EXHIBIT 13
Mackinac
Financial
Corporation
2004
Annual
Report
TABLE OF CONTENTS
To Our Shareholders................................................ 1
Selected Financial Highlights...................................... 3
Five-Year Comparisons.............................................. 5
Report of Independent Registered Public Accounting Firm............ 7
Consolidated Balance Sheets........................................ 9
Consolidated Statements of Operations.............................. 10
Consolidated Statements of Changes in Shareholders' Equity......... 11
Consolidated Statements of Cash Flows.............................. 12
Notes to Consolidated Financial Statements......................... 14
Selected Financial Data............................................ 45
Summary Quarterly Financial Information............................ 46
Market Information................................................. 47
Forward-Looking Statements......................................... 48
Management's Discussion and Analysis of Financial Condition and
Results of Operations........................................... 49
General Information ............................................... 72
Branch Locations .................................................. 73
TO OUR SHAREHOLDERS
[MACKINAC FINANCIAL LOGO]
March 28, 2005
Dear Shareholders:
2004 was a year of great change for Mackinac Financial Corporation. The year
began with a new and dedicated turn-around management team, led by Jim Bess,
coping with a troubled loan portfolio, and a bank that had to shrink to survive.
Jim and his able team, collected, sold or wrote off the vast majority of the
troubled assets. They also took the necessary steps to shrink the bank to
preserve liquidity and offer a chance at survival. Their efforts were rewarded
in December when a new group of investors purchased $30 million of Mackinac
Financial Corporation common stock. The proceeds from this offering were used to
redeem holding company subordinated debentures and to re-capitalize North
Country Bank. In December, Eliot Stark and I led the recapitalization effort and
joined the holding company as CFO and CEO respectively. Our immediate vision is
to rebuild the community banking franchise in Northern Michigan and diversify
the loan portfolio by building a commercial banking presence in Southeastern
Michigan.
For the year of 2004, the financial results reflect the events referenced above.
The company is much smaller with $339 million in total assets, down from $423
million last year. Deposits are also reduced from $306 million to $216 million
and branch locations have been reduced from 22 to 12. You will also note the
improved capital position with shareholders equity of $35 million, up from
approximately $11 million last year.
Net interest income dropped from $9.6 million to $8.2 million with the net loss
before taxes decreasing from $7.3 million to $1.4 million. On a fully diluted
per share basis, the net loss dropped from $27.32 to $3.23. Our results in 2004
benefited from the redemption of our subordinated debentures at a significant
discount.
1
We should note that the first quarter of 2005 will reflect a significant loss
due to the prepayment of high fixed-rate long-term Federal Home Loan Bank
advances. The prepayment penalty associated with this $48.6 million debt
retirement amounted to $4.3 million.
So why are we excited about our prospects? We believe the highlights that follow
also reflect the positive developments last year. First and foremost the loan
portfolio has been substantially improved. Non-performing assets dropped from
$50.4 million a year ago to $6.0 million and fell as a percentage of total
assets from 11.94% to 1.78%. We believe that we are adequately reserved for our
current loan portfolio.
Additionally, we are starting to see improvement in our net interest margin as
we remove the high fixed rate advances and the negative impact on earnings
attributed to problem loans and other real estate owned.
Most importantly, we have a great team and one that is growing. We have added a
very talented and experienced commercial lender in Oakland County and already
have developed a significant backlog of good loan prospects. Additionally, we
recently hired three commercial lenders, two credit analysts, and soon will be
adding additional mortgage lenders. We are also poised to launch a new identity
and a branding and marketing campaign to help us recapture lost market share in
Northern Michigan. We will be revising our product line up to make us
competitive as deposit gatherers and with our consumer loan products.
Our plan is simple and that is to return to our roots as a customer responsive
community bank that makes good loans. We believe that we can compete very
effectively in all of our markets using "big bank" lending skills and delivering
our products through first class community bankers.
We hope to achieve profitability on a consistent basis about mid-year 2005, as
we execute our plan.
