FNBH Bancorp 10-Q 2013 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

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

For the quarterly period ended September 30, 2013

OR

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

For the transition period from ________ to _______

Commission File Number 0-25752

FNBH BANCORP, INC.

(Exact name of registrant as specified in its charter)

MICHIGAN	38-2869722
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

101 East Grand River, Howell, Michigan 48843

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (517) 546-3150

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes x  No ¨

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

Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨  No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 455,115.

Shares of the Corporation’s Common Stock (no par value) were outstanding as of November 14, 2013.

TABLE OF CONTENTS

		Page
		Number
Part IFinancial Information (unaudited)
Item 1.	Financial Statements:
	Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012	1
	Consolidated Statements of Income for the three and nine months ended September 30, 2013 and 2012	2
	Consolidated Statements of Comprehensive Income (Loss) for the three and nine months ended
	September 30, 2013 and 2012	3
	Consolidated Statements of Shareholders’ Equity for the nine months ended September 30, 2013 and 2012	4
	Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012	5
	Notes to Interim Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	21
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	34
Item 4.	Controls and Procedures	34
Part II. Other Information
Item 1A	Risk Factors	34
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	35
Item 6.	Exhibits	35
Signatures		36

Discussions and statements in this report that are not statements of historical fact, including, without limitation, 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 and other statements that are not historical facts, are forward-looking statements. Forward-looking statements include, but are not limited to, statements about the likelihood, timing, and terms of our ability to raise new capital; 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; predictions as to our subsidiary bank’s ability to achieve or maintain certain regulatory capital standards; our expectation that we will have or be able to obtain sufficient cash to meet expected obligations; and descriptions of other steps we may take to improve our capital position. These forward-looking statements express our current expectations, forecasts of future events, or long-term goals and, by their nature, are subject to assumptions, risks, and uncertainties. Although we believe that the expectations, forecasts, and goals reflected in these forward-looking statements are reasonable, actual results could differ materially for a variety of reasons, including, among others:

⋅      our ability to successfully raise new capital and/or our ability to implement our capital restoration and recovery plan;

⋅      our ability to continue as a going concern in light of the uncertainty regarding the extent and timing of possible future regulatory enforcement action against our subsidiary bank;

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

⋅      our ability to comply with the various requirements imposed by the regulatory Consent Order against our bank;

⋅     the timing and pace of an economic recovery in Michigan and the United States in general, including regional and local real estate markets;

⋅      the ability of our bank to attain and maintain certain regulatory capital standards;

⋅     limitations on our ability to access and rely on wholesale funding sources;

⋅      the continued services of our management team, particularly as we work through our asset quality issues and the implementation of our capital restoration plan; and

⋅     implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act or other 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 A of our Annual Report on Form 10-K for the year ended December 31, 2012, 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 all known risk 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.

 

Part I  –    Financial Information

Item 1.      Financial Statements

FNBH BANCORP, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(Unaudited)

	September 30, 2013		December 31, 2012
	(in thousands, except share amounts)
Assets
Cash and due from banks	$	60,832	$	41,824
Short term investments		198		197
Total cash and cash equivalents		61,030		42,021
Investment securities:
Investment securities available for sale, at fair value		72,162		72,586
FHLBI and FRB stock, at cost		779		779
Total investment securities		72,941		73,365
Loans held for investment:
Commercial		138,791		152,152
Consumer		15,985		14,582
Real estate mortgage		12,331		13,457
Total loans held for investment		167,107		180,191
Less allowance for loan losses		(9,168)		(11,769)
Net loans held for investment		157,939		168,422
Premises and equipment, net		7,354		7,211
Other real estate owned, held for sale		690		3,427
Accrued interest and other assets		1,845		2,425
Total assets	$	301,799	$	296,871
Liabilities and Shareholders' Equity
Liabilities
Deposits:
Demand (non-interest bearing)	$	96,523	$	95,779
NOW		30,278		29,501
Savings and money market		83,367		79,566
Time deposits		79,175		81,716
Brokered certificates of deposit		1,122		1,120
Total deposits		290,465		287,682
Other borrowings		188		148
Accrued interest, taxes, and other liabilities		2,001		1,672
Total liabilities		292,654		289,502
Shareholders' Equity
Preferred stock, no par value. Authorized 30,000 shares; no shares issued and     outstanding		-		-
Common stock, no par value. Authorized 11,000,000 shares at September 30, 2013     and December 31, 2012; 455,115 shares issued and outstanding at September 30,     2013 and 454,327 shares issued and outstanding at December 31, 2012.		7,321		7,202
Retained earnings (deficit)		2,446		(496)
Deferred directors' compensation		342		461
Accumulated other comprehensive income (loss)		(964)		202
Total shareholders' equity		9,145		7,369
Total liabilities and shareholders' equity	$	301,799	$	296,871

See accompanying notes to interim consolidated financial statements (unaudited).

1

 

FNBH BANCORP, INC. AND SUBSIDIARIES

Consolidated Statements of Income

Three and Nine Months Ended September 30, 2013 and 2012

(Unaudited)

	Three months ended September 30,				Nine months ended September 30,
	2013		2012		2013		2012
	(in thousands, except per share amounts)
Interest and dividend income:
Interest and fees on loans	$	2,345	$	2,433	$	7,112	$	7,624
Interest and dividends on investment securities:
Agency securities and CMOs		257		269		772		757
Obligations of states and political subdivisions		12		11		35		37
Other securities		6		6		20		18
Interest on short term investments		1		-		2		2
Total interest and dividend income		2,621		2,719		7,941		8,438
Interest expense		232		263		698		847
Net interest income		2,389		2,456		7,243		7,591
Provision for loan losses		-		300		(2,250)		1,200
Net interest income after provision for loan losses		2,389		2,156		9,493		6,391
Noninterest income:
Service charges and other fee income		687		691		1,898		2,073
Trust income		36		43		115		134
Loss on available for sale securities		-		-		-		(3)
Other		12		24		131		24
Total noninterest income		735		758		2,144		2,228
Noninterest expense:
Salaries and employee benefits		1,344		1,250		3,974		3,725
Net occupancy expense		222		187		685		590
Equipment expense		88		77		255		252
Professional and service fees		433		404		1,264		1,250
Loan collection and foreclosed property expenses		88		175		253		462
Computer service fees		123		109		348		334
Computer software amortization expense		11		9		29		71
FDIC assessment fees		263		257		772		760
Insurance		131		150		392		445
Printing and supplies		35		36		121		128
Director fees		-		21		-		61
Net gain on sale/writedown of OREO and     repossessions		(29)		(23)		(75)		(4)
Other		178		163		573		489
Total noninterest expense		2,887		2,815		8,591		8,563
Income before federal income taxes		237		99		3,046		56
Federal income tax expense (benefit)		-		(19)		104		(19)
Net income	$	237	$	118	$	2,942	$	75
Per share statistics:
Basic and diluted EPS	$	0.52	$	0.26	$	6.43	$	0.16
Basic and diluted average shares outstanding		457,435		460,191		457,435		459,750

See accompanying notes to interim consolidated financial statements (unaudited).

2

 

FNBH BANCORP, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Loss)

Three and Nine Months Ended September 30, 2013 and 2012

	Three months ended September 30,		Three months ended September 30,		Nine months ended September 30,		Nine months ended September 30,
	2013		2012		2013		2012
	(in thousands)
Net income	$	237	$	118	$	2,942	$	75
Other comprehensive income (loss):
Unrealized gains (losses):
Net change in unrealized gains (losses) on securities     available for sale		(527)		193		(1,166)		258
Less: reclassification adjustment for loss recognized in     earnings		-		-		-		3
Other comprehensive income (loss)		(527)		193		(1,166)		261
Comprehensive income (loss)	$	(290)	$	311	$	1,776	$	336

See accompanying notes to interim consolidated financial statements (unaudited).

3

 

FNBH BANCORP, INC. AND SUBSIDIARIES

Consolidated Statements of Shareholders' Equity

Nine Months Ended September 30, 2013 and 2012

(Unaudited)

	Common Stock		Retained Earnings (Deficit)		Deferred Directors' Compensation		Accumulated Other Comprehensive Income (Loss)		Total
	(in thousands)
Balances at January 1, 2012	$	7,082	$	(825)	$	577	$	(224)	$	6,610
Earned portion of long term incentive plan		2								2
Issued 774 shares for deferred directors' fees		116				(116)				-
Net income				75						75
Other comprehensive income								261		261
Balances at September 30, 2012		7,200		(750)		461		37		6,948
Balances at January 1, 2013		7,202		(496)		461		202		7,369
Issued 788 shares for deferred directors' fees		119				(119)				-
Net income				2,942						2,942
Other comprehensive loss								(1,166)		(1,166)
Balances at September 30, 2013	$	7,321	$	2,446	$	342	$	(964)	$	9,145

See accompanying notes to interim consolidated financial statements (unaudited).

4

 

FNBH BANCORP, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)

	Nine months ended September 30,
	2013		2012
	(in thousands)
Cash flows from operating activities:
Net income	$	2,942	$	75
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		(2,250)		1,200
Depreciation and amortization		334		361
Deferred income tax expense (benefit)		104		(19)
Net amortization on investment securities		884		596
Loss on sale of available for sale securities		-		3
Earned portion of long term incentive plan		-		2
Net gain on sale/writedown of OREO and repossessions		(75)		(4)
Decrease (increase) in accrued interest income and other assets		564		(95)
Increase (decrease) in accrued interest, taxes, and other liabilities		329		(73)
Net cash provided by operating activities		2,832		2,046
Cash flows from investing activities
Purchases of available for sale securities		(20,684)		(61,540)
Proceeds from the sales of available for sale securities		-		247
Proceeds from maturities and calls of available for sale securities		3,000		6,990
Proceeds from mortgage-backed securities paydowns - available for sale		15,953		8,691
Proceeds from sale of OREO and repossessions		2,899		647
Net decrease in loans		12,647		19,229
Capital expenditures		(461)		(118)
Net cash used in investing activities		13,354		(25,854)
Cash flows from financing activities:
Net increase in deposits		2,783		13,482
Proceeds from other borrowings		40		79
Net cash used in financing activities		2,823		13,561
Net change in cash and cash equivalents		19,009		(10,247)
Cash and cash equivalents at beginning of year		42,021		50,217
Cash and cash equivalents at end of period	$	61,030	$	39,970
Supplemental disclosures:
Interest paid	$	707	$	880
Loans transferred to other real estate owned		86		619
Loans charged off		859		3,617

See accompanying notes to interim consolidated financial statements (unaudited).

5

 

Notes to Consolidated Financial Statements

1. Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, these financial statements do not include all of the information and footnotes required by US GAAP for complete financial statements.  In the opinion of management of FNBH Bancorp, Inc. (the Corporation), all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation were included. The results of operations for the three and nine month period ended September 30, 2013 are not necessarily indicative of the results to be expected for the year ending December 31, 2013. For further information, refer to the consolidated financial statements and footnotes thereto included in the 2012 Annual Report contained in the Corporation’s report on Form 10-K filing. Certain reclassifications have been made to prior period financial statements to conform to the current period presentation. 

The consolidated financial statements included in this Form 10-Q have been prepared assuming our wholly-owned subsidiary bank, First National Bank in Howell (the Bank), continues to operate in the normal course of business for the foreseeable future, and do not include any adjustments to recorded assets or liabilities should we be unable to continue as a going concern.

2. Financial Condition and Management’s Plan

In light of the Bank’s significant losses since 2008, insufficient capital position at September 30, 2013 and noncompliance with a regulatory capital directive stipulated under a former Consent Order dated September 24, 2009 and new Consent Order executed on October 31, 2013 (as described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”), management believes it is reasonable that further regulatory enforcement action may occur if the capital raise described below is not completed or the Corporation is unable to effect another recapitalization within the relatively near future. Management continues to pursue initiatives identified in its recovery plan to achieve full compliance with all requirements of the Consent Order in order to mitigate the impact of the regulatory challenges. In addition, execution of the recovery plan includes implementation of measures necessary to position the Bank to overcome current economic challenges. Management’s recovery plan is detailed in Note 2 of the consolidated financial statements included in the 2012 Annual Report within the Corporation’s Form 10-K filing.

Although management’s recovery plan is intended to restore the Bank’s regulatory standing and return the Bank to core profitability, there is uncertainty as to the plan’s ultimate effectiveness, the Bank’s ability to meet existing regulatory requirements, the ability of management to achieve the objectives of the recovery plan and the potential impact of future regulatory action against the Bank, which raises substantial doubt about the Corporation’s ability to continue as a going concern. The ability of the Corporation to continue as a going concern is dependent upon many factors, including regulatory action, the ability to complete the pending capital raise or some other recapitalization of the Corporation and the Bank, and the ability of management to achieve the other objectives in its recovery plan. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

As part of the recovery plan that was initiated in late 2008, management and the Board of Directors have been aggressively pursuing all available alternatives to improve the Bank’s capital ratios, including raising capital, reducing non-performing assets, and cutting expenses. The recovery plan was designed to improve the Bank’s financial health by completing a significant recapitalization, aggressively reducing credit risk exposure in the loan portfolio and improving the efficiency and effectiveness of core business processes. The most important objective of the recovery plan is to restore the Bank’s capital to a level sufficient to comply with the capital directive in the Consent Order and provide sufficient capital resources and liquidity to meet commitments and business needs. To date, the Bank has not raised the capital necessary to satisfy requirements of the Consent Order. 

As disclosed in a Current Report on Form 8-K filed with the Securities and Exchange Commission on June 14, 2013, the Corporation terminated certain subscription agreements related to a proposed capital raise by the Corporation due to lack of regulatory approval. However, in a continued effort to raise additional capital necessary to improve the capital position of its subsidiary bank, the Corporation initiated a second private placement offering to certain accredited investors. Unlike the previous transaction, the new offering does not involve the issuance of any debt by the Corporation. 

In a Current Report on Form 8-K filed with the Securities and Exchange Commission on August 8, 2013, the Corporation disclosed its acceptance of subscription agreements pursuant to which the Corporation has agreed to sell shares of a new series of mandatorily convertible preferred stock of the Corporation (the “Preferred Stock”) in exchange for approximately $17.1 million in cash from investors, subject to satisfaction of certain closing conditions. As structured, the Preferred Stock will be convertible into shares of the Corporation’s common stock at a rate reflecting a price per share of common stock of $0.70, subject to certain anti-dilution adjustments. The conversion into common stock will take place automatically upon the approval by the Corporation’s shareholders of additional shares of authorized common stock. Until converted into common stock, the Preferred Stock will have terms that will be substantially identical to the terms applicable to the outstanding common stock with respect to dividends, distributions, voting, and other matters. For matters submitted to a vote of the holders of the Corporation’s common stock, including the proposal to authorize additional shares of common stock, the Preferred Stock will vote with the common stock, as a single class, as if the Preferred Stock was already converted into common stock.

The closing of this new private placement offering (“Capital Raise”) is subject to material conditions, including a requirement to obtain the approval of the Federal Reserve and compliance by one or more investors with federal law applicable to the acquisition of "control" of a bank holding company. The Corporation believes these conditions have been satisfied. The Corporation currently expects to close the Capital Raise by year-end 2013, however there is no assurance this will take place at such time or at all.

6

The Corporation is hopeful that its ongoing efforts to complete a recapitalization of the Corporation in the near future will be successful. However, the Corporation cannot give any assurances that it will be successful in closing the Capital Raise or, if it is unable to close the Capital Raise, that it will be successful in completing some other recapitalization of the Corporation on a timely basis, or at all. Therefore, a reader of this Quarterly Report should not make a decision regarding whether to invest in the Corporation based on an assumption that the Capital Raise or some other recapitalization of the Corporation will close. 

