additional allocations based on subjective factors, including local and general economic business factors and trends, portfolio concentrations and changes in the size and/or the general terms of the loan portfolios.

The first AFLL element (specific allocations) reflects our estimate of probable incurred losses based upon our systematic review of specific loans. These estimates are based upon a number of objective factors, such as payment history, financial condition of the borrower, discounted collateral exposure and discounted cash flow analysis. Impaired commercial, mortgage and installment loans are allocated AFLL amounts using this first element. The second AFLL element (other adversely rated commercial loans) reflects the application of our loan rating system. This rating system is similar to those employed by state and federal banking regulators. Commercial loans that are rated below a certain predetermined classification are assigned a loss allocation factor for each loan classification category that is based upon a historical analysis of both the probability of default and the expected loss rate (“loss given default”). The lower the rating assigned to a loan or category, the greater the allocation percentage that is applied. The third AFLL element (historical loss allocations) is determined by assigning allocations to higher rated (“non-watch credit”) commercial loans using a probability of default and loss given default similar to the second AFLL element and to homogenous mortgage and installment loan groups based upon borrower credit score and portfolio segment. For homogenous mortgage and installment loans a probability of default for each homogenous pool is calculated by way of credit score migration. Historical loss data for each homogenous pool coupled with the associated probability of default is utilized to calculate an expected loss allocation rate. The fourth AFLL element (additional allocations based on subjective factors) is based on factors that cannot be associated with a specific credit or loan category and reflects our attempt to reasonably ensure that the overall AFLL appropriately reflects a margin for the imprecision necessarily inherent in the estimates of expected credit losses. We consider a number of subjective factors when determining this fourth element, including local and general economic business factors and trends, portfolio concentrations and changes in the size, mix and the general terms of the overall loan portfolio.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

During the first quarter of 2019, we deployed a third-party software solution (we previously used spreadsheet software) to assist in the determination of our AFLL. This new third-party software also has assisted us in moving to the expected loss framework that was required to be implemented on January 1, 2020. Although the use of this new third-party software did not have any material impact on our overall AFLL, it did result in some classification shifts from the AFLL related to subjective factors into the AFLL related to historical losses as the new software model allowed us to capture longer historical look-back periods (previously this was being captured in the subjective portion of the AFLL).

We generally charge-off commercial, homogenous residential mortgage and installment loans (and payment plan receivables prior to the sale of Mepco) when they are deemed uncollectible or reach a predetermined number of days past due based on loan product, industry practice and other factors. Collection efforts may continue and recoveries may occur after a loan is charged against the AFLL.

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

A loan is impaired when full payment under the loan terms is not expected. Generally, those loans included in each commercial loan class that are rated substandard, classified as non-performing or were classified as non-performing in the preceding quarter, are evaluated for impairment. Those loans included in each mortgage loan or installment loan class whose terms have been modified and considered a troubled debt restructuring are also impaired. Loans which have been modified resulting in a concession, and which the borrower is experiencing financial difficulties, are considered troubled debt restructurings (“TDR”) and classified as impaired. We measure our investment in an impaired loan based on one of three methods: the loan’s observable market price, the fair value of the collateral or the present value of expected future cash flows discounted at the loan’s effective interest rate. Large groups of smaller balance homogeneous loans, such as those loans included in each installment and mortgage loan class (and each payment plan receivable class prior to the sale of Mepco), are collectively evaluated for impairment and accordingly, they are not separately identified for impairment disclosures. TDR loans are measured at the present value of estimated future cash flows using the loan’s effective interest rate at inception of the loan. If a TDR is considered to be a collateral dependent loan, the loan is reported net, at the fair value of collateral. A loan can be removed from TDR status if it is subsequently restructured and the borrower is no longer experiencing financial difficulties and the newly restructured agreement does not contain any concessions to the borrower. The new agreement must specify market terms, including a contractual interest rate not less than a market interest rate for a new loan with similar credit risk characteristics, and other terms no less favorable to us than those we would offer for a similar new loan.

PROPERTY AND EQUIPMENT — Property and equipment is stated at cost less accumulated depreciation and amortization. Depreciation and amortization is computed using the straight-line method over the estimated useful lives of the related assets. Buildings are generally depreciated over a period not exceeding 39 years and equipment is generally depreciated over periods not exceeding 7 years. Leasehold improvements are depreciated over the shorter of their estimated useful life or lease period.

BANK OWNED LIFE INSURANCE — We have purchased a group flexible premium non-participating variable life insurance contract on approximately 265 lives (who were salaried employees at the time we purchased the contract) in order to recover the cost of providing certain employee benefits. Bank owned life insurance is recorded at its cash surrender value or the amount that can be currently realized.

OTHER REAL ESTATE AND REPOSSESSED ASSETS — Other real estate at the time of acquisition is recorded at fair value, less estimated costs to sell, which becomes the property’s new basis. Fair value is typically determined by a third party appraisal of the property. Any write-downs at date of acquisition are charged to the AFLL. Expense incurred in maintaining other real estate and subsequent write-downs to reflect declines in value and gains or losses on the sale of other real estate are recorded in non-interest expense in the Consolidated Statements of Operations. Non-real estate repossessed assets are treated in a similar manner.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

OTHER INTANGIBLES — Other intangible assets consist of core deposits. They are initially measured at fair value and then are amortized on both straight-line and accelerated methods over their estimated useful lives, which range from 10 to 15 years.

GOODWILL — Goodwill arises from business combinations and is generally determined as the excess of the fair value of the consideration transferred over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill acquired in a purchase business combination and determined to have an indefinite useful life is not amortized, but tested for impairment at least annually or more frequently if events and circumstances exists that indicate that a goodwill impairment test should be performed. We have selected December 31 as the date to perform the annual impairment test. Goodwill is the only intangible asset with an indefinite life on our Consolidated Statements of Financial Condition.

INCOME TAXES — We employ the asset and liability method of accounting for income taxes. This method establishes deferred tax assets and liabilities for the temporary differences between the financial reporting basis and the tax basis of our assets and liabilities at tax rates expected to be in effect when such amounts are realized or settled. Under this method, the effect of a change in tax rates is recognized in the period that includes the enactment date. The deferred tax asset is subject to a valuation allowance for that portion of the asset for which it is more likely than not that it will not be realized.

A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination.

We recognize interest and/or penalties related to income tax matters in income tax expense in the Consolidated Statements of Operations.

We file a consolidated federal income tax return. Intercompany tax liabilities are settled as if each subsidiary filed a separate return.

COMMITMENTS TO EXTEND CREDIT AND RELATED FINANCIAL INSTRUMENTS — Financial instruments may include commitments to extend credit and standby letters of credit. Financial instruments involve varying degrees of credit and interest-rate risk in excess of amounts reflected in the Consolidated Statements of Financial Condition. Exposure to credit risk in the event of non-performance by the counterparties to the financial instruments for loan commitments to extend credit and letters of credit is represented by the contractual amounts of those instruments. In general, we use a similar methodology to estimate our liability for these off-balance sheet credit exposures as we do for our AFLL. For commercial related commitments, we estimate liability using our loan rating system and for mortgage and installment commitments we estimate liability principally upon historical loss experience. Our estimated liability for off balance sheet commitments is included in accrued expenses and other liabilities in our Consolidated Statements of Financial Condition and any charge or recovery is recorded in non-interest expense - other in our Consolidated Statements of Operations.

DERIVATIVE FINANCIAL INSTRUMENTS — We record derivatives on our Consolidated Statements of Financial Condition as assets and liabilities measured at their fair value. The accounting for increases and decreases in the value of derivatives depends upon the use of derivatives and whether the derivatives qualify for hedge accounting.

At the inception of the derivative we designate the derivative as one of three types based on our intention and belief as to likely effectiveness as a hedge. These three types are (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (“Fair Value Hedge”), (2) a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (“Cash Flow Hedge”), or (3) an instrument with no hedging designation. For a Fair Value Hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item, are recognized in non-interest income – other in our Consolidated Statements of Operations. For a Cash Flow Hedge, the gain or loss on the derivative is reported in other comprehensive income (loss) and is reclassified into earnings in the same periods during which the hedged transaction affects earnings. For instruments with no hedging designation, the gain or loss on the derivative is reported in earnings. These free standing instruments currently consist of (i) mortgage banking related derivatives and include rate-lock loan commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and mandatory forward commitments for the future delivery of these mortgage loans, (ii) certain pay-fixed and

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

pay-variable interest rate swap agreements related to commercial loan customers and (iii) certain purchased and written options related to a time deposit product. The fair value of rate-lock mortgage loan commitments is based on agency cash window loan pricing for comparable assets and the fair value of mandatory commitments to sell mortgage loans is based on mortgage backed security pricing for comparable assets. We enter into mandatory forward commitments for the future delivery of mortgage loans generally when interest rate locks are entered into in order to hedge the change in interest rates resulting from our commitments to fund the loans. Changes in the fair values of these derivatives are included in net gains on mortgage loans in the Consolidated Statements of Operations. Fair values of the pay-fixed and pay-variable interest rate swap agreements are derived from proprietary models which utilize current market data and are included in net interest income in the Consolidated Statements of Operations. Fair values of the purchased and written options are based on prices of financial instruments with similar characteristics and are included in net interest income in the Consolidated Statements of Operations.

Net cash settlements on derivatives that qualify for hedge accounting are recorded in interest expense in the Consolidated Statements of Operations. Net cash settlements on derivatives that do not qualify for hedge accounting are reported in non-interest income (mortgage banking related derivatives) or net interest income (interest rate swap agreements and options) in the Consolidated Statements of Operations. Cash flows on hedges are classified in the cash flow statement the same as the cash flows of the items being hedged.

We formally document the relationship between derivatives and hedged items, as well as the risk- management objective and the strategy for undertaking hedge transactions, at the inception of the hedging relationship. This documentation includes linking Fair Value or Cash Flow Hedges to specific assets and liabilities on the Consolidated Statements of Financial Condition or to specific firm commitments or forecasted transactions. We discontinue hedge accounting when it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of the hedged item, the derivative is settled or terminates, a hedged forecasted transaction is no longer probable, a hedged firm commitment is no longer firm, or treatment of the derivative as a hedge is no longer appropriate or intended.

When hedge accounting is discontinued, subsequent changes in fair value of the derivative are recorded in earnings. When a Fair Value Hedge is discontinued, the hedged asset or liability is no longer adjusted for changes in fair value and the existing basis adjustment is amortized or accreted over the remaining life of the asset or liability. When a Cash Flow Hedge is discontinued but the hedged cash flows or forecasted transactions are still expected to occur, gains or losses that were accumulated in other comprehensive income (loss) are amortized into earnings over the same periods which the hedged transactions will affect earnings.

COMPREHENSIVE INCOME — Comprehensive income consists of net income and unrealized gains and losses, net of tax, on securities available for sale and derivative instruments classified as cash flow hedges.

NET INCOME PER COMMON SHARE — Basic net income per common share is computed by dividing net income by the weighted average number of common shares outstanding during the period and participating share awards. All outstanding unvested share-based payment awards that contain rights to nonforfeitable dividends are considered participating securities for this calculation. For diluted net income per common share, net income is divided by the weighted average number of common shares outstanding during the period plus the assumed exercise of stock options, restricted stock units, performance share units and stock units for a deferred compensation plan for non-employee directors.

SHARE BASED COMPENSATION — Cost is recognized for non-vested share awards issued to employees based on the fair value of these awards at the date of grant. A simulation analysis which considers potential outcomes for a large number of independent scenarios is utilized to estimate the fair value of performance share units and the market price of our common stock at the date of grant is used for other non-vested share awards. Cost is recognized over the required service period, generally defined as the vesting period. Forfeitures are recognized as they occur. Cost is also recognized for stock issued to non-employee directors. These shares vest immediately and cost is recognized during the period they are issued.

COMMON STOCK — At December 31, 2019, 0.1 million shares of common stock were reserved for issuance under the dividend reinvestment plan and 0.7 million shares of common stock were reserved for issuance under our long-term incentive plans.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

RECLASSIFICATION — Certain amounts in the 2018 and 2017 consolidated financial statements have been reclassified to conform to the 2019 presentation.

ADOPTION OF NEW ACCOUNTING STANDARDS — In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-02, “Leases (Topic 842)”. This ASU amends existing guidance related to the accounting for leases. These amendments, among other things, require lessees to account for most leases on the balance sheet while recognizing expense on the income statement in a manner similar to existing guidance. For lessors the guidance modifies the classification criteria and the accounting for sales-type and direct finance leases. This amended guidance was effective for us on January 1, 2019 and did not have a material impact on our consolidated operating results or financial condition. Based on our operating leases that we had in place at the date of adoption we did not have a material change in the recognition, measurement and presentation of lease expense or impact on cash flow. The primary impact was the recognition of certain operating leases on our Consolidated Statements of Financial Condition which resulted in the recording of right of use (“ROU”) assets and offsetting lease liabilities each totaling approximately $7.7 million at January 1, 2019. See note #18.

In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging (Topic 815), Targeted Improvements to Accounting for Hedging Activities”. This new ASU amends the hedge accounting model in Topic 815 to enable entities to better portray the economics of their risk management activities in the financial statements and enhance the transparency and understandability of hedge results. The amendments expand an entity’s ability to hedge nonfinancial and financial risk components and reduce complexity in fair value hedges of interest rate risk. The guidance eliminates the requirement to separately measure and report hedge ineffectiveness and generally requires the entire change in the fair value of a hedging instrument to be presented in the same income statement line as the hedged item. The guidance also eases certain documentation and assessment requirements and modifies the accounting for components excluded from the assessment of hedge effectiveness. This amended guidance was effective for us on January 1, 2019, and did not have a material impact on our consolidated operating results or financial condition.

In June 2016, the FASB issued ASU 2016-13, “Financial Instruments — Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments”. This ASU significantly 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. This ASU:

•

Replaces the existing incurred loss impairment guidance and establishes a single allowance framework for financial assets carried at amortized cost, which will reflect our estimate of credit losses over the full remaining expected life of the financial assets and will consider expected future changes in macroeconomic conditions.

•

Eliminates existing guidance for purchase credit impaired (“PCI”) loans, and requires recognition of the nonaccretable difference as an increase to the allowance for expected credit losses on financial assets purchased with more than insignificant credit deterioration since origination, which will be offset by an increase in the recorded investment of the related loans.

•

Requires inclusion of expected recoveries, limited to the cumulative amount of prior write-offs, when estimating the allowance for credit losses for in scope financial assets (including collateral dependent assets).

•

Amends existing impairment guidance for securities available for sale to incorporate an allowance, which will allow for reversals of credit impairments in the event that the credit of an issuer improves. Credit losses on securities available for sale are limited to the amount of the decline in fair value regardless of what the credit loss model would show for impairment.

•

Generally requires a cumulative-effect adjustment to retained earnings as of the beginning of the reporting period of adoption.

We began evaluating this ASU in 2016 and established a company-wide, cross-discipline governance structure, which provides implementation oversight. We continued to test and refine our current expected credit loss models that satisfied the requirements of this ASU. Oversight and testing, as well as efforts to meet expanded disclosure requirements, extended through the end of 2019. We currently estimate losses over approximately a two year forecast

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period using the Federal Open Market Committee median economic projections as well as considering other economic forecast sources, and then revert to longer term historical loss experience to estimate losses over more extended periods. This amended guidance was effective for us on January 1, 2020. We have not completed finalizing the results of our current expected credit loss (“CECL”) estimate as of year-end. The required financial reporting disclosures are being further refined and internally validated. We are in the process of finalizing the review of our model and assumptions including qualitative adjustments and economic forecasts. During the first quarter of 2020, we expect to finalize our model and all assumptions as well as obtain formal approval from all internal committees and governance processes related to CECL.

We expect to recognize a one-time cumulative effect adjustment increasing the allowance for loan losses. Because we do not have final approval from our oversight and governance committees, we are estimating an increase to the allowance for loan losses to be in the range of $8.0 million to $10.0 million primarily driven by the longer contractual maturities of our mortgage and consumer installment loan segments. In addition, we currently expect this ASU to increase the allowance for losses related to unfunded loan commitments between $1.0 million and $2.0 million. The ultimate impact of adopting this ASU, and at each subsequent reporting period, is highly dependent on credit quality, economic forecasts and conditions, composition of our loan portfolios and securities available for sale, along with other management judgements. The transition adjustment to record the allowance for credit losses may fall outside of our estimated increase based on the finalization of assumptions including qualitative adjustments and the economic forecast used in calculating the allowance for credit losses upon the adoption of CECL.

We do not expect a material allowance for credit losses to be recorded on securities available for sale upon adoption of this ASU.

In August 2018, the FASB issued ASU 2018-13, “Fair Value Measurement (Topic 820), Disclosure Framework – Changes to the Disclosure Requirements for Fair Value Measurement”. This new ASU amends disclosure requirements in Topic 820 to eliminate, add and modify certain disclosure requirements for fair value measurements as part of its disclosure framework project. The amended guidance eliminates the requirements to disclose the amount of and reasons for transfers between Level 1 and Level 2 of the fair value hierarchy, the entity’s policy for the timing of transfers between levels of the fair value hierarchy and the entity’s valuation processes for Level 3 fair value measurements. The amended guidance adds the requirements to disclose the changes in unrealized gains and losses for the period included in other comprehensive income (loss) for recurring Level 3 fair value measurements of instruments held at the end of the reporting period and for recurring and nonrecurring Level 3 fair value measurements, the range and weighted average used to develop significant unobservable inputs and how the weighted average was calculated, with certain exceptions. This amended guidance was effective for us on January 1, 2020, and did not have a material impact on our consolidated operating results or financial condition.