We thank our investors for their loyalty and we promise to work hard and
efficiently so that we can deliver solid profits and enhance shareholder value.
Sincerely,
MACKINAC FINANCIAL CORPORATION
/s/ Paul D. Tobias
Paul D. Tobias
Chairman and Chief Executive Officer
2
SELECTED FINANCIAL HIGHLIGHTS
(Dollars in thousands, except per share data)
For The Year December 31,
2004 2003
----------- -----------
SELECTED FINANCIAL CONDITION DATA (AT END OF PERIOD):
Total assets $ 339,497 $ 422,539
Total loans 203,832 297,846
Total deposits 215,650 305,794
Borrowings and subordinated debentures 85,039 99,476
Total shareholders' equity 34,730 10,700
SELECTED STATEMENTS OF INCOME DATA:
Net interest income $ 8,238 $ 9,626
Loss before taxes (1,448) (7,259)
Net loss (1,595) (9,588)
Loss per common share - Basic (3.23) (27.32)
Loss per common share - Diluted (3.23) (27.32)
SELECTED FINANCIAL RATIOS AND OTHER DATA:
PERFORMANCE RATIOS:
Net interest margin 2.57% 2.25%
Efficiency ratio 103.05 150.82
Return on average assets (.44) (1.96)
Return on average equity (18.64) (59.15)
Average total assets $ 365,024 $ 489,184
Average total shareholders' equity $ 8,555 $ 16,210
Average loans to average deposits ratio 97.40% 99.30%
COMMON SHARE DATA (AT END OF PERIOD):
Market price per common share $ 17.97 $ 35.20
Book value per common share $ 10.13 $ 30.40
Common shares outstanding 3,428,695 350,958
OTHER DATA (AT END OF PERIOD):
Allowance for loan losses $ 6,966 $ 22,005
Non-performing assets $ 6,037 $ 50,438
Allowance for loan losses to total loans 3.42% 7.39%
Non-performing assets to total assets 1.78% 11.94%
Number of:
Branch locations 12 22
The above summary should be read in connection with the related consolidated
financial statements and notes included elsewhere in this report.
3
BUSINESS OF THE CORPORATION
North Country Financial Corporation is a registered bank holding company formed
under the Bank Holding Company Act of 1956, as amended. The principal assets of
the Corporation are its ownership of all of the outstanding capital stock of
North Country Bank and Trust, North Country Financial Group, North Country
Capital Trust, First Rural Relending Company, and First Manistique Agency. North
Country Bank and Trust, headquartered in Manistique, Michigan, provides a full
range of commercial and retail banking services to customers in Michigan. North
Country Bank and Trust owns North Country Mortgage Company LLC, North Country
Employee Leasing Company LLC, and NCB Real Estate Company. North Country
Mortgage Company LLC is engaged in the business of mortgage lending and
brokering. North Country Employee Leasing Company LLC provides employees to
North Country Bank and Trust. NCB Real Estate Company owns several properties
used by the Bank. North Country Financial Group is an inactive subsidiary. North
Country Capital Trust was formed solely for the issuance of trust preferred
securities. First Rural Relending Company is a rural lending corporation. First
Manistique Agency has limited activity and was formed for the selling of
insurance.
FORM 10-K
A COPY OF THE ANNUAL REPORT TO THE SECURITIES AND EXCHANGE COMMISSION ON FORM
10-K IS AVAILABLE WITHOUT CHARGE BY WRITING THE SHAREHOLDERS' RELATIONS
DEPARTMENT, NORTH COUNTRY FINANCIAL CORPORATION, 130 SOUTH CEDAR STREET,
MANISTIQUE, MICHIGAN, 49854.
MARKET SUMMARY
The Corporation's common stock is traded on the Nasdaq Small Cap Market under
the symbol MFNC. The Corporation had 1,858 shareholders of record as of March
28, 2005.
4
FIVE-YEAR COMPARISONS
ASSETS
Total assets on a consolidated basis decreased by 19.7% during 2004 to $ 339.5
million.