Even if the Corporation is successful in closing the Capital Raise, the net proceeds from the Capital Raise are not expected to be sufficient to enable the Bank to meet the minimum capital ratios required by the Consent Order. In addition, even if the Bank is able to meet the minimum capital ratios following the closing of a recapitalization of the Corporation, it is possible that further losses at the Bank could cause its capital to once again fall below such minimum ratios. In any event, even if the Corporation closes a recapitalization of sufficient size to bring the Bank into compliance with the minimum capital ratios of the Consent Order, the Corporation currently expects that the Bank will continue to be subject to the Consent Order or some other regulatory enforcement action for some period following the closing of a recapitalization while the Bank works to comply with the provisions of the Consent Order and demonstrate a period of performance within the requirements of the Consent Order. Moreover, until the Bank’s regulatory condition improves and the Consent Order is modified, the Company’s financial performance will continue to be negatively impacted as a result of the additional costs and expenses associated with a formal enforcement action against the Bank.

There can be no assurance that the efforts of the Corporation to raise new capital, management's recovery plan, or related efforts will improve the Bank's financial condition; further deterioration of the Bank's capital position is possible. The current economic environment in southeast Michigan and local real estate market conditions, while improving, will continue to present challenges to the Bank's financial performance. Any further declines in the Bank’s capital levels may likely result in more regulatory oversight or enforcement action by either the Office of the Comptroller of the Currency (the “OCC”), as the Bank’s primary regulator, or the Federal Deposit Insurance Corporation (the “FDIC”), which insures the Bank’s deposits. See also the “Capital” section within “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this Form 10-Q.

3. Securities

Securities available for sale consist of the following:

			Unrealized
	Amortized Cost		Gains		Losses		Fair Value
	(in thousands)
September 30, 2013
Obligations of state and political subdivisions	$	1,794	$	11	$	(3)	$	1,802
Mortgage-backed/CMO		71,283		123		(1,522)		69,884
Preferred stock(1)		49		427		-		476
Total available for sale	$	73,126	$	561	$	(1,525)	$	72,162
December 31, 2012
Obligations of state and political subdivisions	$	1,534	$	46	$	-	$	1,580
U.S. agency		3,000		7		-		3,007
Mortgage-backed/CMO		67,697		349		(184)		67,862
Preferred stock(1)		49		88		-		137
Total available for sale	$	72,280	$	490	$	(184)	$	72,586

⁽¹⁾ Represents preferred stocks issued by Freddie Mac and Fannie Mae

Securities are reviewed quarterly for possible other-than-temporary impairment (OTTI) based on guidance included in ASC Topic 320, Investments–Debt and Equity Instruments. This guidance requires an entity to assess whether it intends to sell, or whether it is more likely than not that it will be required to sell, a security in an unrealized loss position before the recovery of the security’s amortized cost basis. If either of these criteria is met, the entire difference between the amortized cost and fair value is recognized in earnings. For debt securities that do not meet the aforementioned 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.

Management’s review of the securities portfolio for the existence of OTTI considers various qualitative and quantitative factors regarding each investment category, including if the securities were U.S. Government issued, the credit rating on the securities, credit outlook, payment status and financial condition, the length of time the security has been in a loss position, the size of the loss position and other meaningful information.

At September 30, 2013, the Corporation had one mortgage-backed security which has been impaired for more than twelve months. At December 31, 2012, there was one non-agency mortgage-backed security impaired for more than twelve months.

A summary of the par value, book value, carrying value (fair value) and unrealized loss for the non-agency mortgage-backed security is presented below:

	September 30, 2013				December 31, 2012
	Amount		% of Par		Amount		% of Par
	(dollars in thousands)
Par value	$	1,788	100.00	%	$	2,387	100.00	%
Book value		1,580	88.37	%		2,097	87.82	%
Carrying value		1,623	90.77	%		2,018	84.51	%
Unrealized gain (loss)		43	2.40	%		(79)	-3.31	%

The Corporation makes a quarterly assessment of OTTI on its non-agency mortgage-backed security primarily based on a quarterly cash flow analysis performed by an independent third-party specialist. The evaluation includes a comparison of the present value of the expected cash flows to previous estimates to determine whether adverse changes in cash flows resulted during the period. The analysis considers attributes of the security, such as its super tranche position, and specific loan level collateral underlying the security. Certain key attributes of the underlying loans supporting the security included the following:

7

	September 30, 2013		December 31, 2012
Weighted average remaining credit score (based on original FICO)	738		738
Primary location of underlying loans:
California	71	%	72	%
Florida	3	%	4	%
Other	26	%	24	%
Delinquency status of underlying loans:
Past due 30-59 days	3.05	%	2.70	%
Past due 60-89 days	2.42	%	2.62	%
Past due 90 days or more	10.38	%	8.03	%
In process of foreclosure	3.07	%	3.58	%
Held as other real estate owned	0.68	%	0.75	%

The specialist calculates an estimate of the fair value of the security's cash flows using an INTEX valuation model, subject to certain assumptions regarding collateral related cash flows such as expected prepayment rates, default rates, loss severity estimates, and discount rates as key valuation inputs. Certain key attributes of the underlying loans supporting the security included the following:

	September 30, 2013		December 31, 2012
Voluntary repayment rate (CRR)	13.27	%	10.14	%
Default rates:
Within next 24 months	7.86	%	6.87	%
Decreasing to (by month 37)	3.77	%	3.15	%
Decreasing to (by month 215)	0.00	%	0.00	%
Loss severity rates:
Initial loss upon default (Year 1)	45.10	%	50.70	%
Per annum decrease in loss rate (Years 2 - 11)	3.50	%	2.50	%
Floor (Year 12)	23.00	%	23.00	%
Discount rate (1):	6.00	%	7.00	%
Remaining credit support provided by     other collateral pools of underlying     loans within the security:	0.00	%	0.02	%

⁽¹⁾ Intended to reflect estimated uncertainty and liquidity premiums, after adjustment for estimated credit loss cash flows.

The prepayment assumptions used within the model consider borrowers’ incentive to prepay based on market interest rates and borrowers’ ability to prepay based on underlying assumptions for borrowers’ ability to qualify for a new loan based on their credit and appraised property value, by location. As such, prepayment speeds decrease as credit quality and home prices deteriorate, reflecting a diminished ability to refinance.

In addition, collateral cash flow assumptions utilize a valuation technique under a “Liquidation Scenario” whereby loans are evaluated by delinquency and are assigned probability of default and loss factors deemed appropriate in the current economic environment. The liquidation scenarios assume that all loans 60 or more days past due migrate to default, are liquidated, and losses are realized over a period of between six and twenty four months based in part upon initial loan to value ratios and estimated changes in both historical and future property values since origination as obtained from financial data sources.

At September 30, 2013, based on a present value at a prospective yield of future cash flows for the investment as provided by the specialist and after management’s evaluation of the reasonableness of the specialist's underlying assumptions regarding Level 2 and Level 3 inputs, the Corporation concluded that the security’s expected cash flows continued to support the amortized cost of the security and no additional other-than-temporary impairment had been incurred.

At September 30, 2013 the non-agency mortgage-backed security was in an unrealized gain position of approximately $43,000 and at December 31, 2012, the unrealized (non-credit) loss on the security was determined to be approximately $79,000, using the valuation methodology and applicable inputs and assumptions described above.

8

The following is a summary of the gross unrealized losses and fair value of securities by length of time that individual securities have been in a continuous loss position:

	Less than 12 months				12 months or more				Total
	Unrealized				Unrealized				Unrealized
	losses		Fair Value		losses		Fair Value		losses		Fair Value
	(in thousands)
September 30, 2013
Obligations of state and political subdivisions	$	(3)	$	461	$	-	$	-	$	(3)		461
Mortgage-backed/CMO		(1,466)		54,706		(56)		1,489		(1,522)		56,195
Total	$	(1,469)	$	55,167	$	(56)	$	1,489	$	(1,525)	$	56,656
December 31, 2012
Mortgage-backed/CMO	$	(105)	$	13,448	$	(79)	$	2,018	$	(184)	$	15,466

The amortized cost and fair value of securities available for sale, by contractual maturity, follow. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	September 30, 2013				December 31, 2012
	Amortized		Approximate		Amortized		Approximate Fair
	Cost		Fair Value		Cost		Value
	(in thousands)
Maturing within one year	$	-	$	-	$	-	$	-
Maturing after one year but within five years		762		761		500		501
Maturing after five years but within ten years		305		309		3,305		3,323
Maturing after ten years		776		1,208		778		900
	$	1,843	$	2,278	$	4,583	$	4,724
Mortgage-backed/CMO securities		71,283		69,884		67,697		67,862
Totals	$	73,126	$	72,162	$	72,280	$	72,586

Proceeds from at-par calls of securities totaled $3.0 million and $7.0 million for the nine months ended September 30, 2013 and 2012, respectively.

At September 30, 2013 and December 31, 2012, the Corporation did not own any investment securities issued by states and political subdivisions in which the amortized cost and fair value of such securities individually exceeded 10% of shareholders’ equity.

Investment securities, with an amortized cost of approximately $67.8 million at September 30, 2013 were pledged to secure public deposits and for other purposes required or permitted by law, including approximately $22.3 million of securities pledged as collateral at the Federal Home Loan Bank of Indianapolis (FHLBI) to support potential liquidity needs of the Bank. At December 31, 2012, the amortized cost of pledged investment securities totaled $69.1 million of which $25.4 million of securities was pledged as collateral at the FHLBI for contingent liquidity needs of the Bank.

The Bank owns stock in both the Federal Home Loan Bank of Indianapolis (FHLBI) and the Federal Reserve Bank (FRB), both of which are recorded at cost. The Bank is required to hold stock in the FHLBI equal to 5% of the institution’s borrowing capacity with the FHLBI. The Bank’s investment in FHLBI stock amounted to $735,000 at September 30, 2013 and December 31, 2012. The Bank’s investment in FRB stock, which totaled $44,000 at September 30, 2013 and December 31, 2012, is a requirement for the Bank’s membership in the Federal Reserve System. These investments can only be resold to, or redeemed by, the issuer.

4. Loans

The recorded investment in portfolio loans consists of the following:

	September 30, 2013		December 31, 2012
	(in thousands)
Commercial	$	13,592	$	16,112
Commercial real estate:
Construction, land development, and other land		6,224		8,741
Owner occupied		51,378		51,202
Nonowner occupied		61,349		69,415
Consumer real estate:
Commercial purpose		6,461		6,911
Mortgage - Residential		13,212		14,604
Home equity and home equity lines of credit		8,934		8,307
Consumer and Other		6,142		5,103
Subtotal		167,292		180,395
Unearned income		(185)		(204)
Total Loans	$	167,107	$	180,191

Included in the consumer real estate loans above are residential first mortgages reported as “real estate mortgages” on the consolidated balance sheets. In addition, a portion of these consumer real estate loans include commercial purpose loans where the borrower has pledged a 1-4 family residential property as collateral. Loans also include the reclassification of demand deposit overdrafts, which amounted to $125,000 at September 30, 2013 and $116,000 at December 31, 2012, respectively.

9

Loans serviced for others, including commercial participations sold, are not reported as assets of the Bank and approximated $4.0 million at September 30, 2013 and $4.3 million at December 31, 2012.

5. Allowance for Loan Losses and Credit Quality of Loans

The Corporation separates its loan portfolio into segments to perform the calculation and analysis of the allowance for loan losses. The four segments analyzed are Commercial, Commercial Real Estate, Consumer Real Estate, and Consumer and Other. The Commercial segment includes loans to finance commercial and industrial businesses that are not secured by real estate. The Commercial Real Estate segment includes: i) construction real estate loans to finance construction and land development and/or loans secured by vacant land and ii) commercial real estate loans secured by non-farm, non-residential real estate which are further classified as either owner occupied or non-owner occupied based on the underlying collateral type. The Consumer Real Estate segment includes (commercial and non-commercial purpose) loans that are secured by 1 – 4 family residential real estate properties, including first mortgages on residential properties and home equity loans and lines of credit that are secured by first or second liens on residential properties. The Consumer and Other segment include all loans not included in any other segment. These are primarily loans to consumers for household, family, and other personal expenditures, such as autos, boats, and recreational vehicles.

Activity in the allowance for loan losses by portfolio segment for three and nine months ended:

			Commercial		Consumer		Consumer
	Commercial		Real Estate		Real Estate		and Other		Total
	(in thousands)
Three months ended
September 30, 2013
Allowance for loan losses:
Beginning balance	$	770	$	6,803	$	1,733	$	177	$	9,483
Charge offs		-		(435)		(20)		(20)		(475)
Recoveries		60		55		24		21		160
Provision		(187)		636		(455)		6		-
Ending balance	$	643	$	7,059	$	1,282	$	184	$	9,168
September 30, 2012
Allowance for loan losses:
Beginning balance	$	674	$	9,326	$	2,071	$	91	$	12,162
Charge offs		(64)		(920)		(245)		(23)		(1,252)
Recoveries		138		386		12		19		555
Provision		128		56		81		35		300
Ending balance	$	876	$	8,848	$	1,919	$	122	$	11,765
Nine months ended
September 30, 2013
Allowance for loan losses:
Beginning balance	$	908	$	8,682	$	2,036	$	143	$	11,769
Charge offs		(164)		(523)		(83)		(89)		(859)
Recoveries		114		67		243		84		508
Provision		(215)		(1,167)		(914)		46		(2,250)
Ending balance	$	643	$	7,059	$	1,282	$	184	$	9,168
September 30, 2012
Allowance for loan losses:
Beginning balance	$	636	$	9,113	$	2,680	$	261	$	12,690
Charge offs		(304)		(2,616)		(607)		(90)		(3,617)
Recoveries		250		1,066		116		60		1,492
Provision		294		1,285		(270)		(109)		1,200
Ending balance	$	876	$	8,848	$	1,919	$	122	$	11,765

10

The following presents the balance in allowance for loan losses and loan balances by portfolio segment based on impairment method:

			Commercial		Consumer		Consumer
	Commercial		Real Estate		Real Estate		and Other		Total
	(in thousands)
September 30, 2013
Allowance for loan losses:
Individually evaluated for impairment	$	14	$	2,621	$	141	$	-	$	2,776
Collectively evaluated for impairment		629		4,438		1,141		184		6,392
Total allowance for loan losses	$	643	$	7,059	$	1,282	$	184	$	9,168
Recorded investment in loans:
Individually evaluated for impairment	$	241	$	19,597	$	1,932	$	-	$	21,770
Collectively evaluated for impairment		13,351		99,354		26,675		6,142		145,522
Total recorded investment in loans	$	13,592	$	118,951	$	28,607	$	6,142	$	167,292
December 31, 2012
Allowance for loan losses:
Individually evaluated for impairment	$	49	$	1,245	$	377	$	-	$	1,671
Collectively evaluated for impairment		859		7,437		1,659		143		10,098
Total allowance for loan losses	$	908	$	8,682	$	2,036	$	143	$	11,769
Recorded investment in loans:
Individually evaluated for impairment	$	710	$	19,853	$	2,380	$	-	$	22,943
Collectively evaluated for impairment		15,402		109,505		27,442		5,103		157,452
Total recorded investment in loans	$	16,112	$	129,358	$	29,822	$	5,103	$	180,395

Management’s on-going monitoring of the credit quality of the portfolio relies on an extensive credit risk monitoring process that considers several factors including: current economic conditions affecting the Bank’s customers, the payment performance of individual loans and pools of homogenous loans, portfolio seasoning, changes in collateral values, and detailed reviews of specific relationships.

Our internal loan grading system assigns a risk grade to all commercial loans. This grading system is similar to those employed by banking regulators. Grades 1 through 5 are considered “pass” credits and grade 6 are considered “watch” credits and are subject to greater scrutiny. Those loans graded 7 and higher are considered substandard and are individually evaluated for impairment if reported as nonaccrual and are greater than $100,000 or part of an aggregate relationship exceeding $100,000. All commercial loans are graded at inception and reviewed, and if appropriate, re-graded at various intervals thereafter. Additionally, our commercial loan portfolio and assigned risk grades are periodically subjected to review by external loan reviewers and banking regulators. Certain of the key factors considered in assigning loan grades include: cash flows, operating performance, financial condition, collateral, industry condition, management, and the strength, liquidity and willingness of guarantors’ support.