NOTE 2 – RESTRICTIONS ON CASH AND DUE FROM BANKS

Our Bank is required to maintain reserve balances in the form of vault cash and balances with the FRB. The average reserve balances to be maintained during 2019 and 2018 were $26.6 million and $9.6 million, respectively. We do not maintain compensating balances with correspondent banks. We are also required to maintain reserve balances related primarily to our merchant payment processing operations and for certain investment security transactions. These balances are held at unrelated financial institutions and totaled $0.01 million and $0.13 million at December 31, 2019 and 2018, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

NOTE 3 – SECURITIES

Securities available for sale consist of the following at December 31:

	Amortized Cost		Unrealized				Fair Value
	Amortized Cost		Gains		Losses		Fair Value
	(In thousands)
2019
U.S. agency	$	14,591	$	89	$	19	$	14,661
U.S. agency residential mortgage-backed		226,130		1,910		278		227,762
U.S. agency commercial mortgage-backed		10,671		113		28		10,756
Private label mortgage-backed		39,248		544		99		39,693
Other asset backed		94,158		103		375		93,886
Obligations of states and political subdivisions		94,499		1,724		121		96,102
Corporate		31,904		1,296		5		33,195
Trust preferred		1,968		—		125		1,843
Foreign government		499		3		—		502
Total	$	513,668	$	5,782	$	1,050	$	518,400

2018
U.S. agency	$	20,198	$	9	$	193	$	20,014
U.S. agency residential mortgage-backed		124,777		817		1,843		123,751
U.S. agency commercial mortgage-backed		5,909		1		184		5,726
Private label mortgage-backed		29,735		321		637		29,419
Other asset backed		83,481		86		248		83,319
Obligations of states and political subdivisions		130,244		257		2,946		127,555
Corporate		34,866		29		586		34,309
Trust preferred		1,964		—		145		1,819
Foreign government		2,050		—		36		2,014
Total	$	433,224	$	1,520	$	6,818	$	427,926

Total OTTI recognized in accumulated other comprehensive loss for securities available for sale was zero at both December 31, 2019 and 2018, respectively.

Our investments’ gross unrealized losses and fair values aggregated by investment type and length of time that individual securities have been at a continuous unrealized loss position, at December 31 follows:

	Less Than Twelve Months				Twelve Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(In thousands)
2019
U.S. agency	$	2,782	$	8	$	2,712	$	11	$	5,494	$	19
U.S. agency residential mortgage-backed		56,377		126		13,551		152		69,928		278
U.S. agency commercial mortgage-backed		3,284		24		659		4		3,943		28
Private label mortgage-backed		16,387		55		343		44		16,730		99
Other asset backed		34,027		233		13,839		142		47,866		375
Obligations of states and political subdivisions		15,666		84		5,396		37		21,062		121
Corporate		2,125		5		—		—		2,125		5
Trust preferred		—		—		1,843		125		1,843		125
Total	$	130,648	$	535	$	38,343	$	515	$	168,991	$	1,050

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

	Less Than Twelve Months				Twelve Months or More				Total
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
	(In thousands)
2018
U.S. agency	$	7,150	$	46	$	11,945	$	147	$	19,095	$	193
U.S. agency residential mortgage-backed		18,374		180		48,184		1,663		66,558		1,843
U.S. agency commercial mortgage-backed		566		3		5,094		181		5,660		184
Private label mortgage-backed		8,273		57		16,145		580		24,418		637
Other asset backed		53,043		160		10,235		88		63,278		248
Obligations of states and political subdivisions		25,423		262		80,701		2,684		106,124		2,946
Corporate		17,758		343		9,222		243		26,980		586
Trust preferred		939		61		880		84		1,819		145
Foreign government		—		—		2,014		36		2,014		36
Total	$	131,526	$	1,112	$	184,420	$	5,706	$	315,946	$	6,818

Our portfolio of securities available for sale is reviewed quarterly for impairment in value. In performing this review, management considers (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) the impact of changes in market interest rates on the market value of the security and (4) an assessment of whether we intend to sell, or it is more likely than not that we will be required to sell a security in an unrealized loss position before recovery of its amortized cost basis. For securities that do not meet the aforementioned recovery criteria, the amount of impairment recognized in earnings is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income (loss).

U.S. agency, U.S. agency residential mortgage-backed securities and U.S. agency commercial mortgage backed securities — at December 31, 2019, we had 29 U.S. agency, 111 U.S. agency residential mortgage-backed and 9 U.S. agency commercial mortgage-backed securities whose fair value is less than amortized cost. The unrealized losses are largely attributed to increases in interest rates since acquisition and widening spreads to Treasury bonds.

Private label mortgage backed, other asset backed and corporate securities — at December 31, 2019, we had 22 private label mortgage backed, 58 other asset backed and two corporate securities whose fair value is less than amortized cost. Unrealized losses are primarily due to credit spread widening and increases in interest rates since their acquisition.

Two private label mortgage-backed securities (discussed further below) were reviewed for other than temporary impairment (“OTTI”) utilizing a cash flow projection. The cash flow analysis forecasts cash flow from the underlying loans in each transaction and then applies these cash flows to the bonds in the securitization.

Obligations of states and political subdivisions — at December 31, 2019, we had 42 municipal securities whose fair value is less than amortized cost. The unrealized losses are primarily due to wider benchmark pricing spreads and increases in interest rates since acquisition.

Trust preferred securities — at December 31, 2019, we had two trust preferred securities whose fair value is less than amortized cost. Both of our trust preferred securities are single issue securities issued by a trust subsidiary of a bank holding company. The pricing of trust preferred securities has suffered from credit spread widening. One of the securities is rated by a major rating agency as investment grade while the other one is non-rated. The non-rated issue is a relatively small bank and was never rated. The issuer of this non-rated trust preferred security, which had a total amortized cost of $1.0 million and total fair value of $0.91 million as of December 31, 2019, continues to have satisfactory credit metrics and make interest payments.

As management does not intend to liquidate any of the securities discussed above and it is more likely than not that we will not be required to sell these securities prior to recovery of these unrealized losses, no declines discussed above (other than certain declines related to the two private label mortgage-backed securities currently being reviewed for OTTI) are deemed to be other than temporary.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

We recorded zero credit related OTTI charges in the Consolidated Statements of Operations on securities available for sale during 2019, 2018, and 2017.

At December 31, 2019, two private label mortgage-backed securities had credit related OTTI and are summarized as follows:

	Senior Security		Super Senior Security		Total
	(In thousands)
As of December 31, 2019
Fair value	$	601	$	603	$	1,204
Amortized cost		511		442		953
Non-credit unrealized loss		—		—		—
Unrealized gain		90		161		251
Cumulative credit related OTTI		757		457		1,214

Both of these securities are receiving principal and interest payments similar to principal reductions in the underlying collateral and have unrealized gains at December 31, 2019. The original amortized cost (current amortized cost excluding cumulative credit related OTTI) for each of these securities has been permanently adjusted downward for previously recorded credit related OTTI. The unrealized loss (based on original amortized cost) for these securities is now less than previously recorded credit related OTTI amounts.

A roll forward of credit losses recognized in earnings on securities available for sale for the years ending December 31 follow:

	2019			2018		2017
	(In thousands)
Balance at beginning of year	$	1,594		$	1,594	$	1,594
Additions to credit losses on securities for which no previous OTTI was recognized		—			—		—
Increases to credit losses on securities for which OTTI was previously recognized		—			—		—
Reduction⁽¹⁾		(380	)		—		—
Total	$	1,214		$	1,594	$	1,594

(1)

During 2019 one security with previously recorded OTTI was settled and balance is now zero.

The amortized cost and fair value of securities available for sale at December 31, 2019, by contractual maturity, follow:

	Amortized Cost		Fair Value
	(In thousands)
Maturing within one year	$	10,737	$	10,761
Maturing after one year but within five years		50,035		50,839
Maturing after five years but within ten years		47,634		49,070
Maturing after ten years		35,055		35,633
		143,461		146,303
U.S. agency residential mortgage-backed		226,130		227,762
U.S. agency commercial mortgage-backed		10,671		10,756
Private label mortgage-backed		39,248		39,693
Other asset backed		94,158		93,886
Total	$	513,668	$	518,400

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

The actual maturity may differ from the contractual maturity because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

A summary of proceeds from the sale of securities available for sale and gains and losses for the years ended December 31 follow:

			Realized
	Proceeds		Gains⁽¹⁾		Losses
	(In thousands)
2019	$	68,716	$	248	$	108
2018		48,736		192		136
2017		17,308		218		3

(1)

2018 excludes a $0.144 million gain on the sale of 1,000 VISA Class B shares.

Certain preferred stocks which were all sold during the first quarter of 2019 had been classified as equity securities at fair value in our Consolidated Statement of Financial Condition. During 2019, 2018 and 2017, we recognized gains (losses) on these preferred stocks of $0.17 million, $(0.06) million and $0.05 million, respectively, that are included in net gains on securities in the Consolidated Statements of Operations. Zero, $(0.06) million and $0.05 million of these amounts relate to gains (losses) recognized on preferred stock still held at each respective year end.

Securities available for sale with a book value of $8.7 million and zero at December 31, 2019 and 2018, respectively, were pledged to secure borrowings, derivatives, public deposits and for other purposes as required by law. There were no investment obligations of state and political subdivisions that were payable from or secured by the same source of revenue or taxing authority that exceeded 10% of consolidated total shareholders’ equity at December 31, 2019 or 2018.

NOTE 4 – LOANS AND PAYMENT PLAN RECEIVABLES

Our loan portfolios at December 31 follow:

	2019		2018
	(In thousands)
Real estate⁽¹⁾
Residential first mortgages	$	843,746	$	811,719
Residential home equity and other junior mortgages		166,735		177,574
Construction and land development		249,747		180,286
Other⁽²⁾		693,580		707,347
Consumer		448,297		379,607
Commercial		318,504		319,058
Agricultural		4,414		6,929
Total loans	$	2,725,023	$	2,582,520

(1)

Includes both residential and non-residential commercial loans secured by real estate.

(2)

Includes loans secured by multi-family residential and non-farm, non-residential property.

Loans include net deferred loan costs of $16.3 million and $13.3 million at December 31, 2019 and 2018, respectively.

During the first quarter of 2019, we sold $40.6 million, of residential adjustable rate mortgage loans servicing released (classified on the Consolidated Statements of Financial Condition as held for sale, carried at the lower of cost or fair value at December 31, 2018) to another financial institution and recognized a gain on sale of $0.01 million. During the first quarter of 2019 we also securitized $29.8 million, of portfolio residential fixed rate mortgage loans servicing retained with Freddie Mac and recognized a gain on sale of $0.53 million. During the third quarter of 2019, we sold $9.9 million of residential fixed and adjustable rate portfolio mortgage loans servicing retained to another financial institution and recognized a gain on sale of $0.07 million. During the third quarter of 2019 we also transferred $36.6 million, of portfolio residential fixed rate mortgage loans to loans held for sale, carried

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

at the lower of cost or fair value of which $35.3 million were subsequently securitized in the fourth quarter of 2019 servicing retained with Freddie Mac recognizing a gain on sale of approximately $1.2 million. These transactions were done primarily for asset/liability management purposes.

During the first and third quarters of 2018, we sold $16.5 million and $11.1 million, respectively, of residential fixed and adjustable rate portfolio mortgage loans servicing retained to another financial institution and recognized a gain (loss) on sale of $0.05 million and ($0.01) million, respectively. During the fourth quarter of 2018 we securitized $10.9 million of portfolio residential fixed rate mortgage loans servicing retained with Freddie Mac recognizing a loss on sale of approximately $0.1 million. These transactions were done primarily for asset/liability management purposes.

An analysis of the allowance for loan losses by portfolio segment for the years ended December 31 follows:

	Commercial			Mortgage			Installment			Subjective Allocation			Total
	(In thousands)
2019
Balance at beginning of period	$	7,090		$	7,978		$	895		$	8,925		$	24,888
Additions (deductions)
Provision for loan losses		(651	)		526			1,147			(198	)		824
Recoveries credited to allowance		2,165			933			863			—			3,961
Loans charged against the allowance		(682	)		(1,221	)		(1,622	)		—			(3,525	)
Balance at end of period	$	7,922		$	8,216		$	1,283		$	8,727		$	26,148

2018
Balance at beginning of period	$	5,595		$	8,733		$	864		$	7,395		$	22,587
Additions (deductions)
Provision for loan losses		(946	)		457			462			1,530			1,503
Recoveries credited to allowance		2,889			734			999			—			4,622
Loans charged against the allowance		(448	)		(1,946	)		(1,430	)		—			(3,824	)
Balance at end of period	$	7,090		$	7,978		$	895		$	8,925		$	24,888

2017
Balance at beginning of period	$	4,880		$	8,681		$	1,011		$	5,662		$	20,234
Additions (deductions)
Provision for loan losses		(327	)		(567	)		360			1,733			1,199
Recoveries credited to allowance		1,497			1,741			967			—			4,205
Loans charged against the allowance		(455	)		(1,122	)		(1,474	)		—			(3,051	)
Balance at end of period	$	5,595		$	8,733		$	864		$	7,395		$	22,587

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Allowance for loan losses and recorded investment in loans by portfolio segment at December 31 follows:

	Commercial		Mortgage		Installment		Subjective Allocation		Total
	(In thousands)
2019
Allowance for loan losses:
Individually evaluated for impairment	$	1,031	$	4,863	$	261	$	—	$	6,155
Collectively evaluated for impairment		6,891		3,353		1,022		8,727		19,993
Loans acquired with deteriorated credit quality		—		—		—		—		—
Total ending allowance for loan losses balance	$	7,922	$	8,216	$	1,283	$	8,727	$	26,148

Loans
Individually evaluated for impairment	$	9,393	$	43,574	$	2,925			$	55,892
Collectively evaluated for impairment		1,158,906		1,058,917		457,370				2,675,193
Loans acquired with deteriorated credit quality		1,394		575		316				2,285
Total loans recorded investment		1,169,693		1,103,066		460,611				2,733,370
Accrued interest included in recorded investment		2,998		4,155		1,194				8,347
Total loans	$	1,166,695	$	1,098,911	$	459,417			$	2,725,023

2018
Allowance for loan losses:
Individually evaluated for impairment	$	1,305	$	4,799	$	206	$	—	$	6,310
Collectively evaluated for impairment		5,785		3,179		689		8,925		18,578
Loans acquired with deteriorated credit quality		—		—		—		—		—
Total ending allowance for loan losses balance	$	7,090	$	7,978	$	895	$	8,925	$	24,888

Loans
Individually evaluated for impairment	$	8,697	$	46,394	$	3,370			$	58,461
Collectively evaluated for impairment		1,137,586		1,000,038		392,460				2,530,084
Loans acquired with deteriorated credit quality		1,609		555		349				2,513
Total loans recorded investment		1,147,892		1,046,987		396,179				2,591,058
Accrued interest included in recorded investment		3,411		4,097		1,030				8,538
Total loans	$	1,144,481	$	1,042,890	$	395,149			$	2,582,520

Non-performing loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans. If these loans had continued to accrue interest in accordance with their original terms, approximately $0.4 million of interest income would have been recognized in each of the years ended 2019, 2018 and 2017. Interest income recorded on these loans was approximately zero during each of the years ended 2019, 2018 and 2017.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Loans on non-accrual status and past due more than 90 days (“Non-performing Loans”) at December 31 follow⁽¹⁾:

	90+ and Still Accruing		Non- Accrual		Total Non- Performing Loans
	(In thousands)
2019
Commercial
Commercial and industrial⁽²⁾	$	—	$	565	$	565
Commercial real estate		—		735		735
Mortgage
1-4 family owner occupied - jumbo		—		1,179		1,179
1-4 family owner occupied - non-jumbo⁽³⁾		—		3,540		3,540
1-4 family non-owner occupied		—		1,039		1,039
1-4 family - 2nd lien		—		979		979
Resort lending		—		690		690
Installment
Boat lending		—		332		332
Recreational vehicle lending		—		3		3
Other		—		470		470
Total recorded investment	$	—	$	9,532	$	9,532
Accrued interest included in recorded investment	$	—	$	—	$	—
2018
Commercial
Commercial and industrial⁽²⁾	$	—	$	1,345	$	1,345
Commercial real estate		—		778		778
Mortgage
1-4 family owner occupied - jumbo		—		184		184
1-4 family owner occupied - non-jumbo⁽³⁾		5		2,974		2,979
1-4 family non-owner occupied		—		1,259		1,259
1-4 family - 2nd lien		—		493		493
Resort lending		—		755		755
Installment
Boat lending		—		166		166
Recreational vehicle lending		—		7		7
Other		—		608		608
Total recorded investment	$	5	$	8,569	$	8,574
Accrued interest included in recorded investment	$	—	$	—	$	—

(1)

Non-performing loans exclude purchase credit impaired loans.

(2)

Non-performing commercial and industrial loans exclude $0.077 million and $0.097 million of government guaranteed loans at December 31, 2019 and 2018, respectively.

(3)

Non-performing 1-4 family owner occupied – non jumbo loans exclude $0.569 million and $0.363 million of government guaranteed loans at December 31, 2019 and 2018, respectively.