ASSETS
(Dollars in Million)
[BAR CHART]
2000 667.0
2001 636.6
2002 565.3
2003 422.5
2004 339.5
SECURITIES
The portfolio of securities decreased during 2004 by 32.7% to $57.1 million.
SECURITIES
(Dollars in Millions)
[BAR CHART]
2000 72.1
2001 61.9
2002 68.0
2003 84.8
2004 57.1
LOANS
Total loans decreased 31.6% to $203.8 million in 2004.
LOANS
(Dollars in Millions)
[BAR CHART]
2000 541.7
2001 504.4
2002 435.0
2003 297.8
2004 203.8
5
FIVE-YEAR COMPARISONS (CONTINUED)
DEPOSITS
Total deposits decreased by 29.5% to $215.7 million.
DEPOSITS
(Dollars in Millions)
[BAR CHART]
2000 531.9
2001 482.5
2002 437.5
2003 305.8
2004 215.7
SHAREHOLDERS' EQUITY
During 2004, shareholders' equity increased $24.0 million, or 224.6%, to $34.7
million.
SHAREHOLDERS' EQUITY
(Dollars in Millions)
[BAR CHART]
2000 44.6
2001 47.9
2002 20.5
2003 10.7
2004 34.7
NET INCOME (LOSS)
The net loss for 2004 was $1.6 million as compared to $9.6 million for 2003.
NET INCOME (LOSS)
(Dollars in Millions)
[BAR CHART]
2000 5.2
2001 5.8
2002 -26.7
2003 -9.6
2004 -1.6
6
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
=================================================
REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM
TO THE SHAREHOLDERS OF
MACKINAC FINANCIAL CORPORATION
MANISTIQUE, MICHIGAN
=================================================
7
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
PLANTE & MORAN, PLLC
Bridgewater place
suite 600
333 Bridge St. N. W.
[PLANTE MORAN LOGO] Grand Rapids, MI 49504
Tel: 616.774.8221
Fax: 616.774.0702
plantemoran.com
Board of Directors and Shareholders
Mackinac Financial Corporation
Manistique, Michigan
We have audited the accompanying consolidated balance sheet of Mackinac
Financial Corporation and Subsidiaries as of December 31, 2004 and 2003, and the
related consolidated statements of operations and changes in stockholders'
equity and cash flows for the three years then ended. These consolidated
financial statements are the responsibility of the Corporation's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Mackinac Financial Corporation
and Subsidiaries as of December 31, 2004 and 2003, and the results of its
operations and its cash flows for the three years then ended, in conformity with
accounting principles generally accepted in the United States of America.
/s/ PLANTE, MORAN, PLLC
Grand Rapids, Michigan
March 18, 2005
8
CONSOLIDATED BALANCE SHEETS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
December 31, 2004 and 2003
(Dollars in Thousands)
2004 2003
--------- ----------
ASSETS
Cash and due from banks $ 4,230 $ 7,433
Federal funds sold 39,848 15,600
--------- ---------
Cash and cash equivalents 44,078 23,033
Interest-bearing deposits in other financial institutions 18,535 6,048
Securities available for sale 57,075 84,774
Federal Home Loan Bank stock 4,754 4,544
Total loans 203,832 297,846
Allowance for loan losses (6,966) (22,005)
--------- ---------
Net loans 196,866 275,841
Premises and equipment 10,739 13,747
Other real estate held for sale 1,730 4,356
Other assets 5,720 10,196
--------- ---------
TOTAL ASSETS $ 339,497 $ 422,539
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Non-interest-bearing deposits $ 20,956 $ 26,179
Interest-bearing deposits 194,694 279,615
--------- ---------
Total deposits 215,650 305,794
Borrowings 85,039 87,026
Subordinated debentures -0- 12,450
Other liabilities 4,078 6,569
--------- ---------
Total liabilities 304,767 411,839
Shareholders' equity:
Preferred stock - No par value:
Authorized 500,000 shares, no shares outstanding -0- -0-
Common stock and additional paid in capital - No par value
Authorized - 18,000,000 shares
Issued and outstanding - 3,428,695 and 350,958, respectively 42,335 16,175
Retained earnings (Accumulated deficit) (8,097) (6,502)
Accumulated other comprehensive income 492 1,027
--------- ---------
Total shareholders' equity 34,730 10,700
--------- ---------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 339,497 $ 422,539
========= =========
See accompanying notes to consolidated financial statements.