A description of the general characteristics of each risk grade follows:

· RATING 1 (Satisfactory – Minimal Risk) - Loans in this category are to persons or entities of unquestioned financial strength, a highly liquid financial position, with collateral that is liquid and well margined. These borrowers have performed without question on past obligations, and the Bank expects their performance to continue. Internally generated cash flow covers current maturities of long-term debt by a substantial margin.

· RATING 2 (Satisfactory – Modest Risk) – These loans to persons or entities with strong financial condition and above-average liquidity who have previously satisfactorily handled their obligations with the Bank. Collateral securing the Bank’s debt is margined in accordance with policy guidelines. Internally-generated cash flow covers current maturities of long-term debt more than adequately.

· RATING 3 (Satisfactory - Average) – These are loans with average cash flow and ratios compared to peers. Usually RMA comparisons show where companies fall in the performance spectrum. Companies have consistent performance for 3 or more years.

· RATING 4 (Satisfactory – Acceptable Risk) – Loans to persons or entities with an average financial condition, adequate collateral margins, adequate cash flow to service long-term debt, and net worth comprised mainly of fixed assets are included in this category. These entities are minimally profitable now, with projections indicating continued profitability into the foreseeable future. Overall, these loans are basically sound.

· RATING 5 (Satisfactory - Acceptable – Monitor) -These loans are characterized by borrowers who have marginal, but adequate cash flow, marginal profitability, but currently have been meeting the obligations of their loan structure. However, adverse changes in the borrower’s circumstances and/ or current economic conditions are more likely to impair their capacity for repayment. The borrower has in the past satisfactorily handled debts with the Bank, but may be experiencing some minor delinquency in making payments, or other signs of temporary cash flow issues. Borrower may be experiencing declining margins or other negative financial trends, despite the borrower’s continued satisfactory condition and positive cash flow. Other characteristics of borrowers in this class include inadequate credit information, weakness of financial statement, or declining but positive repayment capacity. This classification includes loans to new or established borrowers with satisfactory loan structure, but where near term economic or business issues appears to remain stable and the near term projections would limit the ability for an improvement in the financial trends of the borrower.

11

·	RATING 6 (Special Mention - OAEM) - Loans in this class have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Bank’s credit position at some future date. These potential weaknesses may result in a deterioration of the repayment of the loan and increase the credit risk. Special mention assets are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification. Special mention credits may include a borrower that pays the Bank on a timely basis (occasional 30 day delinquent) and may be experiencing temporary cash flow deficiencies.
·	RATING 7 (Substandard) – A substandard loan is inadequately protected by the current sound worth and paying capacity of the borrower or of the collateral pledged, if any. Loans so classified must have a well-defined weakness, or weaknesses, that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard loans, does not have to exist in individual loans. Substandard credits may include a borrower that pays consistently past due, has significant cash flow shortages and may have a collateral shortfall that requires a specific reserve.
·	RATING 8 (Doubtful) -This risk rating class has all of the weaknesses inherent in the substandard rating but with the added characteristic that the weaknesses make collection in full or liquidation, on the basis of currently known existing facts, condition, and values, highly questionable and improbable. These are poor quality loans in which neither the collateral, if any, nor the financial condition of the borrower presently ensure collectability in full within a reasonable period of time; in fact, there is permanent impairment in the collateral securing the Bank’s loan. These loans are in a work-out status, must be non-accrual status and have a defined work-out strategy.
	This is a transitional risk rating class while collateral value and other factors are assessed. Loans will remain in this class for the assessment period, but in no event for more than 1 year. If there is no improvement in the Bank’s position during that time, a charge-off will be taken to best reflect known asset collateral value. If the loan goes into a “Deeds in Redemption” status before 1 year, any shortfall will be recognized immediately.

The assessment of compensating factors may result in a rating plus or minus one grade from those listed above. These factors include, but are not limited to collateral, guarantors, environmental conditions, history, plan/projection reasonableness, quality of information, and payment delinquency.

The internal loan grading system is applied to the residential real estate portion of our consumer loan portfolio upon certain triggering events (e.g., delinquency, bankruptcy, restructuring, etc.). However, large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans are collectively evaluated for impairment and they are not separately identified for impairment disclosures. The primary risk element for the residential real estate portion of consumer loans is the timeliness of borrowers’ scheduled payments. We rely primarily on our internal reporting system to monitor past due loans and have internal policies and procedures to pursue collection and protect our collateral interests in order to mitigate losses.

Our monitoring of credit quality is further denoted by classification of loans as nonperforming, which reflects loans where the accrual of interest has been discontinued and loans that are past due 90 days or more and still accruing interest. In addition, nonperforming loans include troubled debt restructured loans (as discussed below) that are on nonaccrual status or past due 90 days or more. Troubled debt restructured loans that are accruing interest and not past due 90 days or more are excluded from nonperforming loans.

12

The following presents the recorded investment in loans by risk grade and a summary of nonperforming loans, by class of loan:

	Not Rated		1		2		3		4		5		6		7		8		Total		Nonperforming
	(in thousands)
September 30, 2013
Commercial	$	125	$	463	$	28	$	1,776	$	4,678	$	5,672	$	629	$	221	$	-	$	13,592	$	15
Commercial Real Estate:
Construction, land development, and other land		-		-		-		-		2,080		2,052		-		618		1,474		6,224		1,870
Owner occupied		35		-		792		3,166		21,263		19,487		2,796		3,839		-		51,378		2,875
Nonowner occupied		-		-		408		1,380		20,312		25,928		4,486		8,835		-		61,349		4,048
Consumer real estate:
Commercial Purpose		-		-		-		167		1,130		3,462		742		960		-		6,461		725
Mortgage - Residential		10,146		-		-		-		-		-		-		3,066		-		13,212		1,646
Home equity and home equity lines of credit		8,429		-		-		-		-		72		-		433		-		8,934		374
Consumer and Other		6,018		-		-		-		5		12		-		107		-		6,142		107
Total	$	24,753	$	463	$	1,228	$	6,489	$	49,468	$	56,685	$	8,653	$	18,079	$	1,474	$	167,292	$	11,660
December 31, 2012
Commercial	$	391	$	430	$	-	$	2,356	$	5,881	$	5,360	$	1,000	$	694	$	-	$	16,112	$	264
Commercial Real Estate:
Construction, land development, and other land		-		-		-		-		1,431		4,006		136		3,168		-		8,741		2,391
Owner occupied		42		-		-		1,671		18,963		21,619		3,594		5,313		-		51,202		3,040
Nonowner occupied		-		-		451		1,404		17,057		30,847		11,307		8,349		-		69,415		3,632
Consumer real estate:
Commercial Purpose		-		-		-		297		948		3,594		758		1,314		-		6,911		1,158
Mortgage - Residential		11,232		-		-		-		-		-		-		3,372		-		14,604		2,019
Home equity and home equity lines of credit		7,760		-		-		-		-		-		-		547		-		8,307		411
Consumer and Other		4,948		-		-		-		6		5		-		144		-		5,103		125
Total	$	24,373	$	430	$	451	$	5,728	$	44,286	$	65,431	$	16,795	$	22,901	$	-	$	180,395	$	13,040

Loans are considered past due when contractually required principal or interest has not been received. The amount classified as past due is the entire principal balance outstanding of the loan, not just the amount of payments that are past due.

An aging analysis of the recorded investment in past due loans, segregated by class of loans follows:

													90+ Days
	Loans Past Due												Past Due
	30-59 Days		60-89 Days		90+ Days		Total		Current		Total		and Accruing
	(in thousands)
September 30, 2013
Commercial	$	11	$	-	$	1	$	12	$	13,580	$	13,592	$	1
Commercial real estate:
Construction, land development, and other land		69		126		-		195		6,029		6,224		-
Owner occupied		-		87		1,293		1,380		49,998		51,378		-
Nonowner occupied		406		316		247		969		60,380		61,349		-
Consumer real estate:
Commercial purpose		290		-		270		560		5,901		6,461		-
Mortgage - Residential		106		329		308		743		12,469		13,212		-
Home equity and home equity lines of credit		83		-		-		83		8,851		8,934		-
Consumer and Other		70		7		26		103		6,039		6,142		-
Total	$	1,035	$	865	$	2,145	$	4,045	$	163,247	$	167,292	$	1
December 31, 2012
Commercial	$	136	$	6	$	51	$	193	$	15,919	$	16,112	$	-
Commercial real estate:
Construction, land development, and other land		1,609		-		30		1,639		7,102		8,741		-
Owner occupied		142		32		1,837		2,011		49,191		51,202		-
Nonowner occupied		-		-		558		558		68,857		69,415		-
Consumer real estate:
Commercial purpose		133		-		558		691		6,220		6,911		201
Mortgage - Residential		1,109		753		21		1,883		12,721		14,604		-
Home equity and home equity lines of credit		302		76		-		378		7,929		8,307		-
Consumer and Other		71		24		32		127		4,976		5,103		-
Total	$	3,502	$	891	$	3,087	$	7,480	$	172,915	$	180,395	$	201

Loans are placed on nonaccrual when, in the opinion of management, the collection of additional interest is doubtful. Loans are generally placed on nonaccrual upon becoming ninety days past due. However, loans may be placed on nonaccrual regardless of whether or not they are past due. All cash received on nonaccrual loans is applied to the principal balance. Loans are considered for return to accrual status on an individual basis when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

13

The following is a summary of the recorded investment in nonaccrual loans, by class of loan:

	September 30, 2013		December 31, 2012
	(in thousands)
Commercial	$	14	$	264
Commercial real estate:
Construction, land development, and other land		1,870		2,391
Owner occupied		2,875		3,040
Nonowner occupied		4,048		3,632
Consumer real estate:
Commercial purpose		725		957
Mortgage - Residential		1,646		2,019
Home equity and home equity lines of credit		374		411
Consumer and Other		107		125
Total	$	11,659	$	12,839

The following presents information pertaining to impaired loans and related valuation allowance allocations by class of loan:

	September 30, 2013						December 31, 2012
			Unpaid						Unpaid
	Recorded		Principal		Valuation		Recorded		Principal			Valuation
	Investment		Balance		Allowance		Investment		Balance			Allowance
	(in thousands)
With an allowance recorded:
Commercial	$	227	$	246	$	14	$	463	$	543	$	49
Commercial real estate:
Construction, land development, and other land		2,485		4,792		1,686		1,211		1,396		166
Owner occupied		3,515		3,868		305		5,473		6,045		498
Nonowner occupied		6,954		7,216		630		5,764		6,962		581
Consumer real estate:
Commercial purpose		1,262		1,425		141		1,698		2,018		377
Mortgage - Residential		-		-		-		-		-		-
Home equity and home equity lines of credit		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-
Total		14,443		17,547		2,776		14,609		16,964		1,671
With no related allowance recorded:
Commercial		14		471		-		246		724		-
Commercial real estate:
Construction, land development, and other land		327		429		-		2,391		4,730		-
Owner occupied		3,019		4,387		-		2,084		3,914		-
Nonowner occupied		3,298		4,158		-		2,930		3,616		-
Consumer real estate:
Commercial purpose		670		1,330		-		683		1,150		-
Mortgage - Residential		-		-		-		-		-		-
Home equity and home equity lines of credit		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-
Total		7,328		10,775		-		8,334		14,134		-
Total:
Commercial		241		717		14		710		1,267		49
Commercial real estate:
Construction, land development, and other land		2,812		5,221		1,686		3,602		6,126		166
Owner occupied		6,534		8,255		305		7,557		9,959		498
Nonowner occupied		10,252		11,374		630		8,694		10,578		581
Consumer real estate:
Commercial purpose		1,932		2,755		141		2,380		3,168		377
Mortgage - Residential		-		-		-		-		-		-
Home equity and home equity lines of credit		-		-		-		-		-		-
Consumer and Other		-		-		-		-		-		-
Total Impaired Loans	$	21,771	$	28,322	$	2,776	$	22,943	$	31,098	$	1,671

14

 

The following presents information pertaining to the recorded investment in impaired loans for the three and nine months ended as follows:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2013		2012		2013		2012
	(in thousands)
Average of impaired loans during the period
Commercial	$	204	$	648	$	217	$	685
Commercial real estate:
Construction, land development, and other land		2,973		4,675		2,974		4,829
Owner occupied		7,386		8,522		7,413		9,045
Nonowner occupied		10,014		10,208		9,964		11,563
Consumer real estate:
Commercial purpose		1,968		2,505		2,030		2,662
Mortgage - Residential		-		-		-		-
Home equity and home equity lines of credit		-		-		-		-
Consumer and Other		-		-		-		-
Total	$	22,545	$	26,558	$	22,598	$	28,784

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2013		2012		2013		2012
Interest income recognized during impairment
Commercial	$	3	$	5	$	12	$	18
Commercial real estate:
Construction, land development, and other land		18		14		50		35
Owner occupied		99		41		256		125
Nonowner occupied		109		78		253		181
Consumer real estate:
Commercial purpose		15		4		64		19
Mortgage - Residential		-		-		-		-
Home equity and home equity lines of credit		-		-		-		-
Consumer and Other		-		-		-		-
Total	$	244	$	142	$	635	$	378

For loans where impairment is measured based on the present value of expected future cash flows, subsequent changes in present value and related allowance adjustments resulting from the passage of time are accounted within the provision for loan losses rather than interest income.

Troubled Debt Restructurings

The Corporation may agree to modify the terms of a loan to improve its ability to collect amounts due. The modified terms are intended to enable customers to mitigate the risk of foreclosure by creating a payment structure that provides for continued loan payment requirements based on their current cash flow ability. Modifications, including renewals, where concessions are made by the Bank and result from the debtor’s financial difficulties are considered troubled debt restructurings (TDRs).

Loan modifications are considered TDRs when the modification includes terms outside of normal lending practices (i.e., concessions) to a borrower who is experiencing financial difficulties.

Typical concessions granted include, but are not limited to:

1.	Agreeing to interest rates below prevailing market rates for debt with similar risk characteristics
2.	Extending the amortization period beyond typical lending guidelines for debt with similar risk characteristics
3.	Forbearance of principal
4.	Forbearance of accrued interest

To determine if a borrower is experiencing financial difficulties, the Corporation considers if:

1.	The borrower is currently in default on any other of their debt
2.	It is likely that the borrower would default on any of their debt if the concession was not granted
3.	The borrower’s cash flow was sufficient to service all of their debt if the concession was not granted
4.	The borrower has declared, or is in the process of declaring bankruptcy
5.	The borrower is a going concern (if the entity is a business)

15

The following summarizes troubled debt restructurings:

	September 30, 2013						December 31, 2012
	Outstanding Recorded Investment						Outstanding Recorded Investment
	Accruing		Nonaccrual		Total		Accruing		Nonaccrual		Total
	(in thousands)
Commercial	$	227	$	14	$	241	$	446	$	264	$	710
Commercial real estate:
Construction, land development, and other land		942		1,675		2,617		1,211		2,271		3,482
Owner occupied		3,484		2,541		6,025		4,335		2,029		6,364
Nonowner occupied		6,204		3,360		9,564		5,063		3,447		8,510
Consumer real estate:
Commercial purpose		1,207		604		1,811		1,424		596		2,020
Mortgage - Residential		950		853		1,803		738		1,232		1,970
Home equity and home equity lines of credit		59		257		316		62		284		346
Consumer and Other		7		80		87		9		96		105
Total	$	13,080	$	9,384	$	22,464	$	13,288	$	10,219	$	23,507

Troubled debt restructured loans may qualify for return to accrual status if the borrower complies with the revised terms and conditions and has demonstrated sustained payment performance consistent with the modified terms for a minimum of six consecutive payment cycles after the restructuring date. In addition, the collection of future payments must be reasonably assured.