TABLE OF CONTENTS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

An aging analysis of loans by class at December 31 follows:

	Loans Past Due								Loans not Past Due		Total Loans
	30-59 days		60-89 days		90+ days		Total		Loans not Past Due		Total Loans
	(In thousands)
2019
Commercial
Commercial and industrial	$	—	$	289	$	102	$	391	$	564,480	$	564,871
Commercial real estate		177		—		735		912		603,910		604,822
Mortgage
1-4 family owner occupied - jumbo		1,757		1,037		—		2,794		398,759		401,553
1-4 family owner occupied - non-jumbo		2,672		852		1,387		4,911		342,349		347,260
1-4 family non-owner occupied		695		136		623		1,454		168,083		169,537
1-4 family - 2nd lien		909		90		386		1,385		115,157		116,542
Resort lending		364		53		565		982		67,192		68,174
Installment
Boat lending		337		107		88		532		202,750		203,282
Recreational vehicle lending		161		97		3		261		153,184		153,445
Other		377		275		202		854		103,030		103,884
Total recorded investment	$	7,449	$	2,936	$	4,091	$	14,476	$	2,718,894	$	2,733,370
Accrued interest included in recorded investment	$	74	$	34	$	—	$	108	$	8,239	$	8,347

2018
Commercial
Commercial and industrial	$	1,582	$	—	$	—	$	1,582	$	580,935	$	582,517
Commercial real estate		—		—		—		—		565,375		565,375
Mortgage
1-4 family owner occupied - jumbo		—		—		184		184		313,154		313,338
1-4 family owner occupied - non-jumbo		1,519		145		3,524		5,188		362,767		367,955
1-4 family non-owner occupied		265		49		1,259		1,573		162,673		164,246
1-4 family - 2nd lien		446		100		493		1,039		118,628		119,667
Resort lending		252		—		755		1,007		80,774		81,781
Installment
Boat lending		316		295		166		777		169,117		169,894
Recreational vehicle lending		28		21		7		56		125,780		125,836
Other		552		210		627		1,389		99,060		100,449
Total recorded investment	$	4,960	$	820	$	7,015	$	12,795	$	2,578,263	$	2,591,058
Accrued interest included in recorded investment	$	44	$	11	$	—	$	55	$	8,483	$	8,538

TABLE OF CONTENTS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Impaired loans are as follows:

	December 31,
	2019		2018
	(In thousands)
Impaired loans with no allocated allowance for loan losses
TDR	$	337	$	—
Non - TDR		1,550		—
Impaired loans with an allocated allowance for loan losses
TDR - allowance based on collateral		1,587		2,787
TDR - allowance based on present value cash flow		48,798		53,258
Non - TDR - allowance based on collateral		3,365		2,145
Total impaired loans	$	55,637	$	58,190

Amount of allowance for loan losses allocated
TDR - allowance based on collateral	$	542	$	769
TDR - allowance based on present value cash flow		4,641		4,849
Non - TDR - allowance based on collateral		972		692
Total amount of allowance for loan losses allocated	$	6,155	$	6,310

Impaired loans by class as of December 31 are as follows:

	2019						2018
	Recorded Investment		Unpaid Principal Balance		Related Allowance for Loan Losses		Recorded Investment		Unpaid Principal Balance		Related Allowance for Loan Losses
	(In thousands)
With no related allowance for loan losses recorded:
Commercial
Commercial and industrial	$	257	$	257	$	—	$	—	$	—	$	—
Commercial real estate		796		796		—		—		—		—
Mortgage
1-4 family owner occupied - jumbo		—		—		—		—		—		—
1-4 family owner occupied - non-jumbo		212		217		—		3		474		—
1-4 family non-owner occupied		214		366		—		—		—		—
1-4 family - 2nd lien		407		438		—		—		—		—
Resort lending		—		—		—		—		—		—
Installment
Boat lending		—		—		—		—		5		—
Recreational vehicle lending		—		—		—		—		—		—
Other		1		41		—		1		137		—
		1,887		2,115		—		4		616		—

TABLE OF CONTENTS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

	2019						2018
	Recorded Investment		Unpaid Principal Balance		Related Allowance for Loan Losses		Recorded Investment		Unpaid Principal Balance		Related Allowance for Loan Losses
	(In thousands)
With an allowance for loan losses recorded:
Commercial
Commercial and industrial		1,655		1,706		453		3,637		3,735		967
Commercial real estate		6,685		6,661		578		5,060		5,047		338
Mortgage
1-4 family owner occupied - jumbo		1,447		1,445		91		1,348		1,649		151
1-4 family owner occupied - non-jumbo		10,163		10,695		1,031		25,877		26,737		2,203
1-4 family non-owner occupied		4,962		5,542		572		5,565		5,988		507
1-4 family - 2nd lien		14,059		15,243		1,695		273		272		11
Resort lending		12,110		12,263		1,474		13,328		13,354		1,927
Installment
Boat lending		—		—		—		—		—		—
Recreational vehicle lending		—		—		—		79		79		4
Other		2,924		3,153		261		3,290		3,421		202
		54,005		56,708		6,155		58,457		60,282		6,310
Total
Commercial
Commercial and industrial		1,912		1,963		453		3,637		3,735		967
Commercial real estate		7,481		7,457		578		5,060		5,047		338
Mortgage
1-4 family owner occupied - jumbo		1,447		1,445		91		1,348		1,649		151
1-4 family owner occupied - non-jumbo		10,375		10,912		1,031		25,880		27,211		2,203
1-4 family non-owner occupied		5,176		5,908		572		5,565		5,988		507
1-4 family - 2nd lien		14,466		15,681		1,695		273		272		11
Resort lending		12,110		12,263		1,474		13,328		13,354		1,927
Installment
Boat lending		—		—		—		—		5		—
Recreational vehicle lending		—		—		—		79		79		4
Other		2,925		3,194		261		3,291		3,558		202
Total	$	55,892	$	58,823	$	6,155	$	58,461	$	60,898	$	6,310

Accrued interest included in recorded investment	$	255					$	271

TABLE OF CONTENTS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Average recorded investment in and interest income earned (of which the majority of these amounts were received in cash and related primarily to performing TDR’s) on impaired loans by class for the years ended December 31 follows:

	2019				2018				2017
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(In thousands)
With no related allowance for loan losses recorded:
Commercial
Commercial and industrial	$	51	$	—	$	378	$	20	$	751	$	22
Commercial real estate		278		5		961		—		183		—
Mortgage
1-4 family owner occupied - jumbo		—		—		41		—		—		—
1-4 family owner occupied - non-jumbo		201		—		15		27		52		21
1-4 family non-owner occupied		123		—		—		—		—		—
1-4 family - 2nd lien		136		7		—		—		—		—
Resort lending		—		—		—		—		—		—
Installment
Boat lending		—		—		—		—		—		—
Recreational vehicle lending		—		—		—		—		—		—
Other		—		1		1		11		1		6
		789		13		1,396		58		987		49
With an allowance for loan losses recorded:
Commercial
Commercial and industrial		2,256		72		2,641		127		3,298		132
Commercial real estate		5,778		315		5,199		288		7,242		377
Mortgage
1-4 family owner occupied - jumbo		995		39		1,335		69		2,425		67
1-4 family owner occupied - non-jumbo		15,183		594		28,183		1,408		31,468		1,439
1-4 family non-owner occupied		2,874		291		5,475		314		5,362		269
1-4 family - 2nd lien		13,383		809		284		12		306		11
Resort lending		11,697		669		14,687		606		16,383		616
Installment
Boat lending		54		—		1		—		1		1
Recreational vehicle lending		22		—		84		4		100		5
Other		3,186		189		3,640		224		4,335		265
		55,428		2,978		61,529		3,052		70,920		3,182

TABLE OF CONTENTS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

	2019				2018				2017
	Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized		Average Recorded Investment		Interest Income Recognized
	(In thousands)
Total
Commercial
Commercial and industrial		2,307		72		3,019		147		4,049		154
Commercial real estate		6,056		320		6,160		288		7,425		377
Mortgage
1-4 family owner occupied - jumbo		995		39		1,376		69		2,425		67
1-4 family owner occupied - non-jumbo		15,384		594		28,198		1,435		31,520		1,460
1-4 family non-owner occupied		2,997		291		5,475		314		5,362		269
1-4 family - 2nd lien		13,519		816		284		12		306		11
Resort lending		11,697		669		14,687		606		16,383		616
Installment
Boat lending		54		—		1		—		1		1
Recreational vehicle lending		22		—		84		4		100		5
Other		3,186		190		3,641		235		4,336		271
Total	$	56,217	$	2,991	$	62,925	$	3,110	$	71,907	$	3,231

Troubled debt restructurings at December 31 follow:

	2019
	Commercial		Retail⁽¹⁾			Total
	(In thousands)
Performing TDR's	$	7,974	$	39,601		$	47,575
Non-performing TDR's⁽²⁾		540		2,607	⁽³⁾		3,147
Total	$	8,514	$	42,208		$	50,722

	2018
	Commercial		Retail⁽¹⁾			Total
	(In thousands)
Performing TDR's	$	6,460	$	46,627		$	53,087
Non-performing TDR's⁽²⁾		74		2,884	⁽³⁾		2,958
Total	$	6,534	$	49,511		$	56,045

(1)

Retail loans include mortgage and installment loan portfolio segments.

(2)

Included in non-performing loans table above.

(3)

Also includes loans on non-accrual at the time of modification until six payments are received on a timely basis.

We have allocated $5.2 million and $5.6 million of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of December 31, 2019 and 2018, respectively. We have committed to lend additional amounts totaling up to $0.05 million and $0.04 million at December 31, 2019 and 2018, respectively, to customers with outstanding loans that are classified as troubled debt restructurings.

The terms of certain loans were modified as troubled debt restructurings and generally included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for a new loan with similar risk; or a permanent reduction of the recorded investment in the loan.

Modifications involving a reduction of the stated interest rate of the loan have generally been for periods ranging from 9 months to 36 months but have extended to as much as 480 months in certain circumstances. Modifications

TABLE OF CONTENTS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

involving an extension of the maturity date have generally been for periods ranging from 1 month to 60 months but have extended to as much as 230 months in certain circumstances.

Loans that have been classified as troubled debt restructurings during the years ended December 31 follow:

	Number of Contracts		Pre-modification Recorded Balance		Post-modification Recorded Balance
	(Dollars in thousands)
2019
Commercial
Commercial and industrial		8	$	1,609	$	1,609
Commercial real estate		3		1,479		1,479
Mortgage
1-4 family owner occupied - jumbo		—		—		—
1-4 family owner occupied - non-jumbo		2		478		483
1-4 family non-owner occupied		1		507		505
1-4 family - 2nd lien		3		75		75
Resort lending		—		—		—
Installment
Boat lending		—		—		—
Recreational vehicle lending		—		—		—
Other		7		188		191
Total		24	$	4,336	$	4,342
2018
Commercial
Commercial and industrial		7	$	652	$	652
Commercial real estate		2		204		204
Mortgage
1-4 family owner occupied - jumbo		1		419		419
1-4 family owner occupied - non-jumbo		9		991		994
1-4 family non-owner occupied		—		—		—
1-4 family - 2nd lien		—		—		—
Resort lending		1		115		114
Installment
Boat lending		—		—		—
Recreational vehicle lending		—		—		—
Other		14		708		709
Total		34	$	3,089	$	3,092

TABLE OF CONTENTS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

	Number of Contracts		Pre-modification Recorded Balance		Post-modification Recorded Balance
	(Dollars in thousands)
2017
Commercial
Commercial and industrial		15	$	925	$	925
Commercial real estate		—		—		—
Mortgage
1-4 family owner occupied - jumbo		—		—		—
1-4 family owner occupied - non-jumbo		5		423		429
1-4 family non-owner occupied		1		33		33
1-4 family - 2nd lien		—		—		—
Resort lending		1		189		189
Installment
Boat lending		—		—		—
Recreational vehicle lending		—		—		—
Other		15		551		559
Total		37	$	2,121	$	2,135

The troubled debt restructurings described above increased (decreased) the AFLL by $0.5 million, $(0.2) million and $0.1 million during the years ended December 31, 2019, 2018 and 2017, respectively and resulted in charge offs of zero during each of the years ended December 31, 2019, 2018 and 2017, respectively.

Loans that have been classified as troubled debt restructured during the past twelve months and that have subsequently defaulted during the years ended December 31 follows:

	Number of Contracts		Recorded Balance
	(Dollars in thousands)
2019
Commercial
Commercial and industrial		1	$	19
Commercial real estate		—		—
Mortgage
1-4 family owner occupied - jumbo		—		—
1-4 family owner occupied - non-jumbo		1		12
1-4 family non-owner occupied		—		—
1-4 family - 2nd lien		—		—
Resort lending		—		—
Installment
Boat lending		—		—
Recreational vehicle lending		—		—
Other		—		—
Total		2	$	31

TABLE OF CONTENTS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

	Number of Contracts		Recorded Balance
	(Dollars in thousands)
2018
Commercial
Commercial and industrial		—	$	—
Commercial real estate		—		—
Mortgage
1-4 family owner occupied - jumbo		—		—
1-4 family owner occupied - non-jumbo		—		—
1-4 family non-owner occupied		—		—
1-4 family - 2nd lien		—		—
Resort lending		—		—
Installment
Boat lending		—		—
Recreational vehicle lending		—		—
Other		1		13
Total		1	$	13

2017
Commercial
Commercial and industrial		6	$	164
Commercial real estate		—		—
Mortgage
1-4 family owner occupied - jumbo		—		—
1-4 family owner occupied - non-jumbo		—		—
1-4 family non-owner occupied		—		—
1-4 family - 2nd lien		—		—
Resort lending		—		—
Installment
Boat lending		—		—
Recreational vehicle lending		—		—
Other		1		13
Total		7	$	177

A loan is generally considered to be in payment default once it is 90 days contractually past due under the modified terms for commercial loans and installment loans and when four consecutive payments are missed for mortgage loans.

The troubled debt restructurings that subsequently defaulted described above increased (decreased) the AFLL by zero, zero and $0.04 million during the years ended December 31, 2019, 2018 and 2017, respectively and resulted in charge offs of zero, zero and $0.05 million during the years ended December 31, 2019, 2018 and 2017, respectively.

The terms of certain other loans were modified during the years ending December 31, 2019, 2018 and 2017 that did not meet the definition of a troubled debt restructuring. The modification of these loans could have included modification of the terms of a loan to borrowers who were not experiencing financial difficulties or a delay in a payment that was considered to be insignificant.

In order to determine whether a borrower is experiencing financial difficulty, we perform an evaluation of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under our internal underwriting policy.

TABLE OF CONTENTS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Credit Quality Indicators – As part of our on-going monitoring of the credit quality of our loan portfolios, we track certain credit quality indicators including (a) weighted-average risk grade of commercial loans, (b) the level of classified commercial loans, (c) credit scores of mortgage and installment loan borrowers, and (d) delinquency history and non-performing loans.

For commercial loans, we use a loan rating system that is similar to those employed by state and federal banking regulators. Loans are graded on a scale of 1 to 12. A description of the general characteristics of the ratings follows:

Rating 1 through 6: These loans are generally referred to as our “non-watch” commercial credits that include very high or exceptional credit fundamentals through acceptable credit fundamentals.

Rating 7 and 8: These loans are generally referred to as our “watch” commercial credits. These ratings include loans to borrowers that exhibit potential credit weakness or downward trends. If not checked or cured these trends could weaken our asset or credit position. While potentially weak, no loss of principal or interest is envisioned with these ratings.

Rating 9: These loans are generally referred to as our “substandard accruing” commercial credits. This rating includes loans to borrowers that exhibit a well-defined weakness where payment default is probable and loss is possible if deficiencies are not corrected. Generally, loans with this rating are considered collectible as to both principal and interest primarily due to collateral coverage.

Rating 10 and 11: These loans are generally referred to as our “substandard - non-accrual” and “doubtful” commercial credits. Our doubtful rating includes a sub classification for a loss rate other than 50% (which is the standard doubtful loss rate). These ratings include loans to borrowers with weaknesses that make collection of debt in full, on the basis of current facts, conditions and values at best questionable and at worst improbable. All of these loans are placed in non-accrual.

Rating 12: These loans are generally referred to as our “loss” commercial credits. This rating includes loans to borrowers that are deemed incapable of repayment and are charged-off.

The following table summarizes loan ratings by loan class for our commercial loan portfolio segment at December 31:

	Commercial
	Non-watch 1-6		Watch 7-8		Substandard Accrual 9		Non- Accrual 10-11		Total
	(In thousands)
2019
Commercial and industrial	$	515,955	$	44,384	$	3,967	$	565	$	564,871
Commercial real estate		580,516		23,036		535		735		604,822
Total	$	1,096,471	$	67,420	$	4,502	$	1,300	$	1,169,693
Accrued interest included in total	$	2,763	$	205	$	30	$	—	$	2,998

2018
Commercial and industrial	$	551,441	$	23,910	$	5,577	$	1,589	$	582,517
Commercial real estate		531,069		33,274		200		832		565,375
Total	$	1,082,510	$	57,184	$	5,777	$	2,421	$	1,147,892
Accrued interest included in total	$	3,107	$	174	$	130	$	—	$	3,411

TABLE OF CONTENTS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

For each of our mortgage and installment portfolio segment classes we generally monitor credit quality based on the credit scores of the borrowers. These credit scores are generally updated semi-annually. The following tables summarize credit scores by loan class for our mortgage and installment loan portfolio segments at December 31:

	Mortgage⁽¹⁾
	1-4 Family Owner Occupied - Jumbo		1-4 Family Owner Occupied - Non-jumbo		1-4 Family Non-owner Occupied		1-4 Family 2nd Lien		Resort Lending		Total
	(In thousands)
2019
800 and above	$	48,486	$	43,848	$	24,315	$	13,905	$	11,076	$	141,630
750-799		198,491		111,521		84,656		50,012		29,364		474,044
700-749		106,609		95,064		34,839		30,697		14,626		281,835
650-699		31,553		51,174		13,995		14,267		8,063		119,052
600-649		13,230		21,938		5,897		4,097		2,074		47,236
550-599		514		12,308		1,863		1,703		673		17,061
500-549		1,519		7,940		1,870		1,281		889		13,499
Under 500		641		2,208		533		511		79		3,972
Unknown		510		1,259		1,569		69		1,330		4,737
Total	$	401,553	$	347,260	$	169,537	$	116,542	$	68,174	$	1,103,066
Accrued interest included in total	$	1,139	$	1,662	$	586	$	502	$	266	$	4,155

2018
800 and above	$	33,337	$	46,509	$	19,191	$	11,077	$	10,898	$	121,012
750-799		167,992		136,105		79,837		56,008		36,542		476,484
700-749		69,018		96,378		36,103		33,345		17,282		252,126
650-699		28,637		48,663		15,854		11,361		9,945		114,460
600-649		9,911		19,139		5,533		4,077		3,088		41,748
550-599		2,034		9,619		2,396		1,385		1,867		17,301
500-549		—		7,463		1,338		882		106		9,789
Under 500		647		1,181		802		382		143		3,155
Unknown		1,762		2,898		3,192		1,150		1,910		10,912
Total	$	313,338	$	367,955	$	164,246	$	119,667	$	81,781	$	1,046,987
Accrued interest included in total	$	851	$	1,789	$	550	$	544	$	363	$	4,097

(1)

Credit scores have been updated within the last twelve months.