9
CONSOLIDATED STATEMENTS OF OPERATIONS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
Years Ended December 31, 2004, 2003, and 2002
(Dollars in Thousands, Except Per Share Data)
2004 2003 2002
-------- -------- ---------
Interest income:
Interest and fees on loans:
Taxable $ 14,517 $ 18,999 $ 29,615
Tax-exempt 1,180 1,534 2,256
Interest on securities:
Taxable 2,401 2,277 3,360
Tax-exempt 171 230 266
Other interest income 584 601 472
-------- -------- --------
Total interest income 18,853 23,641 35,969
-------- -------- --------
Interest expense:
Deposits 5,443 8,695 12,444
Borrowings 4,730 4,832 5,100
Subordinated debentures 442 488 545
-------- -------- --------
Total interest expense 10,615 14,015 18,089
-------- -------- --------
Net interest income 8,238 9,626 17,880
Provision for loan losses -0- -0- 26,658
-------- -------- --------
Net interest income after provision for loan losses 8,238 9,626 (8,778)
-------- -------- --------
Other income:
Service fees 982 1,529 1,899
Loan and lease fees 17 58 1,095
Net security gains -0- 427 746
Net gains on sale of loans 39 136 506
Gain on sale of branches 205 -0- 464
Gain on settlement of subordinated debentures 6,617 -0- -0-
Other 682 1,081 548
-------- -------- --------
Total other income 8,542 3,231 5,258
-------- -------- --------
Other expenses:
Salaries and employee benefits 8,032 5,973 7,589
Furniture and equipment 887 1,367 1,437
Occupancy 994 1,387 1,629
Data processing 1,220 1,517 1,894
Accounting, legal, and consulting fees 1,836 3,145 1,800
Loan and deposit 1,718 1,992 1,111
Telephone 382 1,382 1,305
Impairment loss on intangibles -0- 60 3,647
Impairment loss on other real estate held for sale 265 400 2,418
Loss on sale of premises, equipment, and other real estate
held for sale 459 362 648
Advertising 115 182 545
Amortization of acquisition intangibles 308 460 420
Other 2,012 1,889 2,620
-------- -------- --------
Total other expenses 18,228 20,116 27,063
-------- -------- --------
Loss before provision (credit) for income taxes (1,448) (7,259) (30,583)
Provision (credit) for income taxes 147 2,329 (3,870)
-------- -------- --------
Net loss $ (1,595) $ (9,588) $(26,713)
======== ======== ========
Loss per common share:
Basic $ (3.23) $ (27.32) $ (76.11)
======== ======== ========
Diluted $ (3.23) $ (27.32) $ (76.11)
======== ======== ========
See accompanying notes to consolidated financial statements.
10
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
Years Ended December 31, 2004, 2003, and 2002
(Dollars in Thousands, Except per Share Data)
Retained Accumulated
Shares of Common Stock Earnings Other
Common and Additional (Accumulated Comprehensive
Stock Paid in Capital Deficit) Income (Loss) Total
--------- --------------- ------------ -------------- ---------
BALANCE, DECEMBER 31, 2001 350,958 $ 16,175 $ 31,554 $ 160 $ 47,889
Net loss (26,713) (26,713)
Other comprehensive loss:
Net unrealized gain on
securities available for
sale 1,082 1,082
--------
Total comprehensive income (25,631)
Dividends declared ($5.00
per share) (1,755) (1,755)
--------- -------------- ----------- ------------- --------
BALANCE, DECEMBER 31, 2002 350,958 16,175 3,086 1,242 20,503
Net loss (9,588) (9,588)
Other comprehensive loss:
Net unrealized loss on
securities available for
sale (215) (215)
--------- -------------- ----------- ------------- --------
Total comprehensive loss (9,803)
BALANCE, DECEMBER 31, 2003 350,958 16,175 (6,502) 1,027 10,700
Additional shares issued as a
result of 1:20 reverse stock split 817
Common stock issuance 3,076,920 26,160 -0- -0- 26,160
Net loss (1,595) (1,595)
Other comprehensive loss:
Net unrealized loss on
securities available for
sale (535) (535)
--------- -------------- ----------- ------------- --------
Total comprehensive loss (2,130)
BALANCE, DECEMBER 31, 2004 3,428,695 $ 42,335 $ (8,097) $ 492 $ 34,730
========= ============== =========== ============= ========
See accompanying notes to consolidated financial statements.