The following presents information regarding existing loans that were restructured, resulting in the loan being classified as a troubled debt restructuring:

	Loans Restructured in the Three Months					Loans Restructured in the Nine Months
	Ended September 30, 2013					Ended September 30, 2013
		Pre- Modification		Post-Modification			Pre- Modification		Post-Modification
	Number	Recorded		Recorded		Number	Recorded		Recorded
	of Loans	Investment		Investment		of Loans	Investment		Investment
	(dollars in thousands)
Commercial	1	$	46	$	46	1	$	46	$	46
Commercial real estate:
Construction, land development, and other land	-		-		-	-		-		-
Owner occupied	-		-		-	1		390		390
Nonowner occupied	-		-		-	2		1,470		1,470
Consumer real estate:
Commercial purpose	-		-		-	1		114		114
Mortgage - Residential	-		-		-	-		-		-
Home equity and home equity lines of credit	-		-		-	-		-		-
Consumer and Other	-		-		-	-		-		-
Total	1	$	46	$	46	5	$	2,020	$	2,020

During the three months ended September 30, 2013, the Corporation had one TDR loan with a recorded investment of $75,000 that defaulted within 12 months of restructuring. During the nine months ended September 30, 2013, two TDR loans with an aggregate  recorded investment of $515,000 defaulted within 12 months of restructuring. A loan is considered to be in payment default generally once it is 90 days contractually past due under the modified terms.

	Loans Restructured in the Three Months					Loans Restructured in the Nine Months
	Ended September 30, 2012					Ended September 30, 2012
		Pre- Modification		Post-Modification			Pre- Modification		Post-Modification
	Number	Recorded		Recorded		Number	Recorded		Recorded
	of Loans	Investment		Investment		of Loans	Investment		Investment
	(dollars in thousands)
Commercial	-	$	-	$	-	-	$	-	$	-
Commercial real estate:
Construction, land development, and other land	3		2,631		2,631	3		2,631		2,631
Owner occupied	2		460		460	2		460		460
Nonowner occupied	3		1,480		1,480	6		2,353		2,353
Consumer real estate:
Commercial purpose	-		-		-	2		431		431
Mortgage - Residential	3		159		159	4		366		366
Home equity and home equity lines of credit	1		84		84	2		137		137
Consumer and Other	-		-		-	-		-		-
Total	12	$	4,814	$	4,814	19	$	6,378	$	6,378

During the three months ended September 30, 2012, the Corporation had one TDR loan with a recorded investment of $260,000 that defaulted within 12 months of restructuring. During the nine months ended September 30, 2012, six TDR loans with an aggregate recorded investment of $1.7 million defaulted within 12 months of restructuring. A loan is considered to be in payment default generally once it is 90 days contractually past due under the modified terms.

16

The following summarizes the nature of concessions granted by the Corporation to borrowers experiencing financial difficulties which resulted in troubled debt restructurings:

							Non-Market Interest Rate
				Extension of			and Extension of
	Non-Market Interest Rate			Amortization Period			Amortization Period
		Pre-Modification			Pre-Modification			Pre-Modification
	Number	Recorded		Number	Recorded		Number	Recorded
	of Loans	Investment		of Loans	Investment		of Loans	Investment
	(dollars in thousands)
Three months ended September 30, 2013
Commercial	-	$	-	1	$	46	-	$	-
Commercial real estate:
Construction, land development, and other land	-		-	-		-	-		-
Owner occupied	-		-	-		-	-		-
Nonowner occupied	-		-	-		-	-		-
Consumer real estate:
Commercial purpose	-		-	-		-	-		-
Mortgage - Residential	-		-	-		-	-		-
Home equity and home equity lines of credit	-		-	-		-	-		-
Consumer and Other	-		-	-		-	-		-
Total	-	$	-	1	$	46	-	$	-
Nine months ended September 30, 2013
Commercial	-	$	-	1	$	46	-	$	-
Commercial real estate:
Construction, land development, and other land	-		-	-		-	-		-
Owner occupied	-		-	-		-	1		390
Nonowner occupied	-		-	2		1,470	-		-
Consumer real estate:
Commercial purpose	-		-	1		114	-		-
Mortgage - Residential	-		-	-		-	-		-
Home equity and home equity lines of credit	-		-	-		-	-		-
Consumer and Other	-		-	-		-	-		-
Total	-	$	-	4	$	1,630	1	$	390

During the three and nine months ended September 30, 2013, there were no non-market interest rate restructurings of substandard performing loans that were renewed at their existing contractual rates or non-market rates. Renewals of substandard performing loans at non-market interest rates are considered troubled debt restructurings.

							Non-Market Interest Rate
				Extension of			and Extension of
	Non-Market Interest Rate			Amortization Period			Amortization Period
		Pre-Modification			Pre-Modification			Pre-Modification
	Number	Recorded		Number	Recorded		Number	Recorded
	of Loans	Investment		of Loans	Investment		of Loans	Investment
	(dollars in thousands)
Three months ended September 30, 2012
Commercial	-	$	-	-	$	-	-	$	-
Commercial real estate:
Construction, land development, and other land	-		-	1		104	2		2,527
Owner occupied	-		-	2		460	-		-
Nonowner occupied	1		126	1		902	1		452
Consumer real estate:
Commercial purpose	-		-	-		-	-		-
Mortgage - Residential	1		89	-		-	2		70
Home equity and home equity lines of credit	-		-	-		-	1		84
Consumer and Other	-		-	-		-	-		-
Total	2	$	215	4	$	1,466	6	$	3,133
Nine months ended September 30, 2012
Commercial	-	$	-	-	$	-	-	$	-
Commercial real estate:
Construction, land development, and other land	-		-	1		104	2		2,527
Owner occupied	-		-	2		460	-		-
Nonowner occupied	3		531	1		902	2		920
Consumer real estate:
Commercial purpose	2		431	-		-	-		-
Mortgage - Residential	2		296	-		-	2		70
Home equity and home equity lines of credit	1		53	-		-	1		84
Consumer and Other	-		-	-		-	-		-
Total	8	$	1,311	4	$	1,466	7	$	3,601

17

During the three and nine months ended September 30, 2012, non-market interest rate restructurings included pre-modification recorded investments of $89,000 and $888,000, respectively, related to performing loans that were renewed at either their existing contractual rates or non-market interest rates.

Because these performing loans were graded substandard and the modified rates were not market rates for similar loans, these renewals are considered troubled debt restructurings.

6. Fair Value Measurements

ASC Topic 820 defines fair value and establishes a consistent framework for measuring fair value and expands disclosure requirements for fair value measurements. Fair values represent the estimated price that would be received from selling an asset or paid to transfer a liability, otherwise known as an “exit price”. The three levels of inputs that may be used to measure fair value are as follows:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be derived from or corroborated by observable market data by correlation or other means.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The following is a description of the Corporation’s valuation methodologies used to measure and disclose the fair values of its financial assets and liabilities on a recurring basis:

Securities available for sale. Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based on quoted prices, if available (Level 1). If quoted prices are not available, fair values are measured using independent pricing models such as matrix pricing models (Level 2). Matrix pricing is a mathematical technique widely used in the financial industry to value debt securities without relying exclusively on quoted market prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices. Level 2 securities include U.S. government and agency securities, other U.S. government and agency mortgage-backed securities, municipal bonds and preferred stock securities. Level 3 securities include private collateralized mortgage obligations. The fair value measurement of our only Level 3 security, a non-investment grade CMO, and details regarding significant inputs and assumptions used in estimating its fair value, is detailed in Note 3, Securities.

Fair value of assets measured on a recurring basis:

			Quoted Prices in		Significant Other		Significant
			Active Markets for		Observable		Unobservable
			Identical Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
	(in thousands)
September 30, 2013
Obligations of state and political subdivisions	$	1,802	$	-	$	1,802	$	-
Mortgage-backed/CMO		69,884		-		68,261		1,623
Preferred stock		476		-		476		-
Total investment securities available for sale	$	72,162	$	-	$	70,539	$	1,623
December 31, 2012
Obligations of state and political subdivisions	$	1,580	$	-	$	1,580	$	-
U.S. agency		3,007		-		3,007		-
Mortgage-backed/CMO		67,862		-		65,844		2,018
Preferred stock		137		-		137		-
Total investment securities available for sale	$	72,586	$	-	$	70,568	$	2,018

The reconciliation of the beginning and ending balances of the asset classified by the Corporation within Level 3 of the valuation hierarchy for the nine months ended September 30, 2013 is as follows:

	Fair Value Measurement
	Using Significant
	Unobservable Inputs
	(Level 3)
Fair value of non-agency mortgage-backed security, beginning of year(1)	$	2,018
Total gains (losses) realized/unrealized:
Included in earnings(2)		-
Included in other comprehensive income (2)		122
Purchases, issuances, and other settlements		(517)
Transfers into Level 3		-
Fair value of non-agency mortgage-backed security, September 30, 2013	$	1,623
Total amount of losses for the year included in earnings attributable to the
change in unrealized in unrealized losses relating to assets still held at September 30, 2013	$	-

18

(1)	Non-agency CMO classified as available for sale is valued using internal valuation models and pricing information from third parties.
(2)	Realized gains (losses), including unrealized losses deemed other-than-temporary, are reported in noninterest income. Unrealized gains (losses) are reported in accumulated other comprehensive income (loss).

The following is a description of the Corporation’s valuation methodologies used to measure and disclose the fair values of its financial assets and liabilities on a non-recurring basis:

Loans. The Corporation does not record loans at fair value on a recurring basis. However, from time to time, the Corporation records nonrecurring fair value adjustments to collateral dependent loans to reflect partial write-downs or specific reserves that are based on the observable market price or current appraised value of the collateral. These loans are reported in the nonrecurring table below at initial recognition of impairment and on an ongoing basis until recovery or charge off. When the fair value of the collateral is based on an observable market price or a current appraised value, the Corporation records the impaired loan as nonrecurring Level 2. When a current appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Corporation records the impaired loan as nonrecurring Level 3.

Other real estate owned. Real estate acquired through foreclosure or deed-in-lieu is adjusted to fair value less costs to sell upon transfer of the loan to other real estate owned, usually based on an appraisal of the property. Subsequently, other real estate owned is carried at the lower of carrying value or fair value, less cost to sell. A valuation based on a current appraisal or by a broker’s opinion is considered a Level 2 fair value. If management determines the fair value of the property is further impaired below the appraised value and there is no observable market price, the Corporation records the property as nonrecurring Level 3.

Fair value of assets on a non-recurring basis:

			Quoted Prices in		Significant Other		Significant
			Active Markets for		Observable		Unobservable
			Identical Assets		Inputs		Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
	(in thousands)
September 30, 2013
Impaired loans (1)	$	18,995	$	-	$	-	$	18,995
Other real estate owned	$	690	$	-	$	-	$	690
December 31, 2012
Impaired loans (1)	$	21,272	$	-	$	-	$	21,272
Other real estate owned	$	3,427	$	-	$	-	$	3,427

⁽¹⁾ Represents carrying value and related write-downs and specific reserves pertaining to collateral dependent loans for which adjustments are based on the appraised value of the collateral or by other unobservable inputs. 

7. Fair Value of Financial Instruments

Fair value disclosures require fair-value information about financial instruments for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair-value estimates cannot be substantiated by comparison to independent markets and, in many cases, cannot be realized in immediate settlement of the instrument.

Fair-value methods and assumptions for the Corporation’s financial instruments are as follows:

Cash and cash equivalents – The carrying amounts reported in the consolidated balance sheet for cash and short term investments reasonably approximate those assets’ fair values.

Investment securities – Fair values for investment securities are determined as discussed above.

FHLBI and FRB stock – The carrying amounts reported in the consolidated balance sheet for FHLBI and FRB stock reasonably approximate those assets’ fair values.

Loans – For variable-rate loans that reprice frequently, fair values are generally based on carrying values, adjusted for credit risk. The fair value of fixed-rate loans is estimated by discounting future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Accrued interest income – The carrying amount of accrued interest income is a reasonable estimate of fair value.

Deposit liabilities – The fair value of deposits with no stated maturity, such as demand deposit, NOW, savings, and money market accounts, is equal to the amount payable on demand. The fair value of certificates of deposit is estimated using rates currently offered for wholesale funds with similar remaining maturities.

Other borrowings – The carrying amount of other borrowings is a reasonable estimate of fair value.

Accrued interest payable – The carrying amount of accrued interest payable is a reasonable estimate of fair value.

Off-balance-sheet instruments – The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of commitments to extend credit, including letters of credit, is estimated to approximate their aggregate book balance and is not considered material and therefore not included in the following table.

19

	Level in Fair	September 30, 2013				December 31, 2012
	Value Hierarchy	Carrying Value		Fair Value		Carrying Value		Fair Value
		(in thousands)
Financial assets:
Cash and cash equivalents	Level 1	$	60,832	$	60,832	$	41,824	$	41,824
Short term investments	Level 2		198		198		197		197
Investment and mortgage-backed securities	Level 2		70,539		70,539		70,568		70,568
Non-agency mortgage-backed security	Level 3		1,623		1,623		2,018		2,018
FHLBI and FRB stock	Level 2		779		779		779		779
Loans, net	Level 3		157,939		159,181		168,422		169,365
Accrued interest income	Level 2		611		611		705		705
Financial liabilities:
Deposits	Level 2		290,476		286,917		287,682		287,749
Other borrowings	Level 2		188		188		148		148
Accrued interest expense	Level 2		84		84		93		93

Limitations

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

8. Net Income per Common Share

Basic earnings per common share is based on the weighted average number of common shares and participating securities outstanding during the period. Diluted earnings per share is the same as basic earnings per share because any additional potential common shares issuable are included in the basic earnings per share calculation. On January 1, 2009, the Corporation adopted new guidance impacting ASC Topic 260, Earnings Per Share, related to determining whether instruments granted in a share-based payment transaction are participating securities. This guidance requires that unvested stock awards which contain non-forfeitable rights to dividends or dividend equivalents, whether paid or unpaid (referred to as “participating securities”), be included in the number of shares outstanding for both basic and diluted earnings per share calculations. Our unvested restricted stock under the Long-Term Incentive Plan (see Note 9) is considered a participating security. In the event of a net loss, the participating securities are excluded from the calculation of both basic and diluted earnings per share. Due to our net income for the three and nine months ended September 30, 2012, the unvested restricted shares of 2,771 and 2,338 are included in determining both basic and dilutive earnings per share for the respective periods. At December 31, 2012, all restricted shares granted under the LTIP had vested. The following presents basic and diluted net income per share:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2013		2012		2013		2012
	(dollars in thousands, except per share amounts)
Weighted average basic and diluted shares outstanding		457,435		460,191		457,435		459,750
Net income available to common shareholders	$	237	$	118	$	2,942	$	75
Basic and diluted net income per share	$	0.52	$	0.26	$	6.43	$	0.16

9. Long Term Incentive Plan

Under the Long Term Incentive Plan (the “LTIP”), the Corporation had the authority to grant stock options and restricted stock as compensation to key employees. Such authority expired April 22, 2008. The Corporation did not award any stock options under the LTIP. The restricted shares granted under the LTIP have a five-year vesting period. The awards were recorded at fair value on the grant date and are amortized into salary expense over the vesting period.

As of December 31, 2012, all restricted shares granted under the LTIP had vested and there was no unrecognized compensation cost related to nonvested stock awards. During the three and nine months ended September 30, 2012, the total value of the awards which vested approximated $700 and $2,600, respectively.

10. Income Taxes

No income tax expense was recognized on the Corporation’s pre-tax income for the three and nine months ended September 30, 2013 and 2012 due to the Corporation’s tax loss carryforward position. Reported income tax expense (benefit) resulted from adjustment of the Corporation’s deferred tax valuation allowance established on previously recorded net deferred tax assets for the impact of valuation changes in the available for sale investment portfolio.

20

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The Corporation, a Michigan business corporation, is a one bank holding company which owns all of the outstanding capital stock of First National Bank in Howell (the Bank) and all of the outstanding stock of HB Realty Co., Inc. a subsidiary. The following is a discussion of the Corporation’s regulatory condition, results of operations for the three and nine month periods ended September 30, 2013 and 2012, and the Corporation’s financial condition, focusing on its liquidity and capital resources.