	Installment⁽¹⁾
	Boat Lending		Recreational Vehicle Lending		Other		Total
	(In thousands)
2019
800 and above	$	28,041	$	24,470	$	7,611	$	60,122
750-799		118,380		88,164		37,583		244,127
700-749		41,490		31,055		27,204		99,749
650-699		11,485		7,267		22,517		41,269
600-649		2,254		1,411		4,470		8,135
550-599		946		592		1,884		3,422
500-549		377		464		1,127		1,968
Under 500		309		22		284		615
Unknown		—		—		1,204		1,204
Total	$	203,282	$	153,445	$	103,884	$	460,611
Accrued interest included in total	$	490	$	378	$	326	$	1,194

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

	Installment⁽¹⁾
	Boat Lending		Recreational Vehicle Lending		Other		Total
	(In thousands)
2018
800 and above	$	20,767	$	20,197	$	7,062	$	48,026
750-799		100,191		74,154		34,627		208,972
700-749		35,455		24,890		27,633		87,978
650-699		10,581		4,918		12,663		28,162
600-649		1,657		992		5,019		7,668
550-599		652		453		2,255		3,360
500-549		286		225		1,264		1,775
Under 500		266		7		275		548
Unknown		39		—		9,651		9,690
Total	$	169,894	$	125,836	$	100,449	$	396,179
Accrued interest included in total	$	403	$	311	$	316	$	1,030

(1)

Credit scores have been updated within the last twelve months.

Mortgage loans serviced for others are not reported as assets on the Consolidated Statements of Financial Condition. The principal balances of these loans at December 31 follow:

	2019		2018
	(In thousands)
Mortgage loans serviced for :
Fannie Mae	$	1,449,935	$	1,350,703
Freddie Mac		852,123		712,740
Ginnie Mae		180,941		165,467
FHLB		69,149		78,687
Other		29,018		26,148
Total	$	2,581,166	$	2,333,745

Custodial deposit accounts maintained in connection with mortgage loans serviced for others totaled $29.9 million and $22.0 million, at December 31, 2019 and 2018, respectively.

If we do not remain well capitalized for regulatory purposes (see note #20), meet certain minimum capital levels or certain profitability requirements or if we incur a rapid decline in net worth, we could lose our ability to sell and/or service loans to these investors. This could impact our ability to generate net gains on mortgage loans and generate servicing income. A forced liquidation of our servicing portfolio could also impact the value that could be recovered on this asset. Fannie Mae has the most stringent eligibility requirements covering capital levels, profitability and decline in net worth. Fannie Mae requires seller/servicers to be well capitalized for regulatory purposes. For the profitability requirement, we cannot record four or more consecutive quarterly losses and experience a 30% decline in net worth over the same period. Our net worth cannot decline by more than 25% in one quarter or more than 40% over two consecutive quarters. The highest level of capital we are required to maintain is at least $2.5 million plus 0.25% of all loans serviced for others.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

An analysis of capitalized mortgage loan servicing rights for the years ended December 31 follows:

	2019			2018			2017
	(In thousands)
Balance at beginning of period	$	21,400		$	15,699		$	13,671
Change in accounting (see note #1)		—			—			542
Balance at beginning of period, as adjusted	$	21,400		$	15,699		$	14,213
Originated servicing rights capitalized		7,303			4,977			4,230
Servicing rights acquired		—			3,047			—
Change in fair value due to price		(6,408	)		191			(718	)
Change in fair value due to pay downs		(3,124	)		(2,514	)		(2,026	)
Balance at end of year	$	19,171		$	21,400		$	15,699
Loans sold and serviced that have had servicing rights capitalized	$	2,580,705		$	2,333,081		$	1,815,668

Fair value of capitalized mortgage loan servicing rights was determined using an average coupon rate of 4.22%, average servicing fee of 0.258%, average discount rate of 10.14% and an average Public Securities Association (“PSA”) prepayment rate of 250 for December 31, 2019; and average coupon rate of 4.23%, average servicing fee of 0.258%, average discount rate of 10.15% and an average PSA prepayment rate of 182 for December 31, 2018.

Purchase Credit Impaired (“PCI”) Loans

Loans acquired in a business combination are recorded at estimated fair value on their purchase date with no carryover of the related allowance for loan losses. In determining the estimated fair value of purchased loans, management considers a number of factors including, among others, the remaining life of the acquired loans, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral, and net present value of cash flows expected to be received. Purchased loans are accounted for in accordance with guidance for certain loans acquired in a transfer (ASC 310-30), when the loans have evidence of credit deterioration since origination and it is probable at the date of acquisition that the acquirer will not collect all contractually required principal and interest payments. The difference between contractually required payments and the cash flows expected to be collected at acquisition is referred to as the non-accretable difference. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in expected cash flows will result in a reversal of the provision for loan losses to the extent of prior charges and then an adjustment to accretable yield, which would have a positive impact on interest income.

As a result of our acquisition of TCSB Bancorp, Inc. (“TCSB”) (see note #26) we purchased loans for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected. For these loans that meet the criteria of ASC 310-30 treatment, the carrying amount was as follows:

	December 31,
	2019		2018
	(In thousands)
Commercial	$	1,394	$	1,609
Mortgage		575		555
Installment		316		349
Total carrying amount		2,285		2,513
Allowance for loan losses		—		—
Carrying amount, net of allowance for loan losses	$	2,285	$	2,513

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

The accretable difference on PCI loans is the difference between the expected cash flows and the net present value of expected cash flows with such difference accreted into earnings using the effective yield method over the term of the loans. Accretion recorded as loan interest income is included in the table below. Accretable yield of PCI loans, or income expected to be collected follows:

	Year ended December 31,
	2019			2018
	(In thousands)

Balance at beginning of period	$	462		$	—
New loans purchased		—			568
Accretion of income		(187	)		(106	)
Reclassification from (to) nonaccretable difference		365			—
Displosals/other adjustments		—			—
Balance at end of period	$	640		$	462

NOTE 5 – OTHER REAL ESTATE

A summary of other real estate activity for the years ended December 31 follows⁽¹⁾:

	2019			2018			2017
	(In thousands)
Balance at beginning of year, net of valuation allowance	$	1,178		$	1,628		$	4,956
Loans transferred to other real estate		2,242			1,510			1,735
Sales of other real estate		(1,438	)		(1,822	)		(4,737	)
Additions to valuation allowance charged to expense		(267	)		(138	)		(326	)
Balance at end of year, net of valuation allowance	$	1,715		$	1,178		$	1,628

(1)

Table excludes other repossessed assets totaling $0.15 million and $0.12 million at December 31, 2019 and 2018, respectively.

We periodically review our real estate properties and establish valuation allowances on these properties if values have declined since the date of acquisition. An analysis of our valuation allowance for other real estate follows:

	2019			2018			2017
	(In thousands)
Balance at beginning of year	$	144		$	123		$	793
Additions charged to expense		267			138			326
Direct write-downs upon sale		(319	)		(117	)		(996	)
Balance at end of year	$	92		$	144		$	123

At both December 31, 2019 and 2018, the balance of other real estate includes $1.2 million of foreclosed residential real estate properties. Retail mortgage loans secured by residential real estate properties for which formal foreclosure proceedings are in process according to local requirements totaled $0.7 million and $0.3 million at December 31, 2019 and 2018, respectively.

Other real estate and repossessed assets totaling $1.9 million and $1.3 million at December 31, 2019 and 2018, respectively, are presented net of the valuation allowance on the Consolidated Statements of Financial Condition.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

NOTE 6 – PROPERTY AND EQUIPMENT

A summary of property and equipment at December 31 follows:

	2019			2018
	(In thousands)
Land and land improvements	$	17,478		$	16,843
Buildings		57,363			56,385
Equipment		71,194			70,039
		146,035			143,267
Accumulated depreciation and amortization		(107,624	)		(104,490	)
Property and equipment, net	$	38,411		$	38,777

Depreciation expense was $5.2 million, $5.1 million and $5.3 million in 2019, 2018 and 2017, respectively.

NOTE 7 – GOODWILL AND OTHER INTANGIBLES

Intangible assets, net of amortization, at December 31 follows:

	2019				2018
	Gross Carrying Amount		Accumulated Amortization		Gross Carrying Amount		Accumulated Amortization
	(In thousands)
Amortized intangible assets - core deposits	$	11,916	$	6,590	$	11,916	$	5,501
Unamortized intangible assets - goodwill	$	28,300			$	28,300

At December 31, 2019, the Bank (our reporting unit) had positive equity and we elected to perform a qualitative assessment to determine if it was more likely than not that the fair value of the Bank exceeds its carrying value, including goodwill. The qualitative assessment indicated that it was more likely than not that the fair value of the Bank exceeded its carrying value, resulting in no impairment.

Intangible amortization expense was $1.1 million, $1.0 million and $0.3 million during the years ended 2019, 2018 and 2017, respectively.

A summary of estimated core deposit intangible amortization at December 31, 2019, follows:

	(In thousands)
2020	$	1,020
2021		970
2022		785
2023		547
2024		516
2025 and thereafter		1,488
Total	$	5,326

NOTE 8 – DEPOSITS

A summary of interest expense on deposits for the years ended December 31 follows:

	2019		2018		2017
	(In thousands)
Savings and interest-bearing checking	$	5,371	$	4,146	$	1,530
Reciprocal		6,024		1,292		342
Time		7,148		5,343		4,288
Brokered time		4,882		3,697		615
Total	$	23,425	$	14,478	$	6,775

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Aggregate time deposits in denominations of $0.25 million or more amounted to $71.5 million and $74.0 million at December 31, 2019 and 2018, respectively.

A summary of the maturity of time deposits at December 31, 2019, follows:

	(In thousands)
2020	$	501,609
2021		73,398
2022		13,929
2023		15,136
2024		5,020
2025 and thereafter		445
Total	$	609,537

Reciprocal deposits represent demand, money market and time deposits from our customers that have been placed through Promontory Interfinancial Network’s Insured Cash Sweep® service and Certificate of Deposit Account Registry Service®. These services allow our customers to access multi-million dollar FDIC deposit insurance on deposit balances greater than the standard FDIC insurance maximum.

A summary of reciprocal deposits at December 31 follows:

	2019		2018
	(In thousands)
Demand	$	383,953	$	114,503
Money market		4,416		8,577
Time		42,658		58,992
Total	$	431,027	$	182,072

NOTE 9 – OTHER BORROWINGS

A summary of other borrowings at December 31 follows:

	2019		2018
	(In thousands)
Advances from the FHLB	$	63,640	$	25,696
Federal funds purchased		25,000		—
Other		6		4
Total	$	88,646	$	25,700

Advances from the FHLB are secured by unencumbered qualifying mortgage and home equity loans with a market value equal to at least 132% to 165%, respectively, of outstanding advances. Advances are also secured by FHLB stock that we own, which totaled $8.6 million at December 31, 2019. Unused borrowing capacity with the FHLB (subject to the FHLB’s credit requirements and policies) was $836.5 million at December 31, 2019. Interest expense on advances amounted to $0.7 million, $1.0 million and $0.9 million for the years ended December 31, 2019, 2018 and 2017, respectively. No FHLB advances were terminated during 2019, 2018 or 2017.

As a member of the FHLB, we must own FHLB stock equal to the greater of 0.75% of the unpaid principal balance of residential mortgage assets or 4.5% of our outstanding advances. At December 31, 2019, we were in compliance with the FHLB stock ownership requirements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

The maturity dates, weighted average interest rates and contractually required repayments of FHLB advances at December 31 follow:

	2019					2018
	Amount		Rate			Amount		Rate
	(Dollars in thousands)
Fixed-rate advances
2019						$	10,000		1.60	%
2020	$	28,645		2.19	%		10,762		3.18
2022		4,995		1.69			4,934		1.69
2025 and thereafter		30,000		0.74
Total advances	$	63,640		1.47	%	$	25,696		2.28	%

Borrowings with the FRB at December 31, 2019 and 2018 were zero. Average borrowings with the FRB during the years ended December 31, 2019, 2018 and 2017 totaled $0.305 million, $0.003 million and $0.047 million. We had unused borrowing capacity with the FRB (subject to the FRB’s credit requirements and policies) of $348.6 million at December 31, 2019. Collateral for FRB borrowings are certain commercial and installment loans.

Interest expense on federal funds purchased totaled $0.1 million for each of the years ended December 31, 2019, 2018 and 2017.

Assets, consisting of FHLB stock and loans, pledged to secure other borrowings and unused borrowing capacity totaled $1.9 billion at December 31, 2019.

NOTE 10 – SUBORDINATED DEBENTURES

We have formed various special purpose entities (the “trusts”) for the purpose of issuing trust preferred securities in either public or pooled offerings or in private placements. Independent Bank Corporation owns all of the common stock of each trust and has issued subordinated debentures to each trust in exchange for all of the proceeds from the issuance of the common stock and the trust preferred securities. Trust preferred securities totaling $38.2 million at both December 31, 2019 and 2018, qualified as Tier 1 regulatory capital.

These trusts are not consolidated with Independent Bank Corporation and accordingly, we report the common securities of the trusts held by us in accrued income and other assets and the subordinated debentures that we have issued to the trusts in the liability section of our Consolidated Statements of Financial Condition.

As a result of our acquisition of TCSB (see note #26) we acquired TCSB Statutory Trust I as summarized in the tables below at a discount. The discount at acquisition totaled $1.4 million and is being amortized through its maturity date and is included in interest expense – other borrowings and subordinated debentures in the Consolidated Statements of Operations.

Summary information regarding subordinated debentures as of December 31 follows:

	2019
Entity Name	Issue Date	Subordinated Debentures			Trust Preferred Securities Issued			Common Stock Issued
		(In thousands)
IBC Capital Finance III	May 2007	$	12,372		$	12,000		$	372
IBC Capital Finance IV	September 2007		15,465			15,000			465
Midwest Guaranty Trust I	November 2002		7,732			7,500			232
TCSB Statutory Trust I	March 2005		5,155			5,000			155
Discount on TCSB Statutory Trust I			(1,268	)		(1,268	)		—
		$	39,456		$	38,232		$	1,224

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

	2018
Entity Name	Issue Date	Subordinated Debentures			Trust Preferred Securities Issued			Common Stock Issued
	(In thousands)
IBC Capital Finance III	May 2007	$	12,372		$	12,000		$	372
IBC Capital Finance IV	September 2007		15,465			15,000			465
Midwest Guaranty Trust I	November 2002		7,732			7,500			232
TCSB Statutory Trust I	March 2005		5,155			5,000			155
Discount on TCSB Statutory Trust I			(1,336	)		(1,336	)		—
		$	39,388		$	38,164		$	1,224

Other key terms for the subordinated debentures and trust preferred securities that were outstanding at December 31, 2019 and 2018 follow:

Entity Name	Maturity Date	Interest Rate	First Permitted Redemption Date
IBC Capital Finance III	July 30, 2037	3 month LIBOR plus 1.60%	July 30, 2012
IBC Capital Finance IV	September 15, 2037	3 month LIBOR plus 2.85%	September 15, 2012
Midwest Guaranty Trust I	November 7, 2032	3 month LIBOR plus 3.45%	November 7, 2007
TCSB Statutory Trust I	March 17, 2035	3 month LIBOR plus 2.20%	March 17, 2010

The subordinated debentures and trust preferred securities are cumulative and have a feature that permits us to defer distributions (payment of interest) from time to time for a period not to exceed 20 consecutive quarters. Interest is payable quarterly on each of the subordinated debentures and trust preferred securities and no distributions were deferred at December 31, 2019 and 2018.

We have the right to redeem the subordinated debentures and trust preferred securities (at par) in whole or in part from time to time on or after the first permitted redemption date specified above or upon the occurrence of specific events defined within the trust indenture agreements.

Distributions (payment of interest) on the trust preferred securities are included in interest expense – other borrowings and subordinated debentures in the Consolidated Statements of Operations.

NOTE 11 – COMMITMENTS AND CONTINGENT LIABILITIES

In the normal course of business, we enter into financial instruments with off-balance sheet risk to meet the financing needs of customers or to reduce exposure to fluctuations in interest rates. These financial instruments may include commitments to extend credit and standby letters of credit. Financial instruments involve varying degrees of credit and interest-rate risk in excess of amounts reflected in the Consolidated Statements of Financial Condition. Exposure to credit risk in the event of non-performance by the counterparties to the financial instruments for loan commitments to extend credit and standby letters of credit is represented by the contractual amounts of those instruments. We do not, however, anticipate material losses as a result of these financial instruments.