11
CONSOLIDATED STATEMENTS OF CASH FLOWS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
Years Ended December 31, 2004, 2003, and 2002
(Dollars in Thousands)
2004 2003 2002
-------- --------- ----------
Increase (decrease) in cash and cash equivalents:
Cash flows from operating activities:
Net (loss) $ (1,595) $ (9,588) $ (26,713)
-------- --------- ---------
Adjustments to reconcile net (loss) to
net cash provided by operating activities:
Provision for loan losses -0- -0- 26,658
Provision for impairment of intangible assets -0- 60 3,647
Provision for impairment of other real estate
held for sale 265 400 2,418
Provision for impairment of bank premises
and equipment -0- 669 -0-
Provision for depreciation and net
amortization 1,580 2,546 2,424
Provision (credit) for deferred taxes 147 (543) (6,580)
FHLB stock dividend (210) (169) -0-
Net (gains) losses on sales of:
Securities -0- (427) (746)
Premises, equipment, and other real estate
held for sale 459 356 648
Branches (205) -0- (464)
Change in other assets 4,021 6,881 2,291
Change in other liabilities (2,491) (475) 1,850
-------- --------- ---------
Total adjustments 3,566 9,298 32,146
-------- --------- ---------
Net cash provided by (used in) operating activities 1,971 (290) 5,433
-------- --------- ---------
Cash flows from investing activities:
Net (increase) decrease in interest-bearing
deposits in other financial institutions (12,487) (4,038) (492)
Payment for purchases of securities available for sale (21,910) (70,680) (110,582)
Proceeds from sale of securities available for sale -0- 36,601 95,245
Proceeds from calls and maturities of securities
available for sale 48,840 15,928 11,234
Net decrease in loans 74,265 129,589 52,470
Proceeds from sale of premises, equipment,
and other real estate held for sale 8,732 4,620 1,912
Capital expenditures (150) -0- (878)
Net cash paid for branch sales (25,018) -0- (6,437)
-------- --------- ---------
Net cash provided by investing activities 72,272 112,020 42,472
-------- --------- ---------
See accompanying notes to consolidated financial statements.
12
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
Years Ended December 31, 2004, 2003, and 2002
(Dollars in Thousands)
2004 2003 2002
-------- ---------- ---------
Cash flows from financing activities:
Net decrease in deposits $(64,921) $ (131,700) $(37,487)
Proceeds from borrowings 125 -0- -0-
Principal payments on borrowings (14,562) (789) (734)
Proceeds from issuance of common stock 26,160 -0- -0-
Dividends paid -0- (-0-) (1,755)
-------- ---------- --------
Net cash used in financing activities (53,198) (132,489) (39,976)
-------- ---------- --------
Net increase (decrease) in cash and cash
equivalents 21,045 (20,759) 7,929
Cash and cash equivalents at beginning 23,033 43,792 35,863
-------- ---------- --------
Cash and cash equivalents at end $ 44,078 $ 23,033 $ 43,792
======== ========== ========
Supplemental cash flow information:
Cash paid during the year for:
Interest $ 8,405 $ 14,456 $ 17,943
Income taxes paid or (refunded) -0- (2,137) 292
Noncash investing and financing activities:
Transfer of foreclosures from loans to
other real estate held for sale 4,762 4,340 4,705
Transfer of property from premises and equipment to
other real estate held for sale -0- -0- 1,226
Lease receivable recorded in sale/leaseback transaction -0- -0- 154
Assets and liabilities divested in branch sales:
Loans 11 -0- 4
Premises and equipment 1,442 -0-
Deposits 26,471 -0- 7,547
Other liabilities -0- -0- 23
See accompanying notes to consolidated financial statements.