In a Current Report on Form 8-K filed with the Securities and Exchange Commission on November 6, 2013, the Corporation disclosed that its subsidiary bank, the First National Bank in Howell, entered into a new Consent Order with the Office of the Comptroller of the Currency (the "OCC"), the Bank’s primary federal regulator, on October 31, 2013. The new Consent Order replaces the earlier Consent Order dated September 24, 2009 and includes essentially all of the articles included in the 2009 Consent Order. In addition, the new Consent Order contains certain new conditions and/or articles, including: i) Requirements to obtain certain OCC approval prior to deviating from the Bank’s strategic business plan; ii) Additional requirements to ensure effective management and board composition, establishment of a formal compensation plan structure, and management of third party vendor relationships; iii) A new article requiring the Bank to establish an affiliate transaction policy; and iv) A new article to ensure the effectiveness of the Bank’s internal audit program.

Importantly, the new Consent Order continues to require the Bank to achieve and maintain total capital equal to 11% of risk weighted assets and Tier 1 capital equal to at least 8.5% of adjusted total assets. At September 30, 2013 and through the current date, the Bank’s capital ratios are and continue to be significantly below the minimum requirements imposed by the OCC. In light of the Bank’s significant losses since 2008 and deficient capital position at September 30, 2013, it is reasonable to anticipate further regulatory enforcement action by either the OCC or FDIC, particularly if the Corporation is unsuccessful in completing a recapitalization of the Corporation, as discussed in Note 2 to the Consolidated Financial Statements included within this Quarterly Report. See also the "Capital" and "Regulatory Enforcement Action" sections of this Management’s Discussion and Analysis for further details.

The success of the Corporation depends to a great extent upon the economic conditions in Livingston County and the surrounding area. The Corporation has in general experienced a slowing economy in Michigan since 2001. In particular, Michigan’s current unemployment rate of approximately 9.0%, although improved from highs near 14% during 2009, remains among the worst for all states. Unlike larger banks that are more geographically diversified, we provide banking services to customers primarily in Livingston County. Our loan portfolio, the ability of the borrowers to repay these loans, and the value of the collateral securing these loans is impacted by local economic conditions. The continued economic difficulties in Michigan have had and may continue to have many adverse consequences as described below in "Loans".

Dramatic declines in the housing market in recent years, with falling home prices and elevated levels of foreclosures and unemployment, have resulted in and may continue to result in significant write-downs of asset values by us and other financial institutions. These write-downs have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. Additionally, capital and credit markets have experienced elevated levels of volatility and disruption in recent years. This market turmoil and tightening of credit have led to a lack of general consumer confidence and reduction in business activity. Although we have seen some stabilization and improvements in economic conditions, these factors continue to present a challenge to our recovery and profitability.

Due to the conditions and events discussed above and elsewhere in this Form 10-Q, there is significant uncertainty regarding the impact of potential future regulatory action against the Bank. The extent of such regulatory action may threaten the ability of the Bank to continue operating as a going concern. Even if we do not become subject to more stringent regulatory requirements or restrictions, our current capital deficiencies and elevated levels of nonperforming assets may make it very difficult to continue as a going concern. At September 30, 2013, our nonperforming assets remain elevated and comprise approximately 64% of our capital plus allowance for loan losses As described elsewhere in this Form 10-Q, we have established our allowance for loan losses at a level we currently believe, based on the data available to us, is sufficient to absorb expected losses in our loan portfolio. However, this process involves a very significant degree of judgment, is based on numerous different assumptions that are difficult to make and, by its nature, is inherently uncertain. Moreover, the performance of our existing loan portfolio is, in many respects, dependent on external factors such as our borrowers' ability to repay their loan obligations and the value of collateral securing those obligations, which in turn depend on macro and micro economic conditions including the pace of economic recovery in southeast Michigan. If our loan portfolio performs worse than we currently expect, we may not have sufficient capital to absorb all of the losses, which could render us insolvent. Notwithstanding the above, the consolidated financial statements included in this Form 10-Q have been prepared assuming the Bank continues to operate in the normal course of business for the foreseeable future, and do not include any adjustments to recorded assets or liabilities should we be unable to continue as a going concern.

As fully described in Note 2, "Regulatory Matters and Going Concern", of the consolidated financial statements included in the 2012 Annual Report within the Corporation’s Form 10-K filing, management has undertaken various initiatives identified in its recovery plan to address the current challenges facing the Bank. The successful implementation of the various actions being undertaken by management will be difficult in the current economic environment. Even if such actions are successfully implemented, such strategy may not be sufficient to increase the Bank's capital levels to satisfactory levels, return the Bank to consistent profitability, or otherwise avoid further regulatory oversight or enforcement action. Any further declines in the Bank’s capital levels may result in more severe regulatory oversight or enforcement action by either the OCC or FDIC, including the possibility of regulatory receivership.

Consequently, there can be no assurance these efforts will improve the Bank’s financial condition. Further deterioration of the Bank’s capital position is possible. The current economic environment in southeast Michigan and local real estate market conditions will continue to impose challenges on the Bank and are expected to adversely impact financial results.

It is against this backdrop that we discuss our financial condition and results of operations for the three and nine months ended September 30, 2013 compared to the same periods in 2012.

	Three months ended				Nine months ended
Earnings	September 30,				September 30,
	2013		2012		2013		2012
	(dollars in thousands, except per share amounts)
Net income	$	237	$	118	$	2,942	$	75
Basic and diluted net income per share	$	0.52	$	0.26	$	6.43	$	0.16

Net income for the three months ended September 30, 2013 increased $119,000 compared to the same period last year. In the third quarter of 2013, the Bank recorded no provision for loan losses compared to $300,000 recorded in the same period last year. The reduced provision expense was partially offset by a decrease in net interest income of $67,000, a decrease in noninterest income of $23,000 and an increase in noninterest expense of $72,000.

21

Net income for the nine months ended September 30, 2013, increased $2.9 million compared to the same period last year. For the nine months ended September 30, 2013, the provision for loan losses decreased $3.5 million primarily due to $2.3 million of negative provision expense recorded in the first quarter of 2013. The reduced provision expense was partially offset by a decrease in net interest income of $348,000, a decrease in noninterest income of $84,000, and an increase in noninterest expense by $28,000.

	Three months ended				Nine months ended
Net Interest Income	September 30,				September 30,
	2013		2012		2013		2012
	(dollars in thousands)
Interest and dividend income	$	2,621	$	2,719	$	7,941	$	8,438
Interest expense		232		263		698		847
Net Interest Income	$	2,389	$	2,456	$	7,243	$	7,591

Interest Yields and Costs

The following shows the daily average balances for major categories of interest earning assets and interest bearing liabilities, interest earned (on a taxable equivalent basis) or paid, and the effective rate or yield as follows:

	Three months ended September 30,
	2013						2012
	Average				Yield/		Average				Yield/
	Balance		Interest		Rate		Balance		Interest		Rate
	(in thousands)
Assets:
Interest earning assets:
Short term investments	$	197	$	0.1	0.23	%	$	197	$	0.1	0.23	%
Securities: Taxable		75,587		264.6	1.40	%		71,135		275.4	1.55	%
Tax-exempt (1)		1,033		15.4	5.98	%		1,034		15.4	5.97	%
Commercial loans (2)(3)		140,655		2,040.9	5.68	%		162,507		2,145.2	5.17	%
Consumer loans (2)(3)		15,648		186.1	4.72	%		13,870		176.2	5.05	%
Mortgage loans (2)(3)		12,634		122.6	3.88	%		13,853		118.5	3.42	%
Total earning assets and total interest income		245,754	$	2,629.7	4.21	%		262,596	$	2,730.8	4.09	%
Cash and due from banks		60,778						35,847
All other assets		9,391						12,559
Allowance for loan losses		(9,501)						(12,319)
Total assets	$	306,422					$	298,683
Liabilities and Shareholders' Equity:
Interest bearing deposits:
NOW	$	31,164	$	1.8	0.02	%	$	29,617	$	1.7	0.02	%
Savings		42,897		2.2	0.02	%		42,154		2.3	0.02	%
MMDA		42,143		44.3	0.42	%		36,980		40.9	0.44	%
Time deposits		80,685		184.1	0.91	%		87,152		218.4	1.00	%
Total interest bearing liabilities and total interest expense		196,889		232.4	0.47	%		195,903		263.3	0.53	%
Noninterest bearing deposits		97,981						93,807
All other liabilities		2,497						2,151
Shareholders' equity		9,055						6,822
Total liabilities and     shareholders' equity	$	306,422					$	298,683
Interest spread					3.74	%					3.56	%
Net interest income-FTE			$	2,397.3					$	2,467.5
Net interest margin					3.83	%					3.69	%

(1)	Average yields in the above table have been adjusted to a tax-equivalent basis using a 34% tax rate and exclude the effect of any unrealized market value adjustments included in other comprehensive income recorded under ASC Topic 320, Investments – Debt and Equity Securities.
(2)	For purposes of the computation above, average non-accruing loans of $11.0 million and $20.0 million for the three months ended September 30, 2013 and 2012 are included in the average daily balance.
(3)	Interest on loans includes origination fees totaling $44,000 and $16,000 for the three months ended September 30, 2013 and 2012.

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	Nine months ended September 30,
	2013						2012
	Average				Yield/		Average				Yield/
	Balance		Interest		Rate		Balance		Interest		Rate
	(in thousands)
Assets:
Interest earning assets:
Short term investments	$	197	$	0.3	0.23	%	$	197	$	0.3	0.23	%
Securities: Taxable		80,236		796.5	1.32	%		57,685		775.6	1.79	%
Tax-exempt (1)		1,033		46.3	5.98	%		1,178		54.5	6.14	%
Commercial loans (2)(3)		144,004		6,247.8	5.72	%		170,472		6,716.7	5.18	%
Consumer loans (2)(3)		15,034		537.5	4.78	%		14,149		536.6	5.07	%
Mortgage loans (2)(3)		12,945		343.2	3.54	%		14,209		393.0	3.69	%
Total earning assets and total interest income		253,449	$	7,971.6	4.16	%		257,890	$	8,476.7	4.33	%
Cash and due from banks		44,349						33,504
All other assets		11,329						12,404
Allowance for loan losses		(10,272)						(12,413)
Total assets	$	298,855					$	291,385
Liabilities and Shareholders' Equity:
Interest bearing deposits:
NOW	$	30,889	$	5.1	0.02	%	$	28,947	$	4.6	0.02	%
Savings		42,432		6.5	0.02	%		41,752		7.2	0.02	%
MMDA		40,607		128.6	0.42	%		36,333		129.6	0.48	%
Time deposits		81,229		558.2	0.92	%		89,745		705.8	1.05	%
Total interest bearing liabilities and total interest expense		195,157		698.4	0.48	%		196,777		847.2	0.58	%
Noninterest bearing deposits		92,350						85,768
All other liabilities		2,353						2,050
Shareholders' equity		8,995						6,790
Total liabilities and shareholders' equity	$	298,855					$	291,385
Interest spread					3.68	%					3.75	%
Net interest income-FTE			$	7,273.2					$	7,629.5
Net interest margin					3.79	%					3.89	%

(1)	Average yields in the above table have been adjusted to a tax-equivalent basis using a 34% tax rate and exclude the effect of any unrealized market value adjustments included in other comprehensive income recorded under ASC Topic 320, Investments – Debt and Equity Securities.
(2)	For purposes of the computation above, average non-accruing loans of $11.0 million and $21.6 million for the nine months ended September 30, 2013 and 2012 are included in the average daily balance.
(3)	Interest on loans includes origination fees totaling $102,000 and $48,000 for the nine months ended September 30, 2013 and 2012.

Interest Earning Asset/Interest Income

On a tax equivalent basis, interest income decreased $101,000 (3.7%) in the third quarter of 2013 compared to the third quarter of 2012. The decrease was due to a decrease in average earning assets of $16.8 million (6.4%) partially offset by an increase in the yield on average earning assets of 12 basis points.

The average balance of securities increased $4.5 million (6.2%) in the third quarter of 2013 compared to the same period in 2012. The increase was due to $20.6 million of investment security purchases made in January 2013 funded by excess liquidity from run-off in the existing investment and loan portfolios. The yield on average security balances decreased 15 basis points in the third quarter of 2013 compared to the third quarter of 2012 due to comparatively lower yields on new securities acquired.

Loan average balances decreased $21.3 million (11.2%) in the third quarter of 2013 compared to the same period last year and the average yield increased 42 basis points. The largest decline in terms of average balances was commercial loans, the majority of our portfolio, which decreased $21.9 million (13.4%) in the third quarter of 2013 compared to 2012 while the yield increased 51 basis points. Compared to the same prior year period, the increase in commercial loan yield resulted from increased interest income recognized on payoffs of nonaccrual loans and additional interest income recognized under the effective yield method for certain loans previously on nonaccrual status. Commercial loans have continued to decrease due to receipt of scheduled payments, pay-offs received from borrowers, pay-offs from borrowers’ refinancing with other financial institutions and limited new loan originations. It is possible that continued efforts to manage the Bank’s regulatory capital levels (i.e., shrinking the Bank’s size) may further decrease both average loan balances and net interest income in future periods. In addition, the renewal of maturing loans in the current lower rate environment will continue to exert downward pressure on average loan portfolio yields.

Through nine months of the year, tax equivalent interest income decreased $505,000 (6.0%) compared to the same period of 2012. This was due to a decrease in yield on average earning assets of 17 basis points combined with a decrease in average earning assets of $4.4 million (1.7%).

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The average balance of securities increased $22.4 million (38.1%) for the first nine months of 2013 compared to 2012. As noted above, this increase was due to the gradual investment of a portion of the Corporation’s excess on-balance sheet liquidity into earning assets. The yield on average security balances decreased 50 basis points for the first nine months of 2013 compared to 2012 due to the recent purchases of lower yielding securities in the current rate environment.

Loan average balances decreased $26.8 million (13.5%) in the first nine months of 2013 compared to 2012 and the average yield increased 41 basis points. The largest decline in terms of average balances was in commercial loans, which decreased $26.5 million (15.5%) combined with an increase in yield of 54 basis points in the first nine months of 2013 compared to 2012. As discussed above, the increase in year to date commercial loan yield resulted from an increase in interest income recognized on full payoff of loans that were either currently or previously on nonaccrual and additional interest income recognized under the effective yield method for certain eligible loans previously on nonaccrual status.

Average balances decreased primarily due to receipt of scheduled payments, customer pay-offs including borrowers refinancing at other financial institutions, and limited new loan originations.

 

Interest Bearing Liabilities/Interest Expense

Interest expense on deposits for the third quarter of 2013 decreased $31,000 (11.7%) compared to the third quarter of 2012. This was the result of lower interest rates paid on deposits of 6 basis points partially offset by higher average deposit balances of $986,000 (0.5%).

Interest expense on deposits for the nine months of 2013 decreased $149,000 (17.6%) compared to 2012. This was the result of lower interest rates paid on deposits of 10 basis points combined with lower average deposit balances of $1.6 million (0.8%).

Liquidity and Funds Management

Liquidity is managed to ensure stable, reliable and cost-effective sources of funds to satisfy demand for credit, deposit withdrawals and investment opportunities. Liquidity risk is the risk of the Corporation being unable to meet current and future financial obligations in a timely manner. To manage liquidity risk the Corporation relies primarily on a large, stable core deposit base, excess on-balance sheet cash positions and a readily marketable available for sale investment portfolio. Additionally, the Corporation has access to certain wholesale funding sources (as discussed below) to manage unexpected liquidity needs.

The Corporation identifies, measures and monitors its liquidity profile. The profile is evaluated daily, weekly and monthly by analyzing the composition of all funding sources, reviewing projected liquidity commitments by future month and identifying sources and uses of funds. A contingency funding plan is also prepared that details the potential erosion of funds in the event of a systemic financial market crisis or different levels of institution-specific stress. In addition, the overall management of the Corporation’s liquidity position is integrated into retail deposit pricing policies to ensure a stable core deposit base.