A summary of financial instruments with off-balance sheet risk at December 31 follows:

	2019		2018
	(In thousands)
Financial instruments whose risk is represented by contract amounts
Commitments to extend credit	$	582,457	$	505,421
Standby letters of credit		7,207		4,998

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

and generally require payment of a fee. Since commitments may expire without being drawn upon, the commitment amounts do not represent future cash requirements. Commitments are issued subject to similar underwriting standards, including collateral requirements, as are generally involved in the extension of credit facilities.

Standby letters of credit are written conditional commitments issued to guarantee the performance of a customer to a third party. The credit risk involved in such transactions is essentially the same as that involved in extending loan facilities and, accordingly, standby letters of credit are issued subject to similar underwriting standards, including collateral requirements, as are generally involved in the extension of credit facilities. The majority of the standby letters of credit are on-demand with no stated maturity date and have variable rates that range from 3.75% to 10.75%.

We are also involved in various litigation matters in the ordinary course of business. At the present time, we do not believe any of these matters will have a significant impact on our consolidated financial position or results of operations. The aggregate amount we have accrued for losses we consider probable as a result of these litigation matters is immaterial. However, because of the inherent uncertainty of outcomes from any litigation matter, we believe it is reasonably possible we may incur losses in addition to the amounts we have accrued. At this time, we estimate the maximum amount of additional losses that are reasonably possible is insignificant. However, because of a number of factors, including the fact that certain of these litigation matters are still in their early stages, this maximum amount may change in the future.

The litigation matters described in the preceding paragraph primarily include claims that have been brought against us for damages, but do not include litigation matters where we seek to collect amounts owed to us by third parties (such as litigation initiated to collect delinquent loans). These excluded, collection-related matters may involve claims or counterclaims by the opposing party or parties, however, we have excluded such matters from the disclosure contained in the preceding paragraph in all cases where we believe the possibility of us paying damages to any opposing party is remote.

The provision for loss reimbursement on sold loans represents our estimate of incurred losses related to mortgage loans that we have sold to investors (primarily Fannie Mae, Freddie Mac, Ginnie Mae and the FHLB). Since we sell mortgage loans without recourse, loss reimbursements only occur in those instances where we have breached a representation or warranty or other contractual requirement related to the loan sale. The provision for loss reimbursement on sold loans was an expense of $0.23 million, $0.01 million and $0.17 million for the years ended December 31, 2019, 2018 and 2017, respectively. The reserve for loss reimbursements on sold mortgage loans totaled $0.9 million and $0.8 million at December 31, 2019 and 2018, respectively. This reserve is included in accrued expenses and other liabilities in our Consolidated Statements of Financial Condition. This reserve is based on an analysis of mortgage loans that we have sold which are further categorized by delinquency status, loan to value, and year of origination. The calculation includes factors such as probability of default, probability of loss reimbursement (breach of representation or warranty) and estimated loss severity. We believe that the amounts that we have accrued for incurred losses on sold mortgage loans are appropriate given our analyses. However, future losses could exceed our current estimate.

We own 12,566 shares of VISA Class B common stock. At the present time, these shares can only be sold to other Class B shareholders. As a result, there has generally been limited transfer activity in private transactions between buyers and sellers. Given the limited activity that we have become aware of and the continuing uncertainty regarding the likelihood, ultimate timing and eventual exchange rate for Class B shares into Class A shares, we continue to carry these shares at zero, representing cost basis less impairment. However, given the current conversion ratio of 1.6228 to Class A shares and the closing price of VISA Class A shares on February 27, 2020 of $180.01 per share, our 12,566 Class B shares would have a current “value” of approximately $3.7 million. We continue to monitor Class B trading activity and the status of the resolution of certain litigation matters at VISA that would trigger the conversion of Class B common shares into Class A common shares that would have no trading restrictions.

NOTE 12 – SHAREHOLDERS’ EQUITY AND INCOME PER COMMON SHARE

In January, 2019, 2018 and 2017, our Board of Directors authorized share repurchase plans to buy back up to 5% of our outstanding common stock through the end of each respective year. In addition, in June, 2019 our Board of Directors authorized a 300,000 share expansion of the 2019 repurchase plan. During 2019, 2018 and 2017 repurchases were made through open market and negotiated transactions and totaled 1,204,688, 587,969 and zero shares of common stock, respectively for an aggregate purchase price of $26.3 million, $12.7 million and zero, respectively.

TABLE OF CONTENTS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

A reconciliation of basic and diluted net income per common share for the years ended December 31 follows:

	2019		2018		2017
	(In thousands, except per share amounts)
Net income	$	46,435	$	39,839	$	20,475

Weighted average shares outstanding⁽¹⁾		22,894		23,412		21,327
Stock units for deferred compensation plan for non-employee directors		132		128		121
Effect of stock options		115		176		142
Performance share units		42		53		60
Weighted average shares outstanding for calculation of diluted earnings per share		23,183		23,769		21,650

Net income per common share
Basic⁽¹⁾	$	2.03	$	1.70	$	0.96
Diluted	$	2.00	$	1.68	$	0.95

(1)

Basic net income per common share includes weighted average common shares outstanding during the period and participating share awards.

Weighted average stock options outstanding that were not considered in computing diluted net income per common share because they were anti-dilutive were zero for each year ended 2019, 2018 and 2017, respectively.

NOTE 13 – INCOME TAX

The composition of income tax expense for the years ended December 31 follows:

	2019		2018		2017
	(In thousands)
Current expense	$	10,237	$	—	$	1,927
Deferred expense		1,088		9,294		10,071
Change in statutory rate		—		—		5,965
Income tax expense	$	11,325	$	9,294	$	17,963

The deferred income tax expense of $1.1 million in 2019 can be primarily attributed to the utilization of our alternative minimum tax credit carryforward while the deferred income tax expense of $9.3 million during 2018 can be primarily attributed to the utilization of our net operating loss (“NOL”) carryfoward and alternative minimum tax credit carryforward while the deferred income tax expense of $10.1 million during 2017 can be primarily attributed to the utilization of our NOL carryfoward.

On December 22, 2017, “H.R. 1”, also known as the “Tax Cuts and Jobs Act”, was signed into law. H.R.1, among other things, reduced the federal corporate income tax rate to 21% effective January 1, 2018. As a result, we concluded that our deferred tax assets, net had to be remeasured. Our deferred tax assets, net represents expected corporate tax benefits anticipated to be realized in the future. The reduction in the federal corporate income tax rate reduces these anticipated future benefits. The remeasurement of our deferred tax assets, net at December 31, 2017 resulted in a reduction of these net assets and a corresponding increase in income tax expense of $6.0 million that was recorded in the fourth quarter of 2017.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

A reconciliation of income tax expense to the amount computed by applying the statutory federal income tax rate of 21% for 2019 and 2018 and 35% for 2017 to the income before income tax for the years ended December 31 follows:

	2019			2018			2017
	(In thousands)
Statutory rate applied to income before income tax	$	12,130		$	10,318		$	13,453
Tax-exempt income		(375	)		(383	)		(777	)
Bank owned life insurance		(233	)		(229	)		(372	)
Share-based compensation		(204	)		(367	)		(287	)
Unrecognized tax benefit		(134	)		(162	)		(123	)
Non-deductible meals, entertainment and memberships		86			85			64
Change in statutory rate		—			—			5,965
Other, net		55			32			40
Income tax expense	$	11,325		$	9,294		$	17,963

The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31 follow:

	2019		2018
	(In thousands)
Deferred tax assets
Allowance for loan losses	$	5,355	$	5,052
Lease liabilities		1,744		—
Property and equipment		1,528		1,569
Share-based compensation		808		900
Unrealized loss on derivative financial instruments		459		33
Reserve for unfunded lending commitments		324		272
Deferred compensation		285		253
Loss reimbursement on sold loans reserve		185		165
Non accrual loan interest income		173		179
Other than temporary impairment charge on securities available for sale		147		187
Vehicle service contract counterparty contingency reserve		38		70
Alternative minimum tax credit carry forward		—		1,686
Unrealized loss on securities available for sale		—		1,113
Unrealized loss on equity securities		—		295
Purchase premiums, net		—		71
Other		—		161
Gross deferred tax assets		11,046		12,006
Deferred tax liabilities
Capitalized mortgage loan servicing rights		4,026		4,494
Deferred loan fees		1,852		1,706
Lease right of use asset		1,739		—
Unrealized gain on securities available for sale		994		—
Purchase premiums, net		293		—
Federal Home Loan Bank stock		27		27
Other		43		—
Gross deferred tax liabilities		8,974		6,227
Deferred tax assets, net	$	2,072	$	5,779

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

We assess whether a valuation allowance should be established against our deferred tax assets based on the consideration of all available evidence using a “more likely than not” standard. The ultimate realization of this asset is primarily based on generating future income. We concluded at both December 31, 2019 and 2018, that the realization of substantially all of our deferred tax assets continues to be more likely than not.

Changes in unrecognized tax benefits for the years ended December 31 follow:

	2019			2018			2017
	(In thousands)
Balance at beginning of year	$	588		$	724		$	840
Additions based on tax positions related to the current year		20			26			7
Reductions due to the statute of limitations		(170	)		(162	)		(123	)
Reductions due to settlements		—			—			—
Balance at end of year	$	438		$	588		$	724

If recognized, the entire amount of unrecognized tax benefits, net of $0.1 million of federal tax on state benefits, would affect our effective tax rate. We do not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months. No amounts were expensed for interest and penalties for the years ended December 31, 2019, 2018 and 2017. No amounts were accrued for interest and penalties at December 31, 2019, 2018 and 2017. At December 31, 2019, U.S. Federal tax years 2016 through the present remain open to examination.

NOTE 14 – SHARE BASED COMPENSATION AND BENEFIT PLANS

We maintain share based payment plans that include a non-employee director stock purchase plan and a long-term incentive plan that permits the issuance of share based compensation, including stock options and non-vested share awards. The long-term incentive plan, which is shareholder approved, permits the grant of additional share based awards for up to 0.5 million shares of common stock as of December 31, 2019. The non-employee director stock purchase plan permits the grant of additional share based payments for up to 0.2 million shares of common stock as of December 31, 2019. Share based awards and payments are measured at fair value at the date of grant and are expensed over the requisite service period. Common shares issued upon exercise of stock options come from currently authorized but unissued shares.

During 2019, 2018 and 2017 pursuant to our long-term incentive plan, we granted 0.06 million, 0.05 million and 0.05 million shares, respectively of restricted stock and 0.02 million, 0.02 million and 0.02 million performance stock units (“PSUs”), respectively to certain officers. Except for 0.010 million shares and 0.002 million shares of restricted stock issued in 2019 and 2018, respectively that vest ratably over three years, all shares of restricted stock and PSUs cliff vest after a period of three years. The performance feature of the PSUs is based on a comparison of our total shareholder return over the vesting period starting on the grant date to the total shareholder return over that period for a banking index of our peers. We have not issued stock options since 2013, other than in connection with the Merger (see note #26).

Our directors may elect to receive at least a portion of their quarterly cash retainer fees in the form of common stock (either on a current basis or on a deferred basis) pursuant to the non-employee director stock purchase plan referenced above. Shares equal in value to that portion of each director’s fees that he or she has elected to receive in stock on a current basis are issued each quarter and vest immediately. Shares issued on a deferred basis are credited at the rate of 90% of the current value and vest immediately. We issued 0.01 million shares to directors during each of the years ending 2019, 2018 and 2017 and expensed their value during those same periods.

Total compensation expense recognized for grants pursuant to our long-term incentive plan was $1.6 million, $1.5 million and $1.6 million in 2019, 2018 and 2017, respectively. The corresponding tax benefit relating to this expense was $0.3 million, $0.3 million and $0.6 million in 2019, 2018 and 2017, respectively. Total expense recognized for non-employee director share based payments was $0.3 million, $0.2 million and $0.2 million in 2019, 2018 and 2017, respectively. The corresponding tax benefit relating to this expense was $0.05 million, $0.04 million and $0.06 million in 2019, 2018 and 2017, respectively.

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At December 31, 2019, the total expected compensation cost related to non-vested restricted stock and PSUs not yet recognized was $2.1 million. The weighted-average period over which this amount will be recognized is 1.8 years.

A summary of outstanding stock option grants and related transactions follows:

	Number of Shares			Average Exercise Price		Weighted- Average Remaining Contractual Term (Years)		Aggregated Intrinsic Value
								(In thousands)
Outstanding at January 1, 2019		211,421		$	6.48
Granted		—
Exercised		(71,799	)		9.84
Forfeited		—
Expired		(1,116	)		22.35
Outstanding at December 31, 2019		138,506		$	4.62		3.01	$	2,498
Vested and expected to vest at December 31, 2019		138,506		$	4.62		3.01	$	2,498
Exercisable at December 31, 2019		138,506		$	4.62		3.01	$	2,498

A summary of outstanding non-vested stock and related transactions follows:

	Number of Shares			Weighted- Average Grant Date Fair Value
Outstanding at January 1, 2019		258,419		$	19.00
Granted		86,283			22.87
Vested		(85,978	)		14.57
Forfeited		(12,998	)		22.85
Outstanding at December 31, 2019		245,726		$	21.72

Certain information regarding options exercised during the periods ending December 31 follows:

	2019		2018		2017
	(In thousands)
Intrinsic value	$	897	$	2,333	$	623
Cash proceeds received	$	706	$	1,420	$	142
Tax benefit realized	$	188	$	490	$	218

We maintain 401(k) and employee stock ownership plans covering substantially all of our full-time employees. During 2019, 2018 and 2017, we matched 50% of employee contributions to the 401(k) plan up to a maximum of 8%, 8% and 6% of participating employees’ eligible wages, respectively. Contributions to the employee stock ownership plan are determined annually and require approval of our Board of Directors. The maximum contribution is 6% of employees’ eligible wages. Contributions to the employee stock ownership plan were 2% for 2019, 2018 and 2017. Amounts expensed for these retirement plans were $2.6 million, $2.3 million and $1.6 million in 2019, 2018 and 2017, respectively.

Our employees participate in various performance-based compensation plans. Amounts expensed for all incentive plans totaled $9.5 million, $9.8 million and $8.0 million in 2019, 2018 and 2017, respectively.

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We also provide certain health care and life insurance programs to substantially all full-time employees. Amounts expensed for these programs totaled $5.7 million, $5.2 million and $4.0 million in 2019, 2018 and 2017 respectively. These insurance programs are also available to retired employees at their own expense.

NOTE 15 – OTHER NON-INTEREST INCOME

Other non-interest income for the years ended December 31 follows:

	2019		2018		2017
	(In thousands)
Investment and insurance commissions	$	1,658	$	1,971	$	1,968
ATM fees		1,403		1,457		1,446
Bank owned life insurance		1,111		970		1,061
Other		5,110		4,362		3,693
Total other non-interest income	$	9,282	$	8,760	$	8,168

NOTE 16 – DERIVATIVE FINANCIAL INSTRUMENTS

We are required to record derivatives on our Consolidated Statements of Financial Condition as assets and liabilities measured at their fair value. The accounting for increases and decreases in the value of derivatives depends upon the use of derivatives and whether the derivatives qualify for hedge accounting.

Our derivative financial instruments according to the type of hedge in which they are designated at December 31 follow:

	2019
	Notional Amount		Average Maturity (years)		Fair Value
	(Dollars in thousands)
Fair value hedge designation - Pay-fixed interest rate swap agreements	$	7,117		9.4	$	(242	)

Cash flow hedge designation
Pay-fixed interest rate swap agreements	$	25,000		1.6	$	(174	)
Interest rate cap agreements		150,000		2.6		214
Total	$	175,000		2.5	$	40

No hedge designation
Rate-lock mortgage loan commitments	$	49,268		0.1	$	1,412
Mandatory commitments to sell mortgage loans		95,363		0.1		(150	)
Pay-fixed interest rate swap agreements - commercial		153,946		5.5		(3,641	)
Pay-variable interest rate swap agreements - commercial		153,946		5.5		3,641
Purchased options		2,908		1.5		141
Written options		2,848		1.5		(139	)
Total	$	458,279		3.7	$	1,264

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

	2018
	Notional Amount		Average Maturity (years)		Fair Value
	(Dollars in thousands)
Cash flow hedge designation
Pay-fixed interest rate swap agreements	$	25,000		2.6	$	280
Interest rate cap agreements		150,000		3.6		2,245
Total	$	175,000		3.5	$	2,525

No hedge designation
Rate-lock mortgage loan commitments	$	32,473		0.1	$	687
Mandatory commitments to sell mortgage loans		57,583		0.1		(383	)
Pay-fixed interest rate swap agreements - commercial		94,451		5.5		405
Pay-variable interest rate swap agreements - commercial		94,451		5.5		(405	)
Purchased options		3,095		2.5		116
Written options		3,095		2.5		(116	)
Total	$	285,148		3.7	$	304

We have established management objectives and strategies that include interest-rate risk parameters for maximum fluctuations in net interest income and market value of portfolio equity. We monitor our interest rate risk position via simulation modeling reports. The goal of our asset/liability management efforts is to maintain profitable financial leverage within established risk parameters.