Asset liquidity for financial institutions typically consists of cash and cash equivalents, certificates of deposits and investment securities available for sale. These categories totaled $133.1 million at September 30, 2013 or about 44.2% of total assets. This compares to $114.6 million or about 38.6% of total assets at December 31, 2012. Liquidity is important for financial institutions because of their need to meet loan funding commitments and depositor withdrawal requests. Liquidity can vary significantly on a daily basis based on customer activity.

The core deposit base is the primary source of the Corporation’s liquidity. Management monitors rates at other financial institutions in the area to ascertain that its rates are competitive in the market. Management also attempts to offer a wide variety of products to meet the needs of its customers. The make-up of the Bank’s "Large Certificates", which are generally considered to be more volatile and sensitive to changes in rates, consists principally of local depositors known to the Bank. The Bank had Large Certificates totaling approximately $29.3 million at September 30, 2013 and $30.7 million at December 31, 2012. The Bank had limited (non-core) brokered deposits of approximately $1.1 million at September 30, 2013 and December 31, 2012, respectively. As a result of the Bank’s significantly undercapitalized status for Prompt Corrective Action (PCA) purposes, the Bank is prohibited from accepting, renewing, or rolling over brokered deposits. See the "Capital" section of this Management’s Discussion and Analysis for further details.

Of the Corporation’s available liquidity at September 30, 2013 noted above, investment securities with a fair value of approximately $66.5 million were pledged primarily for borrowing availability on a line of credit from the Federal Home Loan Bank of Indianapolis and to secure public deposits, or for other purposes as required or permitted by law.

The Corporation also has available unused wholesale sources of liquidity, including borrowing availability from the Federal Home Loan Bank of Indianapolis (FHLBI) and through the discount window of the Federal Reserve Bank of Chicago. In the past, the Corporation has also issued certificates of deposit through brokers.

The Corporation’s liquidity could be adversely affected by both direct and indirect circumstances. An example of a direct event would be restrictions imposed by regulators due to factors such as deterioration in asset quality, a large charge to earnings, a decline in profitability or other financial measures. Examples of indirect events unrelated to the Corporation that could have an effect on the Corporation’s access to liquidity would be terrorism or war, natural disasters, political events, or the default or bankruptcy of a major corporation, mutual fund or hedge fund. Similarly, market speculation or rumors about the Corporation or the banking industry in general may adversely affect the cost and availability of normal funding sources.

The Corporation maintains a liquidity contingency plan that outlines the process for addressing a potential liquidity crisis. The plan provides for an evaluation of funding sources under various market conditions. It also assigns specific roles and responsibilities for effectively managing liquidity though a problem period.

It is Bank management’s intention to handle unexpected liquidity needs through its cash and cash equivalents, FHLBI borrowings, or Federal Reserve discount borrowings. At September 30, 2013, the Bank had a $24.4 million line of credit available at the FHLBI for which the Bank has pledged investment securities and certain commercial and consumer loans secured by residential real estate as collateral. The Bank also had a $5.2 million line of credit available at the Federal Reserve for which the Bank has pledged certain commercial loans as collateral. At September 30, 2013, the Bank had no borrowings outstanding against these lines of credit. In addition, during 2013, the Bank had no short-term borrowings on these lines of credit, or from other sources, for liquidity needs or other purposes.

24

Although the Bank has established these lines of credit, because of its significantly undercapitalized status, any borrowing requests are subject to review (i.e., for purpose and repayment ability) and approval by the FHLBI and Federal Reserve, respectively. Consequently, full borrowing availability under these existing lines may be restricted at the respective lender’s discretion and terms may be limited or restricted. However, in the event the Bank would need additional funding and be unable to access either line of credit facility, management could act to remove the pledge of investment securities presently securing a portion of the FHLBI line of credit, thereby allowing such securities to be liquidated to provide further liquidity. If necessary, the Bank could also satisfy unexpected liquidity needs through liquidation of unpledged securities.

Quantitative and Qualitative Disclosures about Market Risk

The current economic outlook and its potential impact on the Bank and current interest rate forecasts are reviewed monthly to determine the potential impact on the Corporation’s performance. Actual results are compared to budget in terms of growth and income. A yield and cost analysis is done to monitor interest margin. Various ratios are monitored including capital ratios and liquidity. Also, the quality of the loan portfolio is reviewed in light of the current allowance for loan losses, and the Bank’s exposure to market risk is reviewed.

Interest rate risk is the potential for economic losses due to future rate changes and can be reflected as a loss of future net interest income and/or a loss of current market values. The Corporation’s Asset/Liability Management Committee’s (ALCO) objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Tools used by management include the standard GAP report which reflects the repricing schedule for various asset and liability categories and an interest rate shock simulation report. The Bank has no market risk sensitive instruments held for trading purposes. However, the Bank is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers including commitments to extend credit and letters of credit. A commitment or letter of credit is not recorded as an asset until the instrument is exercised.

Below shows the scheduled maturity and repricing of the Corporation’s interest sensitive term assets and liabilities as well as the expected retention terms of non-maturity deposit accounts as of September 30, 2013:

	0-3		4-12		1-5		5+
	Months		Months		Years		Years		Total
	(in thousands)
Assets:
Loans	$	58,080	$	54,418	$	54,082	$	527	$	167,107
Securities		3,201		10,946		34,855		23,939		72,941
Short term investments		198		-		-		-		198
Total assets	$	61,479	$	65,364	$	88,937	$	24,466	$	240,246
Liabilities:
NOW, savings, and MMDA	$	-	$	-	$	83,367	$	30,278	$	113,645
Time deposits		14,500		42,094		23,675		29		80,298
Total liabilities	$	14,500	$	42,094	$	107,042	$	30,307	$	193,943
Rate sensitivity GAP:
GAP for period	$	46,979	$	23,270	$	(18,105)	$	(5,841)
Cumulative GAP		46,979		70,249		52,144		46,303
September 30, 2013 cumulative sensitive ratio		4.24		2.24		1.32		1.24
December 31, 2012 cumulative sensitive ratio		1.52		1.71		1.94		1.32

Core non-maturity deposits such as NOW, savings and MMDA are an important stable source of funding and represent significant value to the Corporation. Although these deposits may re-price earlier than what is shown in the preceding table, they are generally less rate sensitive than other non-core funding sources. Allocations for our core non-maturity deposits are made to time periods based on a core deposit study which was performed by a third-party specialist based on the Corporation’s historical experience.

In the GAP table above, the short term (one year and less) cumulative interest rate sensitivity is 2.24% asset sensitive at September 30, 2013.

Because of the Bank’s asset sensitive position, if market interest rates increase, this positive GAP position indicates that the interest margin would be positively affected. However, GAP analysis is limited and may not provide an accurate indication of the impact of general interest rate movements on the net interest margin since repricing of various categories of assets and liabilities is subject to the Bank’s needs, competitive pressures, and the needs of the Bank’s customers. In addition, various assets and liabilities indicated as repricing within the same period may in fact reprice at different times within the period and at different rate indices. Due to these inherent limitations in the GAP analysis, the Corporation also utilizes simulation modeling, which measures the impact of upward and downward movements of interest rates on interest margin and indicates that a 100 basis point decrease in interest rates would reduce net interest income by approximately 5.6% in the first year, while a 200 basis point increase in interest rates would increase net interest income by approximately 10.5% in the first year. This is influenced by the assumptions regarding how quickly and to what extent liabilities will reprice with a change in interest rates.

25

Loans

	Three months ended				Nine months ended
	September 30,				September 30,
	2013		2012		2013		2012
	(in thousands)
Provision for loan losses	$	-	$	300	$	(2,250)	$	1,200

In the third quarter of 2013 no provision for loan loss was recorded compared to $300,000 of provision expense recognized in the same prior year period. For the nine months ended September 30, 2012, the Bank recognized negative provision expense of $2.3 million compared to $1.2 million of provision expense during the same period in 2012. In general, the reduced 2013 provision expense reflects decreasing trends in the levels of existing and newly identified nonperforming loans, gradual stabilization in real estate values for certain problem credits, and continued shrinkage in the overall loan portfolio relative to conditions faced by the Bank one year ago. In addition, consistent with the improved portfolio trends, continued improvement in our rolling 12 quarter loss history correlates with the current overall level of allowance and related provision expense relative to the prior comparative periods. Absent unforeseen further deterioration in the economy and based on the present trends in the loan portfolio and the anticipated continued improvement in our loss history as significant prior year charge offs exit the rolling 12 quarter look back period, it is reasonably likely that future negative provision expense will be necessary to maintain the directional consistency of the overall level of the allowance with the actual performance of the loan portfolio.

Loan charge offs for the nine months ended September 30, 2013 totaled $859,000 compared to $3.6 million recognized during the same prior year period. The 2012 charge offs related primarily to collateral liquidation shortfalls on then existing impaired loans and management’s determination of certain borrowers’ inability to support future cash flow projections. In addition, 2012 charge offs included approximately $539,000 of protective advances paid to protect the Bank’s interest in collateral scheduled for tax sale. Based on remediation plans for our remaining problem loans at September 30, 2013, including those previously charged-down for collateral deficiencies, and an assessment of current risks impacting the overall portfolio, management believes that the general rate of decline in real estate values has slowed and may portend a continued decrease in future charge offs.

Management considered these factors in conjunction with its quarterly analysis of the loan portfolio to identify and quantify the level of credit risk to estimate losses in its determination that no provision expense was required for the three months ended September 30, 2013 and determination of the adequacy of the $9.2 million allowance for loan losses at September 30, 2013.

Loan and Asset Quality

The following table reflects the composition of the commercial and consumer loans in the Consolidated Financial Statements. Included in the residential first mortgage totals below are the “real estate mortgage” loans listed in the Consolidated Financial Statements and other loans to customers who pledge their homes as collateral for their borrowings. A portion of the loans listed in residential first mortgages represent commercial loans where the borrower has pledged a 1 – 4 family residential property as collateral. In the majority of the loans to commercial customers, the Bank is relying on the borrower’s cash flow to service the loans.

The following table shows the balance and percentage composition of loans as of:

	September 30, 2013				December 31, 2012
	Balances		Percent		Balances		Percent
	(dollars in thousands)
Secured by real estate:
Residential first mortgage	$	17,928	10.7	%	$	19,782	11.0	%
Residential home equity/other junior liens		10,679	6.4	%		10,040	5.6	%
Construction, land development and other land		6,224	3.7	%		8,741	4.8	%
Commercial (nonfarm, nonresidential)		112,727	67.4	%		120,617	66.9	%
Commercial		13,592	8.1	%		16,112	8.9	%
Consumer and Other		6,142	3.7	%		5,103	2.8	%
Total gross loans		167,292	100.0	%		180,395	100.0	%
Net unearned fees		(185)				(204)
Total Loans	$	167,107			$	180,191

The loan portfolio decreased $13.1 million (7.3%) in the nine months ended September 30, 2013. The decrease was experienced predominately within the commercial real estate portfolio (i.e., owner occupied and nonowner occupied) which decreased $7.9 million (6.5%) primarily due to five larger borrower relationships aggregating to approximately $6.5 million being refinanced with other financial institutions through September 30, 2013. Other decreases in this portfolio segment resulted from customer pay-downs and pay-offs and the receipt of scheduled payments. Further decreases in the loan portfolio included declines in commercial loans of $2.5 million (15.6%), loans secured by consumer real estate of $1.2 million (4.1%), and construction, land development, and other land loans of $2.5 million (28.8%). These additional decreases were primarily attributable to receipt of scheduled payments from borrowers and limited loan growth experienced to date in 2013 caused by limited loan demand from qualified, credit worthy borrowers.

Loans secured by residential first mortgages decreased $1.9 million (9.4%) as the residential mortgage loan portfolio experienced runoff from scheduled payments and payoffs. Despite continued relatively attractive mortgage rates in 2013, residential loan originations were limited due to the Bank’s lack of an in-house residential lending program and reliance on a third-party for residential mortgage origination services. Current year to date increases in residential home equity loans and consumer loans of $639,000 (6.4%) and $1.0 million (20.3%), respectively, resulted from a strengthening residential housing market, improving real estate values and targeted marketing efforts to expand the Bank’s retail (consumer) loan portfolio.

26

The future size of the loan portfolio is dependent upon a number of economic, competitive and regulatory factors faced by the Bank. In light of the economic and regulatory challenges currently impacting the Bank, we anticipate the possibility of continued and managed shrinkage of the loan portfolio during the remainder of 2013. Further declines in loans, restrictions on the Bank’s ability to make new loans or competition that leads to lower relative pricing on new loans could adversely impact our future operating results.

Nonperforming assets consist of loans accounted for on a nonaccrual basis, loans contractually past due 90 days or more as to interest or principal payments (but not included in nonaccrual loans), and other real estate which has been acquired through foreclosure and is actively managed through the time of disposition to minimize loss. Nonperforming loans include troubled debt restructured loans that are on nonaccrual status or past due 90 days or more. At September 30, 2013, December 31, 2012 and September 30, 2012, there were $9.4 million, $10.2 million and $12.7 million of troubled debt restructurings included in nonperforming loans. Troubled debt restructured loans (“TDRs”) that are not past due 90 days or more are excluded from nonperforming loan totals.

The aggregate amount of nonperforming loans and other nonperforming assets are presented below:

Nonperforming Loans and Assets:	September 30, 2013			December 31, 2012			September 30, 2012
	(dollars in thousands)
Nonaccrual loans	$	11,659		$	12,839		$	17,674
Loans past due 90 days and still accruing		1			201			463
Total nonperforming loans		11,660			13,040			18,137
Other real estate		690			3,427			3,002
Total nonperforming assets	$	12,350		$	16,467		$	21,139
Nonperforming loans as a percent of total loans		6.98	%		7.24	%		9.71	%
Allowance for loan losses as a percent of nonperforming loans		78.63	%		90.25	%		64.87	%
Nonperforming assets as a percent of total loans and other real estate		7.36	%		8.97	%		11.13	%

Nonaccrual loans at September 30, 2013 decreased $1.2 million (9.2%) from December 31, 2012 and $6.0 million (34.0%) from September 30, 2012. The net decrease from December 31, 2012 resulted from the combination of approximately $2.5 million of loans upgraded to accrual status based on demonstration of both improved cash flows and established payment history following the culmination of successful work-outs and/or restructurings, approximately $2.2 million of continued payments and/or payoffs, approximately $4.0 million of newly identified nonperforming loans, charge offs of $335,000 and transfer of one loan for $86,000 to other real estate owned. Management continues to focus on reducing the level of nonperforming assets and making improvements in asset quality.

As of September 30, 2013, approximately $7.4 million (63.3%) of nonperforming loans are making scheduled payments. Management closely monitors each of these loans to identify opportunities where workout efforts or restructuring may improve borrowers’ credit risk profiles to facilitate a return to accrual status for credits with sustained repayment histories. Loans categorized as 90 days past due and still accruing are well secured and in the process of collection. All nonperforming loans are reviewed regularly for collectability and uncollectible balances are promptly charged off.

Management regularly evaluates the condition of problem credits and when reduced cash flows coupled with collateral shortfalls are evident, the loans are placed on nonaccrual. In addition, loans are generally placed on nonaccrual when principal or interest is past due ninety days or more. If management believes there is significant risk of not collecting full principal and interest, we may elect to place the loan on nonaccrual even if the borrower is current. Based on the reduced velocity of newly identified problem loans and remediation plans for existing problem loans, we anticipate other real estate owned to trend lower as the Bank manages through the remaining problem loan portfolio.

Other real estate owned ("OREO") is comprised primarily of commercial real estate properties and totaled $690,000 at September 30, 2013 compared to $3.4 million at December 31, 2012. Through the third quarter of 2013, proceeds of $2.9 million were received on disposition of OREO properties resulting in net gain of $169,000. In addition, valuation write-downs totaling $94,000 were recognized to reflect fair value adjustments based on current appraisals and/or management’s determination of further impairment based on market conditions. There was one new property transferred into OREO during the second quarter of 2013. Nonperforming loans may move into OREO when the foreclosure process is initiated (i.e., as "in substance foreclosure") through the time in which the foreclosure process is completed and any redemption period expires or from the receipt of deeds in lieu of foreclosure.