To meet our asset/liability management objectives, we may periodically enter into derivative financial instruments to mitigate exposure to fluctuations in cash flows resulting from changes in interest rates (“Cash Flow Hedges”). Cash Flow Hedges included certain pay-fixed interest rate swaps and interest rate cap agreements. Pay-fixed interest rate swaps convert the variable-rate cash flows on debt obligations to fixed-rates. Under interest-rate cap agreements, we will receive cash if interest rates rise above a predetermined level. As a result, we effectively have variable-rate debt with an established maximum rate. We pay an upfront premium on interest rate caps which is recognized in earnings in the same period in which the hedged item affects earnings. Unrecognized premiums from interest rate caps aggregated to $2.2 million and $2.7 million at December 31, 2019 and 2018, respectively.

It is anticipated that $0.05 million, net of tax, of unrealized losses on Cash Flow Hedges at December 31, 2019, will be reclassified into earnings over the next twelve months. The maximum term of any Cash Flow Hedge at December 31, 2019 is 3.8 years.

Beginning in the second quarter of 2019 we entered into a pay-fixed interest rate swap to protect a portion of the fair value of a certain fixed rate commercial loan commitment (“Fair Value Hedge”). As a result, changes in the fair value of the pay-fixed interest rate swap is expected to offset changes in the fair value of the fixed rate commercial loan commitment due to fluctuations in interest rates. We record the fair value of Fair Value Hedges in accrued income and other assets and accrued expenses and other liabilities on our Consolidated Statements of Financial Condition. The hedged item (fixed rate commercial loan commitment) is also recorded at fair value which offsets the adjustment to the Fair Value Hedge. On an ongoing basis, we adjust our Consolidated Statements of Financial Condition to reflect the then current fair value of both the Fair Value Hedge and the hedged item. The related gains or losses are reported in non-interest income – other in our Consolidated Statements of Operations.

Certain derivative financial instruments have not been designated as hedges. The fair value of these derivative financial instruments has been recorded on our Consolidated Statements of Financial Condition and is adjusted on an ongoing basis to reflect their then current fair value. The changes in fair value of derivative financial instruments not designated as hedges are recognized in earnings.

In the ordinary course of business, we enter into rate-lock mortgage loan commitments with customers (“Rate-Lock Commitments”). These commitments expose us to interest rate risk. We also enter into mandatory

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

commitments to sell mortgage loans (“Mandatory Commitments”) to reduce the impact of price fluctuations of mortgage loans held for sale and Rate-Lock Commitments. Mandatory Commitments help protect our loan sale profit margin from fluctuations in interest rates. The changes in the fair value of Rate Lock Commitments and Mandatory Commitments are recognized currently as part of net gains on mortgage loans in the Consolidated Statements of Operations. We obtain market prices on Mandatory Commitments and Rate-Lock Commitments. Net gains on mortgage loans, as well as net income, may be more volatile as a result of these derivative instruments, which are not designated as hedges.

In prior periods we offered to our deposit customers an equity linked time deposit product (“Altitude CD”). The Altitude CD was a time deposit that provided the customer a guaranteed return of principal at maturity plus a potential equity return (a written option), while we receive a like stream of funds based on the equity return (a purchased option). The written and purchased options will generally move in opposite directions resulting in little or no net impact on our Consolidated Statements of Operations. All of the written and purchased options in the table above relate to this Altitude CD product.

We have a program that allows commercial loan customers to lock in a fixed rate for a longer period of time than we would normally offer for interest rate risk reasons. We will enter into a variable rate commercial loan and an interest rate swap agreement with a customer and then enter into an offsetting interest rate swap agreement with an unrelated party. The interest rate swap agreement fair values will generally move in opposite directions resulting in little or no net impact on our Consolidated Statements of Operations. All of the interest rate swap agreements with no hedge designation in the table above relate to this program.

The following tables illustrate the impact that the derivative financial instruments discussed above have on individual line items in the Consolidated Statements of Financial Condition for the periods presented:

Fair Values of Derivative Instruments

	Asset Derivatives						Liability Derivatives
	December 31,						December 31,
	2019			2018			2019			2018
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
	(In thousands)
Derivatives designated as hedging instruments
Pay-fixed interest rate swap agreements	Other assets	$	—	Other assets	$	280	Other liabilities	$	416	Other liabilities	$	—
Interest rate cap agreements	Other assets		214	Other assets		2,245	Other liabilities		—	Other liabilities		—
			214			2,525			416			—
Derivatives not designated as hedging instruments
Rate-lock mortgage loan commitments	Other assets		1,412	Other assets		687	Other liabilities		—	Other liabilities		—
Mandatory commitments to sell mortgage loans	Other assets		—	Other assets		—	Other liabilities		150	Other liabilities		383
Pay-fixed interest rate swap agreements - commercial	Other assets		28	Other assets		1,116	Other liabilities		3,669	Other liabilities		711
Pay-variable interest rate swap agreements - commercial	Other assets		3,669	Other assets		711	Other liabilities		28	Other liabilities		1,116
Purchased options	Other assets		141	Other assets		116	Other liabilities		—	Other liabilities		—
Written options	Other assets		—	Other assets		—	Other liabilities		139	Other liabilities		116
			5,250			2,630			3,986			2,326
Total derivatives		$	5,464		$	5,155		$	4,402		$	2,326

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

The effect of derivative financial instruments on the Consolidated Statements of Operations follows:

	Year Ended December 31,
	Gain (loss) Recognized in Other Comprehensive Income (Loss) (Effective Portion)								Location Gain (Loss) Reclassified from Accumulated Other Comprehensive Loss into Income (Effective Portion)		Gain (Loss) Reclassified from Accumulated Other Comprehensive Loss into Income (Effective Portion)							Location of Gain (Loss) Recognized in Income⁽¹⁾	Gain (Loss) Recognized in Income⁽¹⁾
	2019			2018			2017				2019		2018		2017				2019			2018			2017
	(In thousands)
Fair Value Hedges
Pay-fixed interest rate swap agreements																		Non-interest income- other	$	(242	)	$	—		$	—
Cash Flow Hedges
Interest rate cap agreements	$	(1,211	)	$	(340	)	$	108		Interest expense	$	363	$	206	$	—		Interest expense	$	—		$	—		$	—
Pay-fixed interest rate swap agreements		(392	)		78			216		Interest expense		62		31		(18	)	Interest expense		—			(12	)		(12	)
Total	$	(1,603	)	$	(262	)	$	324			$	425	$	237	$	(18	)		$	—		$	(12	)	$	(12	)

No hedge designation
Rate-lock mortgage loan commitments																		Net gains on mortgage loans	$	725		$	157		$	(116	)
Mandatory commitments to sell mortgage loans																		Net gains on mortgage loans		233			(420	)		(593	)
Pay-fixed interest rate swap agreements - commercial																		Interest income		(4,046	)		113			43
Pay-variable interest rate swap agreements -commercial																		Interest income		4,046			(113	)		(43	)
Purchased options																		Interest expense		25			(206	)		84
Written options																		Interest expense		(23	)		206			(84	)
Total																			$	960		$	(263	)	$	(709	)

(1)

For cash flow hedges, this location and amount refers to the ineffective portion.

NOTE 17 – RELATED PARTY TRANSACTIONS

Certain of our directors and executive officers, including companies in which they are officers or have significant ownership, were loan and deposit customers during 2019 and 2018.

A summary of loans to our directors and executive officers (which includes loans to entities in which the individual owns a 10% or more voting interest) for the years ended December 31 follows:

	2019			2018
	(In thousands)
Balance at beginning of year	$	14,205		$	2,621
New loans and advances		713			13,572
Repayments		(1,841	)		(1,988	)
Balance at end of year	$	13,077		$	14,205

Deposits held by us for directors and executive officers totaled $2.0 million and $1.5 million at December 31, 2019 and 2018, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

NOTE 18 – LEASES

We have entered into leases in the normal course of business primarily for office facilities, some of which include renewal options and escalation clauses. Certain leases also include both lease components (fixed payments including rent, taxes and insurance costs) and non-lease components (common area or other maintenance costs) which are accounted for as a single lease component as we have elected the practical expedient to group lease and non-lease components together for all leases. We have also elected not to recognize leases with original lease terms of 12 months or less (short-term leases) on our Consolidated Statements of Financial Condition. Most of our leases include one or more options to renew. The exercise of lease renewal options is typically at our sole discretion and are included in our ROU assets and lease liabilities if they are reasonably certain of exercise.

Leases are classified as operating or finance leases at the lease commencement date (we did not have any finance leases as of December 31, 2019). Lease expense for operating leases and short-term leases is recognized on a straight-line basis over the lease term. The ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. ROU assets and lease liabilities are recognized at the lease commencement date based on the estimated present value of the lease payment over the lease term.

As most of our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at the lease commencement date in determining the present value of the lease payments.

The cost components of our operating leases follows:

	2019
	(In thousands)
Operating lease cost	$	2,217
Variable lease cost		142
Short-term lease cost		19
Total	$	2,378

Variable lease costs consist primarily of taxes, insurance, and common area or other maintenance costs for our leased facilities.

Supplemental balance sheet information related to our operating leases follows:

	2019
	(In thousands)
Lease right of use asset⁽¹⁾	$	8,282
Lease liabilities⁽²⁾	$	8,304

Weighted average remaining lease term (years)		7.47
Weighted average discount rate		2.8	%

(1)

Included in Accrued income and other assets in our Consolidated Statements of Financial Condition.

(2)

Included in Accrued expenses and other liabilities in our Consolidated Statements of Financial Condition.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Maturity analysis of our lease liabilities at December 31, 2019 based on required contractual payments follows:

	(In thousands)
2020	$	1,681
2021		1,418
2022		1,322
2023		1,186
2024		802
2025 and thereafter		2,792
Total lease payments		9,201
Less imputed interest		(897	)
Total	$	8,304

NOTE 19 – CONCENTRATIONS OF CREDIT RISK

Credit risk is the risk to earnings and capital arising from an obligor’s failure to meet the terms of any contract with our organization or otherwise fail to perform as agreed. Credit risk can occur outside of our traditional lending activities and can exist in any activity where success depends on counterparty, issuer or borrower performance. Concentrations of credit risk (whether on- or off-balance sheet) arising from financial instruments can exist in relation to individual borrowers or groups of borrowers, certain types of collateral, certain types of industries or certain geographic regions. Credit risk associated with these concentrations could arise when a significant amount of loans or other financial instruments, related by similar characteristics, are simultaneously impacted by changes in economic or other conditions that cause their probability of repayment or other type of settlement to be adversely affected. Our major concentrations of credit risk arise by collateral type and by industry. The significant concentrations by collateral type at December 31, 2019, include $1.010 billion of loans secured by residential real estate and $249.7 million of construction and development loans.

Additionally, within our commercial real estate and commercial loan portfolio, we had significant standard industry classification concentrations in the following categories as of December 31, 2019: Lessors of Nonresidential Real Estate ($379.9 million); Lessors of Residential Real Estate ($142.0 million); Construction ($97.3 million); Accommodation and Food Services ($76.6 million); Manufacturing ($74.6 million) and Health Care and Social Assistance ($58.9 million). A geographic concentration arises because we primarily conduct our lending activities in the State of Michigan.

NOTE 20 – REGULATORY MATTERS

Capital guidelines adopted by federal and state regulatory agencies and restrictions imposed by law limit the amount of cash dividends our Bank can pay to us. Under these guidelines, the amount of dividends that may be paid in any calendar year is limited to the Bank’s current year net profits, combined with the retained net profits of the preceding two years. Further, the Bank cannot pay a dividend at any time that it has negative undivided profits. As of December 31, 2019, the Bank had positive undivided profits of $44.7 million. It is not our intent to have dividends paid in amounts that would reduce the capital of our Bank to levels below those which we consider prudent and in accordance with guidelines of regulatory authorities.

We are also subject to various regulatory capital requirements. The prompt corrective action regulations establish quantitative measures to ensure capital adequacy and require minimum amounts and ratios of total, Tier 1, and common equity Tier 1 capital to risk-weighted assets and Tier 1 capital to average assets. Failure to meet minimum capital requirements can result in certain mandatory, and possibly discretionary, actions by regulators that could have a material effect on our consolidated financial statements. In addition, capital adequacy rules include a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets that applies to all supervised financial institutions. To avoid limits on capital distributions and certain discretionary bonus payments we must meet the minimum ratio for adequately capitalized institutions plus the buffer. Under capital adequacy guidelines, we must meet specific capital requirements that involve quantitative measures as well as qualitative judgments by the regulators. The most recent regulatory filings as of December 31, 2019 and 2018, categorized our Bank as well capitalized. Management is not aware of any conditions or events that would have changed the most recent Federal Deposit Insurance Corporation (“FDIC”) categorization.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Our actual capital amounts and ratios at December 31 follow⁽¹⁾:

	Actual					Minimum for Adequately Capitalized Institutions					Minimum for Well-Capitalized Institutions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in thousands)
2019
Total capital to risk-weighted assets
Consolidated	$	380,454		13.74	%	$	221,562		8.00	%		NA		NA
Independent Bank		358,914		12.96			221,482		8.00		$	276,852		10.00	%

Tier 1 capital to risk-weighted assets
Consolidated	$	352,764		12.74	%	$	166,171		6.00	%		NA		NA
Independent Bank		331,224		11.96			166,111		6.00		$	221,482		8.00	%

Common equity tier 1 capital to risk-weighted assets
Consolidated	$	314,532		11.36	%	$	124,628		4.50	%		NA		NA
Independent Bank		331,224		11.96			124,583		4.50		$	179,954		6.50	%

Tier 1 capital to average assets
Consolidated	$	352,764		10.11	%	$	139,632		4.00	%		NA		NA
Independent Bank		331,224		9.49			139,615		4.00		$	174,519		5.00	%

2018
Total capital to risk-weighted assets
Consolidated	$	371,603		14.25	%	$	208,572		8.00	%		NA		NA
Independent Bank		337,227		12.94			208,456		8.00		$	260,569		10.00	%

Tier 1 capital to risk-weighted assets
Consolidated	$	345,419		13.25	%	$	156,429		6.00	%		NA		NA
Independent Bank		311,043		11.94			156,342		6.00		$	208,456		8.00	%

Common equity tier 1 capital to risk-weighted assets
Consolidated	$	307,255		11.79	%	$	117,322		4.50	%		NA		NA
Independent Bank		311,043		11.94			117,256		4.50		$	169,370		6.50	%

Tier 1 capital to average assets
Consolidated	$	345,419		10.47	%	$	131,930		4.00	%		NA		NA
Independent Bank		311,043		9.44			131,778		4.00		$	164,723		5.00	%

(1)

These ratios do not reflect a capital conservation buffer of 2.50% and 1.875% at December 31, 2019 and 2018, respectively.

NA - Not applicable

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

The components of our regulatory capital are as follows:

	Consolidated						Independent Bank
	December 31,						December 31,
	2019			2018			2019			2018
	(In thousands)
Total shareholders' equity	$	350,169		$	338,994		$	366,861		$	341,496
Add (deduct)
Accumulated other comprehensive loss for regulatory purposes		(2,011	)		4,311			(2,011	)		4,311
Goodwill and other intangibles		(33,626	)		(34,715	)		(33,626	)		(34,715	)
Disallowed deferred tax assets		—			(1,335	)		—			(49	)
Common equity tier 1 capital		314,532			307,255			331,224			311,043
Qualifying trust preferred securities		38,232			38,164			—			—
Disallowed deferred tax assets		—			—			—			—
Tier 1 capital		352,764			345,419			331,224			311,043
Allowance for loan losses and allowance for unfunded lending commitments limited to 1.25% of total risk-weighted assets		27,690			26,184			27,690			26,184
Total risk-based capital	$	380,454		$	371,603		$	358,914		$	337,227

NOTE 21 – FAIR VALUE DISCLOSURES

FASB ASC topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Valuation is based upon quoted prices for identical instruments traded in active markets. Level 1 instruments include securities traded on active exchange markets, such as the New York Stock Exchange, as well as U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets.

Level 2: Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 2 instruments include securities traded in less active dealer or broker markets.

Level 3: Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

We used the following methods and significant assumptions to estimate fair value:

Securities: Where quoted market prices are available in an active market, securities (equity securities at fair value or available for sale) are classified as Level 1 of the valuation hierarchy. Level 1 securities include certain preferred stocks included in our equity securities at fair value for which there are quoted prices in active markets (at December 31, 2018). If quoted market prices are not available for the specific security, then fair values are estimated by (1) using quoted market prices of securities with similar characteristics, (2) matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices, or (3) a discounted cash flow analysis whose significant fair value inputs can generally be verified and do not typically involve judgment by management. These securities are classified as Level 2 of the valuation hierarchy and

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primarily include agency securities, private label mortgage-backed securities, other asset backed securities, obligations of states and political subdivisions, trust preferred securities, corporate securities and foreign government securities.

Loans held for sale: The fair value of mortgage loans held for sale, carried at fair value is based on agency cash window loan pricing for comparable assets (recurring Level 2) and the fair value of mortgage loans held for sale, carried at the lower of cost or fair value is based on a quoted sales price (non-recurring Level 1).

Impaired loans with specific loss allocations based on collateral value: From time to time, certain loans are considered impaired and an AFLL is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. We measure our investment in an impaired loan based on one of three methods: the loan’s observable market price, the fair value of the collateral or the present value of expected future cash flows discounted at the loan’s effective interest rate. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At December 31, 2019 and 2018, all of our total impaired loans were evaluated based on either the fair value of the collateral or the present value of expected future cash flows discounted at the loan’s effective interest rate. When the fair value of the collateral is based on an appraised value we record the impaired loan as nonrecurring Level 3. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments can be significant and thus will typically result in a Level 3 classification of the inputs for determining fair value.

Other real estate: At the time of acquisition, other real estate is recorded at fair value, less estimated costs to sell, which becomes the property’s new basis. Subsequent write-downs to reflect declines in value since the time of acquisition may occur from time to time and are recorded in net gains on other real estate and repossessed assets in the Consolidated Statements of Operations. The fair value of the property used at and subsequent to the time of acquisition is typically determined by a third party appraisal of the property. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments can be significant and typically result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by us. Once received, an independent third party, or a member of our Collateral Evaluation Department (for commercial properties), or a member of our Special Assets/ORE Group (for residential properties) reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. We compare the actual selling price of collateral that has been sold to the most recent appraised value of our properties to determine what additional adjustment, if any, should be made to the appraisal value to arrive at fair value. For commercial and residential properties we typically discount an appraisal to account for various factors that the appraisal excludes in its assumptions. These additional discounts generally do not result in material adjustments to the appraised value.

Capitalized mortgage loan servicing rights: The fair value of capitalized mortgage loan servicing rights is based on a valuation model used by an independent third party that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income. Certain model assumptions are generally unobservable and are based upon the best information available including data relating to our own servicing portfolio, reviews of mortgage servicing assumption and valuation surveys and input from various mortgage servicers and, therefore, are recorded as Level 3. Management evaluates the third party valuation for reasonableness each quarter as part of our financial reporting control processes.

Derivatives: The fair value of rate-lock mortgage loan commitments is based on agency cash window loan pricing for comparable assets and the fair value of mandatory commitments to sell mortgage loans is based on mortgage backed security pricing for comparable assets (recurring Level 2). The fair value of interest rate swap and interest rate cap agreements are derived from proprietary models which utilize current market data. The significant

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

fair value inputs can generally be observed in the market place and do not typically involve judgment by management (recurring Level 2). The fair value of purchased and written options is based on prices of financial instruments with similar characteristics and do not typically involve judgment by management (recurring Level 2).

Assets and liabilities measured at fair value, including financial assets for which we have elected the fair value option, were as follows:

			Fair Value Measurements Using
	Fair Value Measure- ments		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Un- observable Inputs (Level 3)
	(In thousands)
December 31, 2019:
Measured at Fair Value on a Recurring Basis
Assets
Securities available for sale
U.S. agency	$	14,661	$	—	$	14,661	$	—
U.S. agency residential mortgage-backed		227,762		—		227,762		—
U.S. agency commercial mortgage-backed		10,756		—		10,756		—
Private label mortgage-backed		39,693		—		39,693		—
Other asset backed		93,886		—		93,886		—
Obligations of states and political subdivisions		96,102		—		96,102		—
Corporate		33,195		—		33,195		—
Trust preferred		1,843		—		1,843		—
Foreign government		502		—		502		—
Loans held for sale, carried at fair value		69,800		—		69,800		—
Capitalized mortgage loan servicing rights		19,171		—		—		19,171
Derivatives⁽¹⁾		5,464		—		5,464		—
Liabilities
Derivatives⁽²⁾		4,402		—		4,402		—

Measured at Fair Value on a Non-recurring Basis:
Assets
Impaired loans⁽³⁾
Commercial
Commercial and industrial		655		—		—		655
Commercial real estate		316		—		—		316
Mortgage
1-4 family owner occupied - jumbo		987		—		—		987
1-4 family owner occupied - non-jumbo		470		—		—		470
1-4 family non-owner occupied		281		—		—		281
1-4 family - 2nd lien		294		—		—		294
Resort lending		245		—		—		245
Installment
Boat lending		67		—		—		67
Recreational vehicle lending		2		—		—		2
Other		121		—		—		121
Other real estate⁽⁴⁾
Mortgage - 1-4 family owner occupied - non-jumbo		31		—		—		31
Installment - other		28		—		—		28

(1)

Included in accrued income and other assets in the Consolidated Statements of Financial Condition.

(2)

Included in accrued expenses and other liabilities in the Consolidated Statements of Financial Condition.

(3)

Only includes impaired loans with specific loss allocations based on collateral value.

(4)

Only includes other real estate with subsequent write downs to fair value.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

			Fair Value Measurements Using
	Fair Value Measure- ments		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Un- observable Inputs (Level 3)
	(In thousands)
December 31, 2018:
Measured at Fair Value on a Recurring Basis
Assets
Equity securities at fair value	$	393	$	393	$	—	$	—
Securities available for sale
U.S. agency		20,014		—		20,014		—
U.S. agency residential mortgage-backed		123,751		—		123,751		—
U.S. agency commercial mortgage-backed		5,726		—		5,726		—
Private label mortgage-backed		29,419		—		29,419		—
Other asset backed		83,319		—		83,319		—
Obligations of states and political subdivisions		127,555		—		127,555		—
Corporate		34,309		—		34,309		—
Trust preferred		1,819		—		1,819		—
Foreign government		2,014		—		2,014		—
Loans held for sale, carried at fair value		44,753		—		44,753		—
Capitalized mortgage loan servicing rights		21,400		—		—		21,400
Derivatives⁽¹⁾		5,155		—		5,155		—
Liabilities
Derivatives⁽²⁾		2,326		—		2,326		—

Measured at Fair Value on a Non-recurring Basis:
Assets
Loans held for sale, carried at the lower of cost or fair value		41,471		41,471		—		—
Impaired loans⁽³⁾
Commercial
Commercial and industrial		2,243		—		—		2,243
Commercial real estate		323		—		—		323
Mortgage
1-4 family owner occupied - non-jumbo		316		—		—		316
1-4 family non-owner occupied		17		—		—		17
Resort lending		572		—		—		572
Other real estate⁽⁴⁾
Mortgage
1-4 family owner occupied - non-jumbo		95		—		—		95
1-4 family - 2nd lien		59		—		—		59

(1)

Included in accrued income and other assets in the Consolidated Statements of Financial Condition.

(2)

Included in accrued expenses and other liabilities in the Consolidated Statements of Financial Condition.

(3)

Only includes impaired loans with specific loss allocations based on collateral value.

(4)

Only includes other real estate with subsequent write downs to fair value.

There were no transfers between Level 1 and Level 2 during the years ended December 31, 2019 and 2018.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Changes in fair values of financial assets for which we have elected the fair value option for the years ended December 31 were as follows:

	Net Gains (Losses) on Assets					Mortgage Loan Servicing, net			Total Change in Fair Values Included in Current Period Earnings
	Securities			Mortgage Loans		Mortgage Loan Servicing, net
	(In thousands)
2019
Equity securities at fair value	$	167		$	—	$	—		$	167
Loans held for sale		—			637		—			637
Capitalized mortgage loan servicing rights		—			—		(9,532	)		(9,532	)

2018
Trading securities	$	(62	)	$	—	$	—		$	(62	)
Loans held for sale		—			413		—			413
Capitalized mortgage loan servicing rights		—			—		(2,323	)		(2,323	)

2017
Trading securities	$	45		$	—	$	—		$	45
Loans held for sale		—			407		—			407
Capitalized mortgage loan servicing rights		—			—		(2,744	)		(2,744	)

For those items measured at fair value pursuant to our election of the fair value option, interest income is recorded within the Consolidated Statements of Operations based on the contractual amount of interest income earned on these financial assets and dividend income is recorded based on cash dividends received.

The following represent impairment charges recognized during the years ended December 31, 2019, 2018 and 2017 relating to assets measured at fair value on a non-recurring basis:

•

Loans which are measured for impairment using the fair value of collateral for collateral dependent loans had a carrying amount of $3.4 million, which is net of a valuation allowance of $1.5 million at December 31, 2019, and had a carrying amount of $3.5 million, which is net of a valuation allowance of $1.5 million at December 31, 2018. An additional provision for loan losses relating to these impaired loans of $1.3 million, $1.3 million and $0.5 million was included in our results of operations for the years ending December 31, 2019, 2018 and 2017, respectively.

•

Other real estate, which is measured using the fair value of the property, had a carrying amount of $0.06 million which is net of a valuation allowance of $0.09 million at December 31, 2019, and a carrying amount of $0.15 million which is net of a valuation allowance of $0.14 million, at December 31, 2018. An additional charge relating to other real estate measured at fair value of $0.03 million, $0.09 million and $0.08 million was included in our results of operations during the years ended December 31, 2019, 2018 and 2017, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

A reconciliation for all assets and (liabilities) measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31 follows:

	Capitalized Mortgage Loan Servicing Rights
	2019			2018			2017
	(In thousands)
Beginning balance	$	21,400		$	15,699		$	—
Change in accounting		—			—			14,213
Beginning balance, as adjusted		21,400			15,699			14,213
Total losses realized and unrealized:
Included in results of operations		(9,532	)		(2,323	)		(2,744	)
Included in other comprehensive income (loss)		—			—			—
Purchases, issuances, settlements, maturities and calls		7,303			8,024			4,230
Transfers in and/or out of Level 3		—			—			—
Ending balance	$	19,171		$	21,400		$	15,699

Amount of total losses for the period included in earnings attributable to the change in unrealized losses relating to assets and liabilities still held at December 31	$	(9,532	)	$	(2,323	)	$	(2,744	)

The fair value of our capitalized mortgage loan servicing rights has been determined based on a valuation model used by an independent third party as discussed above. The significant unobservable inputs used in the fair value measurement of the capitalized mortgage loan servicing rights are discount rate, cost to service, ancillary income, float rate and prepayment rate. Significant changes in all five of these assumptions in isolation would result in significant changes to the value of our capitalized mortgage loan servicing rights. Quantitative information about our Level 3 fair value measurements measured on a recurring basis follows:

Asset
Fair Value

Valuation
Technique

Unobservable
Inputs

Range

Weighted
Average

(In thousands)

2019

Capitalized mortgage loan servicing rights

$19,171

Present value of net servicing revenue

Discount rate

10.00% to 13.00%

10.14%

Cost to service

$66 to $316

$81

Ancillary income

20 to 37

Float rate

1.73%

Prepayment rate

7.01% to 69.34%

14.96

2018

Capitalized mortgage loan servicing rights

$21,400

Present value of net servicing revenue

Discount rate

10.00% to 13.00%

10.15%

Cost to service

$68 to $216

$81

Ancillary income

20 to 36

Float rate

2.57%

Prepayment rate

6.68% to 78.78%

10.54

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Quantitative information about Level 3 fair value measurements measured on a non-recurring basis follows:

Asset
Fair
Value

Valuation
Technique

Unobservable
Inputs

Range

Weighted
Average

(In thousands)

2019

Impaired loans

Commercial

971

Sales comparison approach

Adjustment for differences between comparable sales

(48.0)% to 19.2%

(5.6

Mortgage and Installment⁽¹⁾

2,467

Sales comparison approach

Adjustment for differences between comparable sales

(25.2) to 49.2

11.5

Other real estate

Mortgage and Installment

Sales comparison approach

Adjustment for differences between comparable sales

(11.6) to 5.0

(5.1

)

2018

Impaired loans

Commercial⁽²⁾

2,566

Sales comparison approach

Adjustment for differences between comparable sales

(32.5)% to 60.0%

(1.9

Mortgage

905

Sales comparison approach

Adjustment for differences between comparable sales

(40.1) to 25.6

0.7

Other real estate

Mortgage

154

Sales comparison approach

Adjustment for differences between comparable sales

0.0 to 34.1

11.2

(1)

In addition to the valuation techniques and unobservable inputs discussed above, at December 31, 2019 certain impaired collateral dependent installment loans totaling approximately $0.14 million are secured by collateral other than real estate. For the majority of these loans, we apply internal discount rates to industry valuation guides.

(2)

In addition to the valuation techniques and unobservable inputs discussed above, at December 31, 2018, we had an impaired collateral dependent commercial relationship that totaled $0.7 million that was secured by collateral other than real estate. Collateral securing this relationship primarily included accounts receivable, inventory and cash at December 31, 2018. Valuation techniques at December 31, 2018, included discounting financial statement values for each particular asset type. Discount rates used ranged from 20% to 80% of stated values at December 31, 2018.

The following table reflects the difference between the aggregate fair value and the aggregate remaining contractual principal balance outstanding for loans held for sale for which the fair value option has been elected at December 31:

	Aggregate Fair Value		Difference		Contractual Principal
	(In thousands)
Loans held for sale
2019	$	69,800	$	1,894	$	67,906
2018		44,753		1,257		43,496
2017		39,436		844		38,592

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NOTE 22 – FAIR VALUES OF FINANCIAL INSTRUMENTS

Most of our assets and liabilities are considered financial instruments. Many of these financial instruments lack an available trading market and it is our general practice and intent to hold the majority of our financial instruments to maturity. Significant estimates and assumptions were used to determine the fair value of financial instruments. These estimates are subjective in nature, involving uncertainties and matters of judgment, and therefore, fair values may not be a precise estimate. Changes in assumptions could significantly affect the estimates.

Estimated fair values have been determined using available data and methodologies that are considered suitable for each category of financial instrument. For instruments with adjustable interest rates which reprice frequently and without significant credit risk, it is presumed that estimated fair values approximate the recorded book balances.

The estimated recorded book balances and fair values at December 31 follow:

					Fair Value Using
	Recorded Book Balance		Fair Value		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Un- observable Inputs (Level 3)
	(In thousands)
2019
Assets
Cash and due from banks	$	53,295	$	53,295	$	53,295	$	—	$	—
Interest bearing deposits		12,009		12,009		12,009		—		—
Interest bearing deposits - time		350		350		—		350		—
Securities available for sale		518,400		518,400		—		518,400		—
Federal Home Loan Bank and Federal Reserve Bank Stock		18,359		NA		NA		NA		NA
Net loans and loans held for sale		2,768,675		2,768,817		—		69,800		2,699,017
Accrued interest receivable		10,108		10,108		8		1,752		8,348
Derivative financial instruments		5,464		5,464		—		5,464		—
Liabilities
Deposits with no stated maturity⁽¹⁾	$	2,427,190	$	2,427,190	$	2,427,190	$	—	$	—
Deposits with stated maturity⁽¹⁾		609,537		610,235		—		610,235		—
Other borrowings		88,646		88,680		—		88,680		—
Subordinated debentures		39,456		33,149		—		33,149		—
Accrued interest payable		1,296		1,296		97		1,199		—
Derivative financial instruments		4,402		4,402		—		4,402		—
2018
Assets
Cash and due from banks	$	23,350	$	23,350	$	23,350	$	—	$	—
Interest bearing deposits		46,894		46,894		46,894		—		—
Interest bearing deposits - time		595		594		—		594		—
Equity securities at fair value		393		393		393		—		—
Securities available for sale		427,926		427,926		—		427,926		—
Federal Home Loan Bank and Federal Reserve Bank Stock		18,359		NA		NA		NA		NA
Net loans and loans held for sale		2,643,856		2,606,256		41,471		44,753		2,520,032
Accrued interest receivable		10,164		10,164		22		1,789		8,353
Derivative financial instruments		5,155		5,155		—		5,155		—
Liabilities
Deposits with no stated maturity⁽¹⁾	$	2,197,494	$	2,197,494	$	2,197,494	$	—	$	—
Deposits with stated maturity⁽¹⁾		715,934		711,312		—		711,312		—
Other borrowings		25,700		25,706		—		25,706		—
Subordinated debentures		39,388		35,021		—		35,021		—
Accrued interest payable		1,646		1,646		114		1,532		—
Derivative financial instruments		2,326		2,326		—		2,326		—

NA – Not applicable

(1)

Deposits with no stated maturity include reciprocal deposits with a recorded book balance of $388.369 million and $123.080 million at December 31, 2019 and 2018, respectively. Deposits with a stated maturity include reciprocal deposits with a recorded book balance of $42.658 million and $58.992 million at December 31, 2019 and 2018, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

The fair values for commitments to extend credit and standby letters of credit are estimated to approximate their aggregate book balance, which is nominal, and therefore are not disclosed.

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 the entire holdings of a particular financial instrument.

Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business, the value of future earnings attributable to off-balance sheet activities and the value of assets and liabilities that are not considered financial instruments.

Fair value estimates for deposit accounts do not include the value of the core deposit intangible asset resulting from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.

NOTE 23 – ACCUMULATED OTHER COMPREHENSIVE LOSS

A summary of changes in accumulated other comprehensive loss (“AOCL”), net of tax during the years ended December 31 follows:

	Unrealized Gains (Losses) on Securities Available for Sale			Dispropor- tionate Tax Effects from Securities Available for Sale			Unrealized Gains (Losses) on Cash Flow Hedges			Dispropor- tionate Tax Effects from Cash Flow Hedges			Total
2019
Balances at beginning of period	$	(4,185	)	$	(5,798	)	$	(125	)	$	—		$	(10,108	)
Other comprehensive income (loss) before reclassifications		8,035			—			(1,266	)		—			6,769
Amounts reclassified from AOCL		(111	)		—			(336	)		—			(447	)
Net current period other comprehensive income (loss)		7,924			—			(1,602	)		—			6,322
Balances at end of period	$	3,739		$	(5,798	)	$	(1,727	)	$	—		$	(3,786	)
2018
Balances at beginning of period	$	(470	)	$	(5,798	)	$	269		$	—		$	(5,999	)
Other comprehensive loss before reclassifications		(3,671	)		—			(207	)		—			(3,878	)
Amounts reclassified from AOCL		(44	)		—			(187	)		—			(231	)
Net current period other comprehensive loss		(3,715	)		—			(394	)		—			(4,109	)
Balances at end of period	$	(4,185	)	$	(5,798	)	$	(125	)	$	—		$	(10,108	)
2017
Balances at beginning of period	$	(3,310	)	$	(5,798	)	$	—		$	—		$	(9,108	)
Cumulative effect of change in accounting		300			—			—			—			300
Balances at beginning of period, as adjusted		(3,010	)		(5,798	)		—			—			(8,808	)
Other comprehensive income before reclassifications		2,763			—			210			—			2,973
Amounts reclassified from AOCL		(140	)		—			12			—			(128	)
Net current period other comprehensive income		2,623			—			222			—			2,845
Disproportionate tax effects due to change in tax rate		(83	)		83			47			(47	)		—
Reclassification of certain deferred tax effects⁽¹⁾		—			(83	)		—			47			(36	)
Balances at end of period	$	(470	)	$	(5,798	)	$	269		$	—		$	(5,999	)

(1)

Amounts reclassified to accumulated deficit due to adoption of ASU 2018-02, “Income Statement – Reporting Comprehensive Income (Topic 220), Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income” during the fourth quarter of 2017.