Since 2007, the decline in real estate sales and valuations in southeast Michigan has significantly and adversely impacted the quality of the Corporation’s portfolio of loans secured by real estate. In addition, during this time the local economies served by the Corporation have been adversely impacted by the restructuring of the automotive market and related industries which in turn, has caused our borrowers to experience declining revenues, diminished cash flows, and reduced collateral values in their businesses. Due to these factors and the prolonged troubled economy, real estate values in general have remained distressed. Although there has been some recent stabilization in values and increased sales activity for certain real estate, because the Corporation continues to carry a relatively high concentration of loans that are secured by real estate, the Corporation continues to experience elevated levels of nonperforming loans and impaired loans relative to historical levels prior to 2007.

Although management has specific, aggressive remediation plans for a majority of the Bank’s remaining significant classified and criticized loans, execution of such plans will take some time and is, in many respects, dependent on external factors such as the borrowers’ ability to repay their obligations and/or to meet performance criteria and the value of collateral securing those obligations, which in turn depend on macro and micro economic conditions including the pace of an economic recovery in Southeast Michigan. Given the extent of the problem loans secured by real estate, these factors may delay remediation efforts and result in the Bank maintaining higher than anticipated balances of nonperforming loans that may adversely impact the level of provision for loan losses in the near future. Management continues to make oversight of these loans a priority.

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At September 30, 2013, impaired loans totaled approximately $21.8 million, of which $14.4 million were assigned a specific reserve of $2.8 million. Impaired loans without specific reserve allocations totaled $7.3 million. A loan is considered impaired when it is probable that all or part of the amounts due according to contractual terms of the loan agreement will not be collected on a timely basis or the loan has been restructured and is classified as a TDR. Impairment is measured by comparing the Bank’s recorded investment in the loan to the present value of expected future cash flows at the loan’s effective interest rate, the fair value of the collateral less costs to sell, or the loan’s observable market price.

Of the impaired loans reported at September 30, 2013, $9.5 million were on nonaccrual status, based on management’s assessment using criteria discussed above. Included in impaired loans at September 30, 2013 were $13.8 million of commercial and commercial real estate loans identified as TDRs. All cash received on nonaccrual loans is applied to principal balance. Loans are considered for return to accrual status on an individual basis when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. Interest income is recognized on TDRs pursuant to the criteria noted below.

A key component of our asset quality improvement initiative includes procedures intended to improve asset quality levels within the loan portfolio. Management develops specific workout strategies on all significant impaired loans to attempt to mitigate the extent of potential future loss by the Bank and to remediate nonperforming assets, where possible. Loan work out strategies may include the Bank’s willingness to modify the terms of a loan to improve our ability to collect amounts due. The modified terms are intended to enable customers to mitigate the risk of foreclosure by creating payment schedules that provide for continued loan payment requirements based on their current cash flow ability. Common modifications utilized by the Bank may include one of more of the following: interest rate reductions, extension of amortization periods, and forbearance of interest and/or principal payments. Management may extend concessions (modifications) to troubled borrowers in exchange for the pledge of additional collateral and/or guarantors. Loan modifications are considered TDRs when the modification includes terms outside of normal lending practices (i.e., concessions) to a borrower who is experiencing financial difficulties.

The following table summarizes the troubled debt restructuring component of impaired loans at:

	September 30, 2013						December 31, 2012
	Accruing						Accruing
	Interest		Nonaccrual		Total		Interest		Nonaccrual		Total
	(in thousands)
Current	$	13,080	$	7,737	$	20,817	$	13,087	$	8,338	$	21,425
Past due 30-89 days		-		214		214		-		163		163
Past due 90 days or more		-		1,433		1,433		201		1,718		1,919
Total troubled debt restructurings	$	13,080	$	9,384	$	22,464	$	13,288	$	10,219	$	23,507

Troubled debt restructured loans accrue interest if the borrower complies with the revised terms and conditions and has demonstrated sustained payment performance consistent with the modified terms for a minimum of six consecutive payment cycles after the restructuring date and if collection of future payments is reasonably assured.

If the economy weakens further and/or real estate values decline further, the provision for loan losses may continue to be impacted by the Bank’s concentration in real estate secured loans. While we have carefully considered these factors when determining the level of reserves, it is difficult to accurately predict future economic events, especially in the current environment.

The loan portfolio is periodically reviewed by internal and external parties and the results of these reviews are reported to the Bank’s Board of Directors. The purpose of these reviews is to verify proper loan documentation, to provide for the early identification of potential problem loans, to challenge and validate internal risk grades assigned by management, to monitor collateral values and to assist the Bank in evaluating the adequacy of the allowance for loan losses.

Allowance for Loan Losses

The allowance for loan losses at September 30, 2013 was $9.2 million compared to $11.8 million at December 31, 2012, a decrease of $2.6 million. The allowance for loan losses represented 5.49% and 6.53% of gross loans at September 30, 2013 and December 31, 2012 and provided a coverage ratio to nonperforming loans of 78.62% and 90.25% at each respective period-end.

Management estimates the required allowance balance based on past loan loss experience, the nature and volume of the portfolio segments and concentrations, information about specific borrower situations, estimated collateral values, economic conditions and trends, and other factors. Relative to conditions faced by the Bank as recently as one-year ago, combined with the successive decreasing quarterly trends experienced in the levels of existing and newly identified nonperforming loans, the gradual stabilization of real estate values securing certain problem credits, the continued shrinkage in the overall loan portfolio, and continued improvement in our rolling 12 quarter loss history, the allowance for loan loss calculation and analysis at September 30, 2013 supported our determination of the overall level of allowance and related provision expense relative to prior quarters. Management believes that it is reasonably likely that future negative provision expense may be required to reduce the overall level of the allowance based on the continuation of existing portfolio trends and the anticipated improvement in the rolling 12 quarter loss history as significant prior year charge offs exit the calculation.

Allocations of the allowance are made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Management continually analyzes portfolio risk to refine the process of effective risk identification and measurement for determination of what it believes is an adequate allowance for loan losses. When all of these factors were considered, management determined that the $2.3 million negative provision for loan losses in the first nine months of 2013 and resulting $9.2 million allowance as of September 30, 2013 were appropriate.

Given the significant portion of our loans that are secured by real estate, our portfolio continues to be sensitive to the weakened economic conditions in Southeast Michigan and the Bank’s market area, and is especially impacted by depressed real estate values. In response, each quarter our portfolio management practices continue to analyze and quantify risk within all segments of our portfolio to ensure effective problem loan identification procedures. Our practice is to obtain updated appraisals on criticized loans secured by real estate and apply appropriate discounting practices based on perceived declines in market value.

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Although updated appraisals received during more recent quarters indicated that property values for collateral on our impaired loans continue to be depressed, the appraisals did not reflect the extent of value erosion relative to that experienced in prior quarters. However, at present, the weak Michigan economy and elevated unemployment levels continue to dampen signs of economic recovery in our market area. Consequently, we have continued to allocate reserves for these risks and uncertainties, resulting in reserves above normal levels.

If the economy weakens further and/or real estate values decline further, nonperforming loans may increase in subsequent quarters. Due to the uncertainty of future economic conditions and the decline in real estate values, the provision for loan losses for 2013 may continue to be impacted by the Bank’s concentration in real estate secured loans. While we have considered these factors when determining the level of reserves, it is difficult to accurately predict the future economic events, especially in the current environment.

The allowance consists of specific and general components. The specific component relates to loans that are classified as nonaccrual or renegotiated. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan are lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience, adjusted for qualitative factors used to reflect changes in the portfolio’s collectability not captured by historical loss data.

The methodology for measuring the appropriate level of allowance and related provision for loan losses relies on several key elements, which include specific allowances for loans considered impaired, general allowances for non-impaired commercial loans based on our internal loan grading system, and general allocations based on historical trends for homogeneous loan groups with similar risk characteristics.

The general allowance allocated to non-impaired commercial loans was based on the internal risk grade of such loans and their assigned portfolio segment, as primarily determined based on underlying collateral; and, if real estate secured, the type of real estate. Each risk grade within a portfolio segment is assigned a loss allocation factor. The higher a risk grade, the greater the assigned loss allocation percentage. Accordingly, changes in the risk grades of loans affect the amount of the allowance allocation.

Our loss factors are determined based on our actual loss history by portfolio segment and loan grade and are adjusted for significant qualitative factors that, in management’s judgment, affect the collectability of the portfolio at the analysis date. We use a rolling 12 quarter net loss history as the base for our computation which is weighted to give emphasis to more recent quarters.

Groups of homogeneous noncommercial loans, such as residential real estate loans, home equity and home equity lines of credit, and consumer loans receive allowance allocations based on the loan type, primarily determined based on historical loss experience rather than by risk grade. These allocations are adjusted for consideration of general economic and business conditions, credit quality and delinquency trends, collateral values, and recent loss experience for these similar pools of loans.

Although management evaluates the adequacy of the allowance for loan losses based on information known at a given point in time, as facts and circumstances change, the provision and resulting allowance may also change. While we believe that our allowance for loan loss analysis has identified all probable losses inherent in the portfolio at September 30, 2013, there can be no assurance that all losses have been identified or that the amount of the allowance is sufficient.

Noninterest Income

Noninterest income for the three and nine months ended September 30, 2013 decreased $23,000 (3.0%) and $84,000 (3.8%), respectively, compared to the same periods in 2012. The components of noninterest income are shown in the table below:

	Three months ended September 30,				Nine months ended September 30,
	2013		2012		2013		2012
	(in thousands)
Service charges and fees on deposits	$	367	$	382	$	978	$	1,135
Other fees		320		309		920		938
Trust income		36		43		115		134
Loss on available for sale securities		-		-		-		(3)
Gain on sale of loans		-		24		-		24
Other		12		-		131		-
Total	$	735	$	758	$	2,144	$	2,228

For the three months ended September 30, 2013, service charges on deposits and other fee income decreased $4,000 compared to the same period last year. The decrease in service charges and fees on deposit accounts primarily resulted from discontinuing the recognition of overdraft and NSF fee income on customers with either nonaccrual or charged off loan relationships. Other fees increased due to higher check printing fees, consumer and residential loan fees, and network income. These increases were partially offset by lower revenues from sales of our business solutions products and services. Trust income decreased $7,000 due to continued run-off in the number of customer accounts and lower average customer account balances coupled with limited new business opportunities. Other income includes rental income from two commercial OREO properties transferred into OREO at December 31, 2012 which were subsequently sold during 2013. In the third quarter of 2012, the Bank recognized $24,000 of gain on the sale of a government guaranteed SBA loan.

For the nine months ended September 30, 2013, service charges on deposits and other fee income decreased $175,000 compared to the same period last year. Service charges and fees on deposit accounts decreased due to reduced NSF fee income as noted above. Other fees decreased due to lower foreign ATM network income and reduced check printing fees, partially offset by higher commercial and consumer loan fees. Fluctuations in trust income and other income for the nine month comparative periods of 2013 and 2012 parallel those noted above.

 

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Noninterest Expense

Noninterest expense for the three and nine months ended September 30, 2013 increased $72,000 (2.6%) and $28,000 (0.3%) compared to the same periods in 2012. The components of noninterest expense are shown in the table below:  

	Three months ended September 30,				Nine months ended September 30,
	2013		2012		2013		2012
	(in thousands)
Salaries and employee benefits	$	1,344	$	1,250	$	3,974	$	3,725
Occupancy expense		222		187		685		590
Equipment expense		88		77		255		252
Professional and service fees		433		404		1,264		1,250
Loan collection and foreclosed property expense		88		175		253		462
Computer service fees		123		109		348		334
Computer software amortization expense		11		9		29		71
FDIC assessment fees		263		257		772		760
Insurance expense		131		150		392		445
Printing and supplies		35		36		121		128
Director fees		-		21		-		61
Net gain on sale/writedown of OREO and repossessions		(29)		(23)		(75)		(4)
Other		178		163		573		489
Total	$	2,887	$	2,815	$	8,591	$	8,563

The most significant component of our noninterest expense is salaries and employee benefits. In the first nine months of 2013, the increase in salaries and employee benefits resulted primarily from additional staffing in our loan and credit departments. These hires were made to ensure the Bank has appropriate personnel with sufficient experience, training and authority to execute safe and sound banking practices with respect to asset quality. In addition, the 2013 increase includes $68,000 of retirement plan expense designated for employer contributions to the Bank’s 401(k) plan. No retirement plan expense was recognized in 2012. Partially offsetting these increases, contract payroll expense was reduced by $97,000 through September 30, 2013.

Occupancy expense increased relative to 2012 levels primarily due to colder weather, higher snow removal costs, building repairs (asphalt work and painting), security costs and higher property taxes. Equipment expense increased in 2013 due to additional depreciation expense related to new ATMs and security equipment installed in 2013, partially offset by lower equipment maintenance costs.

Professional and service fees increased from 2012 levels primarily as a result of higher third-party consulting fees paid for assistance with the Bank’s strategic and capital plans; review of the Bank’s ALLL calculation and liquidity risk management program; and, validation of assumptions utilized in the Bank’s asset/liability model. In addition, online bill pay expense increased as a result of more customers utilizing our web banking product to pay their bills than in the prior year. These increases were partially offset by reduced network fees expense, lower audit and accounting fees, and continued capitalization of certain legal fees related to the Corporation’s capital raise.

Loan collection and foreclosed property expense include collection costs related to nonperforming and delinquent loans, including costs incurred to protect the Bank’s interest in collateral securing problem loans prior to taking title to the property, appraisal expenses and carrying costs related to other real estate. Other real estate expense was elevated in 2012 due to the Bank’s possession and management (via court appointed receivership) of two hotel properties, both of which were sold by late 2012. In addition, during 2013 the Bank has experienced reduced appraisal fee due to fewer problem loans and OREO properties relative to the same periods in 2012.

FDIC assessments, while comparable to prior year expense levels, remain elevated due to the Bank’s continued troubled financial and regulatory condition.

Insurance expense is lower in 2013 compared to 2012 due to lower premiums negotiated with policy renewals in late 2012.

During the nine months ended September 30, 2013, the Bank sold nine OREO properties for a net gain of $169,000 and recorded valuation write downs/reserves on five OREO properties totaling $94,000.

Other expenses increased in the first nine months of 2013 primarily due to expanded advertising and new marketing initiatives designed to increase the Bank’s visibility in the local market. In addition, community contributions increased from 2012 levels due to the Bank’s support and sponsorship of various additional community activities and programs. Postage, education, memberships and dues, NSF checks and other losses and telephone expenses were also higher compared to the same prior year period. These were partially offset by a decrease in back office losses as (debit and ATM) fraud losses declined from the same prior year period.

Federal Income Tax Expense

We recorded no federal income tax expense on the Corporation’s pre-tax income for the three and nine months ended September 30, 2013 due to the Corporation’s tax loss carry forward position. Due to the uncertainty of generating future taxable income necessary to realize the recorded net deferred tax asset, the Corporation has recorded a valuation allowance against the tax benefit related to its cumulative pre-tax losses.

For the nine months ended September 30, 2013, federal income tax expense resulted from adjustment of the Corporation’s deferred tax valuation allowance established on previously recorded net deferred tax assets for the impact of valuation changes in the available for sale investment portfolio.