The disproportionate tax effects from securities available for sale arose primarily due to tax effects of other comprehensive income (“OCI”) in the presence of a valuation allowance against our deferred tax assets and a pretax loss from operations. Generally, the amount of income tax expense or benefit allocated to operations is determined without regard to the tax effects of other categories of income or loss, such as OCI. However, an exception to the general rule is provided when, in the presence of a valuation allowance against deferred tax assets, there is a pretax loss from operations and pretax income from other categories in the current period. In such instances, income from

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

other categories must offset the current loss from operations, the tax benefit of such offset being reflected in operations. Release of material disproportionate tax effects from other comprehensive income to earnings is done by the portfolio method whereby the effects will remain in AOCL as long as we carry a more than inconsequential portfolio of securities available for sale.

A summary of reclassifications out of each component of AOCL for the years ended December 31 follows:

AOCL Component	Reclassified From AOCL			Affected Line Item in Consolidated Statements of Operations
	(In thousands)
2019
Unrealized gains (losses) on securities available for sale	$	140		Net gains on securities
		—		Net impairment loss recognized in earnings
		140		Total reclassifications before tax
		29		Income tax expense
	$	111		Reclassifications, net of tax
Unrealized gains (losses) on cash flow hedges	$	(425	)	Interest expense
		(89	)	Income tax expense
	$	(336	)	Reclassification, net of tax
	$	447		Total reclassifications for the period, net of tax
2018
Unrealized gains (losses) on securities available for sale	$	56		Net gains on securities
		—		Net impairment loss recognized in earnings
		56		Total reclassifications before tax
		12		Income tax expense
	$	44		Reclassifications, net of tax
Unrealized gains (losses) on cash flow hedges	$	(237	)	Interest expense
		(50	)	Income tax expense
	$	(187	)	Reclassification, net of tax
	$	231		Total reclassifications for the period, net of tax
2017
Unrealized gains (losses) on securities available for sale	$	215		Net gains on securities
		—		Net impairment loss recognized in earnings
		215		Total reclassifications before tax
		75		Income tax expense
	$	140		Reclassifications, net of tax
Unrealized gains (losses) on cash flow hedges	$	18		Interest expense
		6		Income tax expense
	$	12		Reclassification, net of tax
	$	128		Total reclassifications for the period, net of tax

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

NOTE 24 – INDEPENDENT BANK CORPORATION (PARENT COMPANY ONLY) FINANCIAL INFORMATION

Presented below are condensed financial statements for our parent company.

CONDENSED STATEMENTS OF FINANCIAL CONDITION

	December 31,
	2019		2018
	(In thousands)
ASSETS
Cash and due from banks	$	10,505	$	7,624
Interest bearing deposits - time		10,000		25,000
Investment in subsidiaries		369,861		343,872
Accrued income and other assets		463		2,857
Total Assets	$	390,829	$	379,353

LIABILITIES AND SHAREHOLDERS’ EQUITY
Subordinated debentures	$	39,456	$	39,388
Accrued expenses and other liabilities		575		530
Shareholders’ equity		350,798		339,435
Total Liabilities and Shareholders’ Equity	$	390,829	$	379,353

CONDENSED STATEMENTS OF OPERATIONS

	Year Ended December 31,
	2019			2018			2017
	(In thousands)
OPERATING INCOME
Dividends from subsidiary	$	29,000		$	33,500		$	16,000
Interest income		230			160			29
Other income		61			56			41
Total Operating Income		29,291			33,716			16,070

OPERATING EXPENSES
Interest expense		2,104			1,924			1,347
Administrative and other expenses		655			748			714
Total Operating Expenses		2,759			2,672			2,061
Income Before Income Tax and Equity in Undistributed Net Income of Subsidiaries		26,532			31,044			14,009
Income tax expense (benefit)		(423	)		(515	)		1,587
Income Before Equity in Undistributed Net Income of Subsidiaries		26,955			31,559			12,422
Equity in undistributed net income of subsidiaries		19,480			8,280			8,053
Net Income	$	46,435		$	39,839		$	20,475

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

CONDENSED STATEMENTS OF CASH FLOWS

	Year Ended December 31,
	2019			2018			2017
	(In thousands)
Net Income	$	46,435		$	39,839		$	20,475
ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH FROM OPERATING ACTIVITIES
Deferred income tax expense		1,503			6,620			2,146
Share based compensation		65			53			45
Accretion of discount on subordinated debentures		68			51			—
(Increase) decrease in accrued income and other assets		891			(1,307	)		(32	)
Increase in accrued expenses and other liabilities		45			21			121
Equity in undistributed net income of subsidiaries		(19,480	)		(8,280	)		(8,053	)
Total Adjustments		(16,908	)		(2,842	)		(5,773	)
Net Cash From Operating Activities		29,527			36,997			14,702

CASH FLOW FROM (USED IN) INVESTING ACTIVITIES
Purchases of interest bearing deposits - time		(20,000	)		(30,000	)		(10,000	)
Maturity of interest bearing deposits - time		35,000			10,000			10,000
Acquisition of business, less cash received		—			431			—
Net Cash From (Used In) Investing Activities		15,000			(19,569	)		—

CASH FLOW USED IN FINANCING ACTIVITIES
Dividends paid		(16,554	)		(14,055	)		(8,960	)
Proceeds from issuance of common stock		2,074			1,945			1,776
Share based compensation withholding obligation		(882	)		(1,467	)		(579	)
Repurchase of common stock		(26,284	)		(12,681	)		—
Net Cash Used in Financing Activities		(41,646	)		(26,258	)		(7,763	)
Net Increase (Decrease) in Cash and Cash Equivalents		2,881			(8,830	)		6,939
Cash and Cash Equivalents at Beginning of Year		7,624			16,454			9,515
Cash and Cash Equivalents at End of Year	$	10,505		$	7,624		$	16,454

NOTE 25 – REVENUE FROM CONTRACTS WITH CUSTOMERS

We account for revenue in accordance with ASC Topic 606, Revenue from Contracts with Customers. We derive the majority of our revenue from financial instruments and their related contractual rights and obligations which for the most part are excluded from the scope of this topic. These sources of revenue that are excluded from the scope of this topic include interest income, net gains on mortgage loans, net gains on securities, mortgage loan servicing, net and bank owned life insurance and were approximately 84.9% and 82.9% of total revenues at December 31, 2019 and 2018, respectively.

Material sources of revenue that are included in the scope of ASC Topic 606 include service charges on deposits, other deposit related income, interchange income and investment and insurance commissions and are discussed in the following paragraphs. Generally these sources of revenue are earned at the time the service is delivered or over the course of a monthly period and do not result in any contract asset or liability balance at any given period end. As a result, there were no contract assets or liabilities recorded as of December 31, 2019.

Service charges on deposit accounts and other deposit related income: Revenues are earned on depository accounts for commercial and retail customers and include fees for transaction-based, account maintenance and overdraft services. Transaction-based fees, which includes services such as ATM use fees, stop payment charges and ACH fees are recognized at the time the transaction is executed as that is the time we fulfill our customer’s request.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Account maintenance fees, which includes monthly maintenance services are earned over the course of a month representing the period over which the performance obligation is satisfied. Our obligation for overdraft services is satisfied at the time of the overdraft.

Interchange income: Interchange income primarily includes debit card interchange and network revenues. Debit card interchange and network revenues are earned on debit card transactions conducted through payment networks such as MasterCard and NYCE. Interchange income is recognized concurrently with the delivery of services on a daily basis. Interchange and network revenues are presented gross of interchange expenses, which are presented separately as a component of non-interest expense.

Investment and insurance commissions: Investment and insurance commissions include fees and commissions from asset management, custody, recordkeeping, investment advisory and other services provided to our customers. Revenue is recognized on an accrual basis at the time the services are performed and are generally based on either the market value of the assets managed or the services provided. We have an agent relationship with a third party provider of these services and net certain direct costs charged by the third party provider associated with providing these services to our customers.

Net gains on other real estate and repossessed assets: We record a gain or loss from the sale of other real estate when control of the property transfers to the buyer, which generally occurs at the time of an executed deed. If we were to finance the sale of other real estate to the buyer, we would assess whether the buyer is committed to perform their obligations under the contract and whether collectability of the transaction is probable. Once these criteria are met, the other real estate asset would be derecognized and the gain or loss on sale would be recorded upon the transfer of control of the property to the buyer. There were no other real estate properties sold during 2019 that were financed by us.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

Disaggregation of our revenue sources by attribute for the years ended December 31 follow:

2019

	Service Charges on Deposit Accounts		Other Deposit Related Income		Interchange Income		Investment and Insurance Commissions		Total
	(In thousands)
Retail
Overdraft fees	$	7,590	$	—	$	—	$	—	$	7,590
Account service charges		2,103		—		—		—		2,103
ATM fees		—		1,368		—		—		1,368
Other		—		965		—		—		965
Business
Overdraft fees		1,515		—		—		—		1,515
ATM fees		—		35		—		—		35
Other		—		422		—		—		422
Interchange income		—		—		10,297		—		10,297
Asset management revenue		—		—		—		1,123		1,123
Transaction based revenue		—		—		—		535		535

Total	$	11,208	$	2,790	$	10,297	$	1,658	$	25,953

Reconciliation to Consolidated Statement of Operations:
Non-interest income - other:
Other deposit related income	$	2,790
Investment and insurance commissions		1,658
Bank owned life insurance		1,111
Other		3,723
Total	$	9,282

2018

	Service Charges on Deposit Accounts		Other Deposit Related Income		Interchange Income		Investment and Insurance Commissions		Total
	(In thousands)
Retail
Overdraft fees	$	8,285	$	—	$	—	$	—	$	8,285
Account service charges		2,406		—		—		—		2,406
ATM fees		—		1,423		—		—		1,423
Other		—		941		—		—		941
Business
Overdraft fees		1,567		—		—		—		1,567
ATM fees		—		34		—		—		34
Other		—		594		—		—		594
Interchange income		—		—		9,905		—		9,905
Asset management revenue		—		—		—		1,100		1,100
Transaction based revenue		—		—		—		871		871

Total	$	12,258	$	2,992	$	9,905	$	1,971	$	27,126

Reconciliation to Consolidated Statement of Operations:
Non-interest income - other:
Other deposit related income	$	2,992
Investment and insurance commissions		1,971
Bank owned life insurance		970
Other		2,827
Total	$	8,760

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

NOTE 26 – RECENT ACQUISITION

Effective April 1, 2018, we completed the acquisition of all of the issued and outstanding shares of common stock of TCSB through a merger of TCSB into Independent Bank Corporation (“IBCP”), with IBCP as the surviving corporation (the “Merger”). On that same date we also consolidated Traverse City State Bank, TCSB’s wholly-owned subsidiary bank, into Independent Bank (with Independent Bank as the surviving institution). Under the terms of the merger agreement each holder of TCSB common stock received 1.1166 shares of IBCP common stock plus cash in lieu of fractional shares totaling $0.005 million. TCSB option holders had their options converted into IBCP stock options. As a result we issued 2.71 million shares of common stock and 0.19 million stock options with a fair value of approximately $64.5 million to the shareholders and option holders of TCSB. The fair value of common stock and stock options issued as the consideration paid for TCSB was determined using the closing price of our common stock on the acquisition date. This acquisition was accounted for under the acquisition method of accounting. Accordingly, we recognized amounts for identifiable assets acquired and liabilities assumed at their estimated acquisition date fair values. TCSB results of operations are included in our results beginning April 1, 2018. Non-interest expense includes zero, $3.5 million and $0.3 million of costs incurred during the years ended December 31, 2019, 2018 and 2017, respectively related to the Merger.

The following table reflects our preliminary valuation of the assets acquired and liabilities assumed:

	(In thousands)
Cash and cash equivalents	$	23,521
Interest bearing deposits - time		4,054
Securities available for sale		6,066
Federal Home Loan Bank stock		778
Loans, net		295,799
Property and equipement, net		1,067
Capitalized mortgage loan servicing rights		3,047
Accrued income and other assets		3,362
Other intangibles⁽¹⁾		5,798
Total assets acquired		343,492

Deposits		287,710
Other borrowings		14,345
Subordinated debentures		3,768
Accrued expenses and other liabilities		1,429
Total liabilities assumed		307,252
Net assets acquired		36,240
Goodwill		28,300
Purchase price (fair value of consideration)	$	64,540

(1)

Relates to core deposit intangibles (see note #7).

Management views the disclosed fair values presented above to be final as the one-year measurement period for finalizing acquisition-date fair values has expired. During this measurement period we had one adjustment to our acquisition date fair values. During the third quarter of 2018, goodwill was reduced by $0.7 million (to $28.3 million) related to the collection of a TCSB acquired loan that had been charged off in full prior to the Merger. Because of the status of the collection activities related to this loan at the time of the Merger, we determined that this transaction was a measurement period adjustment and reduced goodwill accordingly.

Goodwill related to this acquisition will not be deductible for tax purposes and consists largely of synergies and cost savings resulting from the combining of the operations of TCSB into ours as well as expansion into a new market.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS − (Continued)

The estimated fair value of the core deposit intangible was $5.8 million and is being amortized over an estimated useful life of 10 years.

The fair value of net assets acquired includes fair value adjustments to certain receivables that were not considered impaired as of the acquisition date. The fair value adjustments were determined using discounted contractual cash flows. However, we believe that all contractual cash flows related to these financial instruments will be collected. As such, these receivables were not considered impaired at the acquisition date and were not subject to the guidance relating to purchased credit impaired loans which have shown evidence of credit deterioration since origination. Receivables acquired that are not subject to these requirements included non-impaired customer receivables with a fair value and gross contractual amounts receivable of $292.9 million and $298.6 million on the date of acquisition.

NOTE 27 – MEPCO SALE

On December 30, 2016, Mepco executed an Asset Purchase Agreement (the “APA”) with Seabury Asset Management LLC (“Seabury”). Pursuant to the terms of the APA, we sold our payment plan processing business, payment plan receivables, and certain other assets to Seabury, who also assumed certain liabilities of Mepco.

This transaction closed on May 18, 2017, with an effective date of May 1, 2017. As a result of the closing, Mepco sold $33.1 million of net payment plan receivables, $0.5 million of commercial loans, $0.2 million of furniture and equipment and $1.6 million of other assets to Seabury, who also assumed $2.0 million of specified liabilities. We received cash totaling $33.4 million and recorded no gain or loss in 2017 as the assets were sold and the liabilities were assumed at book value.

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QUARTERLY FINANCIAL DATA (UNAUDITED)

A summary of selected quarterly results of operations for the years ended December 31 follows:

	Three Months Ended
	March 31,		June 30,		September 30,			December 31,
	(In thousands, except per share amounts)
2019
Interest income	$	36,636	$	37,573	$	37,811		$	36,908
Net interest income		30,243		30,756		30,872			30,710
Provision for loan losses		664		652		(271	)		(221	)
Income before income tax		11,548		13,417		15,570			17,225
Net income		9,381		10,730		12,445			13,879

Net income per common share
Basic		0.40		0.47		0.55			0.62
Diluted		0.39		0.46		0.55			0.61

2018
Interest income	$	26,797	$	33,103	$	34,452		$	36,421
Net interest income		23,936		28,980		29,697			30,669
Provision for loan losses		315		650		(53	)		591
Income before income tax		11,199		10,884		14,846			12,204
Net income		9,161		8,817		11,925			9,936

Net income per common share
Basic		0.43		0.37		0.49			0.41
Diluted		0.42		0.36		0.49			0.41

During the fourth quarter of 2019, we recognized a positive fair value adjustment due to price on our capitalized mortgage loan servicing rights of $0.6 million (see note #4). During the fourth quarter of 2018, we recognized a negative fair value adjustment due to price on our capitalized mortgage loan servicing rights of $2.4 million (see note #4).

QUARTERLY SUMMARY (UNAUDITED)

	Reported Sales Prices of Common Shares												Cash Dividends Declared
	2019						2018						Cash Dividends Declared
	High		Low		Close		High		Low		Close		2019		2018
First quarter	$	23.64	$	20.40	$	21.50	$	24.50	$	22.06	$	22.90	$	0.18	$	0.15
Second quarter		22.42		20.60		21.79		27.10		22.20		25.50		0.18		0.15
Third quarter		22.25		18.94		21.32		26.65		21.51		23.65		0.18		0.15
Fourth quarter		23.93		20.40		22.65		25.13		20.18		21.02		0.18		0.15

We have approximately 1,400 holders of record of our common stock. Our common stock trades on the NASDAQ Global Select Market System under the symbol “IBCP.” The prices shown above are supplied by NASDAQ and reflect the inter-dealer prices and may not include retail markups, markdowns or commissions. There may have been transactions or quotations at higher or lower prices of which we are not aware.

In addition to limitations imposed by the provisions of the Michigan Business Corporation Act (which, among other things, limits us from paying dividends to the extent we are insolvent), our ability to pay dividends is limited by our ability to obtain funds from our Bank and by regulatory capital guidelines applicable to us (see note #20).

100

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. freshman Avg

Independent Bank (IBCP) 10-K2019 FY Annual report

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