 

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Capital

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

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) required that the federal regulatory agencies adopt regulations defining five capital tiers for banks:

	Total	Tier 1
	Risk-Based	Risk-Based
	Capital Ratio	Capital Ratio	Leverage Ratio
Well capitalized	10% or above	6% or above	5% or above
Adequately capitalized	8% or above	4% or above	4% or above
Undercapitalized	Less than 8%	Less than 4%	Less than 4%
Significantly undercapitalized	Less than 6%	Less than 3%	Less than 3%
Critically undercapitalized	-	-	A ratio of tangible equity to
			total assets of 2% or less

Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and Tier 1 capital (as defined) to average assets (as defined). The Corporation’s and the Bank’s actual capital amounts and ratios are presented in the following table:

					Minimum for				To be Well Capitalized
					Capital Adequacy				Under Prompt Corrective
	Actual				Purposes				Action Provision
September 30, 2013	Amount		Ratio		Amount		Ratio		Amount		Ratio
	(dollars in thousands)
Total Capital (to risk weighted assets)
Bank	$	13,046	6.66	%	$	15,662	8.00	%	$	19,578	10.00	%
FNBH Bancorp		12,644	6.45	%		15,673	8.00	%		N/A	N/A
Tier 1 Capital (to risk weighted assets)
Bank		10,512	5.37	%		7,831	4.00	%		11,747	6.00	%
FNBH Bancorp		10,108	5.16	%		7,836	4.00	%		N/A	N/A
Tier 1 Capital (to average assets)
Bank		10,512	3.43	%		12,253	4.00	%		15,316	5.00	%
FNBH Bancorp		10,108	3.30	%		12,257	4.00	%		N/A	N/A

December 31, 2012	Amount		Ratio		Amount		Ratio		Amount		Ratio
Total Capital (to risk weighted assets)
Bank	$	10,195	5.02	%	$	16,240	8.00	%	$	20,300	10.00	%
FNBH Bancorp		9,822	4.84	%		16,240	8.00	%		N/A	N/A
Tier 1 Capital (to risk weighted assets)
Bank		7,540	3.71	%		8,120	4.00	%		12,180	6.00	%
FNBH Bancorp		7,167	3.53	%		8,120	4.00	%		N/A	N/A
Tier 1 Capital (to average assets)
Bank		7,540	2.58	%		11,686	4.00	%		14,608	5.00	%
FNBH Bancorp		7,167	2.45	%		11,686	4.00	%		N/A	N/A

The OCC has established the following minimum capital standards for national banks: a leverage requirement consisting of a minimum ratio of Tier 1 capital to total average assets of 3% for the most highly-rated banks, with minimum requirements of 4% to 5% for all others, and a risk-based capital requirement consisting of a minimum ratio of total capital to total risk-weighted assets of 8%, at least one-half of which must be Tier 1 capital. Tier 1 capital consists principally of shareholders’ equity. These capital requirements are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual institutions. Federal law provides the federal banking regulators with broad power to take prompt corrective action to resolve the problems of undercapitalized institutions.

On October 31, 2013, the Bank consented to the issuance of a new Consent Order (the "Consent Order") with the OCC to replace the Consent Order issued September 24, 2009. The new Consent Order requires the Bank to achieve and maintain total capital equal to 11% of risk weighted assets and Tier 1 capital equal to at least 8.5% of adjusted total assets by January 29, 2014. At September 30, 2013 and through the current date, the Bank’s capital ratios are and continue to be significantly below the increased minimum requirements imposed by the OCC. In light of the Bank’s deficient capital position at September 30, 2013, it is reasonable to anticipate further regulatory enforcement action by either the OCC or FDIC, particularly if the Corporation is unsuccessful in raising additional capital. In addition and as a result of noncompliance with certain terms of the former Consent Order, the Bank became categorized as "significantly undercapitalized" for Prompt Corrective Action purposes, as described in Note 2 of the 2012 Annual Report contained in the Corporation’s report on Form 10-K filing. The Prompt Corrective Action provisions impose certain restrictions on institutions that are undercapitalized. The restrictions become increasingly more severe as an institution’s capital category declines from undercapitalized to significantly undercapitalized to critically undercapitalized. 

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Please see Note 2 to the Consolidated Financial Statements included within this Quarterly Report for information on the Corporation's ongoing efforts to complete a recapitalization of the Corporation in order to restore the Bank's capital. As described in that Note 2, the ability of the Corporation to complete a recapitalization is uncertain.

The Corporation’s ability to pay dividends is subject to various regulatory and state law requirements. Due to the Bank’s financial condition, the Bank cannot pay a dividend to the Corporation without the prior approval of the OCC. The Corporation does not anticipate the Bank providing any dividends to the Corporation through at least 2043. The Corporation suspended, indefinitely, the payment of dividends to its shareholders in the third quarter of 2008 due to the Bank’s inability to pay dividends to the holding company and insufficient cash at the holding company to pay the dividends. The Corporation does not anticipate resuming dividend payments to its shareholders in the near future.

Pursuant to the results of recent examinations of the Corporation by the Federal Reserve, the Corporation is considered a troubled institution due to the critically deficient condition of its subsidiary Bank. As such, the Federal Reserve has required the Corporation to take action to support the Bank, which principally involves a capital infusion sufficient to satisfy minimum capital ratios imposed on the Bank. In addition, the Corporation must receive prior approval from the Federal Reserve before the payment of dividends, issuance of debt, or redemption of stock. Additional restrictions imposed on the Corporation by the Federal Reserve relate to changes in the composition of board members, the employment of senior executive officers or changes in the responsibilities of senior executive officers, and limitations on indemnification and severance payments.

As a result of the Bank's current inability to pay dividends to the Corporation, the Corporation has an insufficient level of resources and cash flows to meet operational liquidity needs. The Bank is prohibited from paying expenses on behalf of the Corporation. To resolve the Corporation's illiquidity and the deficient capital levels at the Corporation and the Bank, the Corporation's board of directors has provided certain interim funding to the Corporation in the form of loans to the Corporation. Depending on the extent of the future cash needs of the holding company, the timing and successful completion of the pending capital raise, and the directors' willingness and ability to continue funding holding company expenses (through loans), the Corporation may be required to attempt to borrow funds from other sources to pay its expenses. Even if available, such additional borrowings may be at a price and on terms that are unfavorable to the Corporation. The holding company incurred pre-tax expenses totaling approximately $34,000 and $98,000 for the nine month periods ended September 30, 2013 and 2012, respectively.

Regulatory Enforcement Action

 
As discussed above, the Bank has been subject to a Consent Order issued by the OCC since September 24, 2009 and has recently entered into a new Consent Order effective October 31, 2013. The new Consent Order continues to require the Bank to raise capital in order to achieve certain minimum capital ratios. See "Capital" above for more information regarding these capital requirements and the Bank's current failure to meet the capital requirements of the Consent Order.
 
In addition to the minimum capital ratios, the new Consent Order continues to impose nearly all of the former Consent Order requirements on the Bank and includes certain additional requirements that were not addressed previously, as are identified in the introductory paragraphs of this Management’s Discussion and Analysis. The Bank has taken a number of actions in an attempt to address each of the Consent Order requirements, including:

· the Board of Directors of the Bank appointed a Compliance Committee to ensure the Bank's compliance with the Consent Order and periodically report on such compliance efforts to the OCC;  

· the Bank adopted a written strategic plan that included, among other things, the specific requirements set forth in Consent Order, and the Bank has taken ongoing actions to monitor the Bank's performance relative to the strategic plan;

· the Bank has recruited and hired experienced credit department staff with sufficient training and authority to execute safe and sound banking practices to address the Bank’s asset quality issues;

· the Bank enhanced its liquidity risk management program via improved procedures for cash flow forecasting, monitoring and reporting, development of a contingency funding plan and increased its borrowing availability under lines of credit secured by certain pledged loans and investments;

· the Bank engaged an independent third-party to review and evaluate whether its internal liquidity risk management process conforms with regulatory guidance;

· the Bank has implemented numerous policies and procedures intended to improve asset quality levels within the loan portfolio, including: identifying, monitoring, and reporting of problem loans via application of a comprehensive risk grade assessment system; development of specific workout strategies on all significant impaired loans; attempted restructuring of certain problem credits to mitigate the extent of potential future loss by the Bank; and, overall improvements to underwriting policies and credit structuring practices;

· the Bank engaged an independent third-party loan review specialist to assess the Bank's ability to effectively assign appropriate risk grades and identify problem loans;

· the Bank engaged an independent third-party to validate the Bank's allowance for loan loss methodology to ensure it conforms with regulatory guidance and accounting principles generally accepted in the United States of America, including an evaluation of the key assumptions used in the loan loss analysis; 

· the Bank enhanced its policies and procedures for obtaining and reviewing appraisals on property securing loans made by the Bank;

· the Bank implemented a practice of developing a written action plan for each parcel of other real estate owned;

· the Bank has taken ongoing actions in an effort to reduce the Bank's concentration in commercial real estate (CRE) loans and construction and development (C&D) loans;

· the Bank has taken ongoing actions to improve many aspects of its credit and loan policies and programs; and

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· the Bank enhanced its program designed to maintain an adequate allowance for loan and lease losses (ALLL).

The Bank is working diligently to implement all requirements of the new Consent Order.

Critical Accounting Policies

Our accounting and reporting policies are in accordance with accounting principles generally accepted within the United States of America and conform to general practices within the banking industry. The preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near term relate to the valuation of investment securities, determination of the allowance for loan losses and accounting for income taxes, and actual results could differ from those estimates. Management has reviewed these critical accounting policies with the Audit Committee of our Board of Directors.

Contractual Obligations

The Bank had outstanding irrevocable standby letters of credit, which carry a maximum potential commitment of approximately $10,000 at September 30, 2013 and December 31, 2012, respectively. These letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The majority of these letters of credit are short-term guarantees of one year or less, although some have maturities which extend as long as two years. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Bank primarily holds real estate as collateral supporting those commitments for which collateral is deemed necessary. The extent of collateral held on those commitments at September 30, 2013 and December 31, 2012, where there is collateral, was in excess of the committed amount. A letter of credit is not recorded on the balance sheet unless a customer fails to perform.

New Accounting Standards

The FASB has issued ASU 2013-02, Comprehensive Income (Topic 220): Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. This ASU is intended to improve the reporting of reclassifications out of accumulated other comprehensive income. The ASU requires an entity to report, either on the face of the statement where net income is presented or in the notes to the financial statements, the effect of significant reclassification out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under U.S. GAAP to be reclassified in their entirety to net income. For other amounts that are not required under U.S. GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under U.S. GAAP that provide additional detail about those amounts. The amendments in the ASU apply to all entities that issue financial statements that are presented in conformity with U.S. GAAP and that report items of other comprehensive income. For public entities, the amendments in the ASU are effective prospectively for reporting periods beginning after December 15, 2012. Based on the nature and amount of the Corporation’s reported comprehensive income for the three and six months periods ended June 30, 2013 and 2012, respectively, the impact of adoption of the ASU by the Corporation was not material.

Recent Legislative Developments

In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law.  Uncertainty remains as to the ultimate impact of this law, which could have a material adverse impact either on the financial services industry as a whole or on the Corporation’s and Bank’s business, results of operations and financial condition. This federal law contains a number of provisions that could affect the Corporation and the Bank. For example, the law:

· Makes national banks (such as the Bank) and their subsidiaries subject to a number of state laws that were previously preempted by federal laws;

· Imposes additional restrictions on how mortgage brokers and loan originators may be compensated;

· Establishes a federal consumer protection agency that will have broad authority to develop and implement rules regarding most consumer financial products;

· Creates additional rules affecting corporate governance and executive compensation at all publicly traded companies (such as the Corporation);

· Broadens the base for FDIC insurance assessments and makes other changes to federal deposit insurance, including permanently increasing FDIC deposit insurance coverage to $250,000; and

· Allows depository institutions to pay interest on business checking accounts

Many of these provisions are not yet effective and are subject to implementation by various regulatory agencies. As a result, the actual impact this federal law will have on the Bank's business is not yet known. However, this law and any other changes to laws applicable to the financial industry may impact the profitability of the Bank's business activities or change certain of its business practices and may expose the Corporation and the Bank to additional costs, including increased compliance costs, and require the investment of significant management attention and resources. As a result, this law may negatively affect the business and future financial performance of the Corporation and the Bank.

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On April 5, 2012, the Jumpstart Our Business Startups Act (JOBS Act) was signed into law. The JOBS Act is intended to stimulate economic growth by helping smaller and emerging growth companies access the U.S. capital markets. It amends various provisions of, and adds new sections to, the Securities Act of 1933 and the Securities Exchange Act of 1934, as well as provisions of the Sarbanes-Oxley Act of 2002. The SEC has been directed to issue rules implementing certain JOBS Act amendments. For bank holding companies, the JOBS Act increases the statutory threshold for deregistration under the Securities Exchange Act of 1934 from 300 shareholders to 1,200 shareholders of record.

In December 2010, the Basel Committee on Banking Supervision, an international forum for cooperation on banking supervisory matters, announced the “Basel III” capital rules, which set new capital requirements for banking organizations. In July 2013, the Federal Reserve and the OCC each approved final rules that establish an integrated regulatory capital framework implementing the Basel III regulatory capital reforms in the U.S. These new rules impose higher capital requirements and more restrictive leverage and liquidity ratios than those currently in place. The new capital requirements will be phased in over time. The U.S. implementation of these standards could have an adverse impact on our financial position and future earnings due to, among other things, the increased minimum Tier 1 capital ratio requirements that will be implemented. However, the ultimate impact of these new rules on the Corporation and the Bank is still being reviewed.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

There has been no material change in the market risk faced by the Corporation since December 31, 2012. For information regarding our risk factors, refer to the FNBH Bancorp, Inc. Form 10-K for the year ended December 31, 2012.

Item 4. Controls and Procedures

(a)	Evaluation of Disclosure Controls and Procedures.
	As of the end of the period covered by this Quarterly Report on Form 10-Q, the Corporation evaluated the effectiveness of the design and operation of its “disclosure controls and procedures” as defined in Rule 13a - 15(e) and 15d – 15(e) under the Securities Exchange Act of 1934, as amended (the “Disclosure Controls”). The Disclosure Controls are designed to allow the Corporation to reach a reasonable level of assurance that information required to be disclosed by the Corporation in the reports it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time period specified in the SEC's rules and forms and that such information is accumulated and communicated to management, including its principal executive and financial officers to allow timely decisions regarding required disclosure. The evaluation of the Disclosure Controls ("Controls Evaluation") was conducted under the supervision and with the participation of the Corporation’s management, including the chief executive officer and the chief financial officer. Based upon the Controls Evaluation and subsequent discussions, the chief executive officer and chief financial officer have concluded that as of September 30, 2013, the Corporation’s Disclosure Controls were effective at a reasonable assurance level.
(b)	Changes in Internal Control Over Financial Reporting.
	During the quarter ended September 30, 2013 there were no changes in the Corporation’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
	Limitations on the Effectiveness of Controls
	The Corporation’s management, including the chief executive officer and chief financial officer, does not expect that its Disclosure Controls and/or its internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.
	Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Corporation have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

PART II - OTHER INFORMATION

Item 1A. Risk Factors

There have been no material changes to the risk factors disclosed in Item 1A. Risk Factors of the Corporation's Annual Report on Form 10-K for the year ended December 31, 2012.

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

There were no sales or repurchases of stock by the Corporation for the three months ended September 30, 2013, except as may have been previously disclosed by the Corporation in a Current Report on Form 8-K.

Item 6. Exhibits

The following exhibits (listed by number corresponding to the Exhibit Table as Item 601 in Regulation S-K) are filed with this report:

10.1	Stipulation and Consent to the Issuance of a Consent Order, dated October 31, 2013, pursuant to which First National Bank in Howell consented to the issuance of a Consent Order by the Office of the Comptroller of the Currency (incorporated by reference to Exhibit 10.1 of the Current Report on Form 8-K filed November 6, 2013).
31.1	Certificate of the Chief Executive Officer of FNBH Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certificate of the Chief Financial Officer of FNBH Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certificate of the Chief Executive Officer of FNBH Bancorp, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).

32.2 Certificate of the Chief Financial Officer of FNBH Bancorp, Inc. pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Quarterly Report on Form 10-Q for the quarter ended September 30, 2013 to be signed on its behalf by the undersigned hereunto duly authorized.

FNBH BANCORP, INC.

/s/Ronald L. Long

Ronald L. Long

President and Chief Executive Officer

/s/Mark J. Huber

Mark J. Huber

Chief Financial Officer

Date: November 14, 2013

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