13
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting policies of Mackinac Financial Corporation (the "Corporation")
and Subsidiaries conform to accounting principles generally accepted in the
United States and prevailing practices within the banking industry. Significant
accounting policies are summarized below.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Corporation
and its wholly owned subsidiaries, North Country Bank and Trust (the "Bank"),
North Country Financial Group and other minor subsidiaries, after elimination of
intercompany transactions and accounts.
CAPITAL
On December 15, 2004, the Corporation consummated a recapitalization through the
issuance of $30 million of common stock in a private placement. The net proceeds
of this offering amounted to $26.2 million. This recapitalization provided the
funding to enable the Corporation to recapitalize the Bank with a $15.5 million
capital infusion. This capital infusion provided the Bank with enough capital to
be deemed a "well capitalized" institution by regulatory standards. The
Corporation used $6.5 million of the proceeds to settle the $12,450,000
liability of the subordinated debentures. The settlement of this liability also
included the accrued interest of approximately $1.2 million. The Corporation
recognized a gain from the settlement of the subordinated debentures of $6.6
million.
NATURE OF OPERATIONS
The Corporation's and the Bank's revenues and assets are derived primarily from
banking activities. The Bank's primary market area is the upper peninsula and
the northern portion of the lower peninsula of Michigan. The Bank provides to
its customers commercial, real estate, agricultural, and consumer loans, as well
as a variety of traditional deposit products. A significant portion,
approximately 15%, of the Bank's commercial loan portfolio consists of leases to
commercial and governmental entities, which are secured by various types of
equipment. These leases are dispersed geographically throughout the country.
Approximately 1% of the Corporation's business activity is with Canadian
customers and denominated in Canadian dollars.
While the Corporation's chief decision makers monitor the revenue streams of the
various Corporation products and services, operations are managed and financial
performance is evaluated on a Corporation-wide basis. Accordingly, all of the
Corporation's banking operations are considered by management to be aggregated
in one reportable operating segment.
USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenue and expenses during the period.
Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change in
the near term relate to the determination of the allowance for loan losses, and
the valuation of foreclosed real estate, deferred tax assets, and impairment of
intangible assets.
CASH AND CASH EQUIVALENTS
For purposes of reporting cash flows, cash and cash equivalents include cash on
hand, non-interest-bearing deposits in correspondent banks, and federal funds
sold. Generally, federal funds are purchased and sold for one-day periods.
14
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
SECURITIES
The Corporation's securities are classified and accounted for as securities
available for sale. These securities are stated at fair value. Premiums and
discounts are recognized in interest income using the interest method over the
period to maturity. Unrealized holding gains and losses on securities available
for sale are reported as accumulated other comprehensive income within
shareholders' equity until realized. When it is determined that securities or
other investments are impaired and the impairment is other than temporary, an
impairment loss is recognized in earnings and a new basis in the affected
security is established. Gains and losses on the sale of securities are recorded
on the trade date and determined using the specific-identification method.
FEDERAL HOME LOAN BANK STOCK
As a member of the Federal Home Loan Bank (FHLB) system, the Bank is required to
hold stock in the FHLB based on the anticipated level of borrowings to be
advanced. This stock is recorded at cost, which approximates fair value.
Transfer of the stock is substantially restricted.
INTEREST INCOME AND FEES ON LOANS
Interest on loans is accrued and credited to income based on the principal
amount outstanding. The accrual of interest on loans is discontinued when, in
the opinion of management, there is an indication that the borrower may be
unable to meet payments as they become due. Upon such discontinuance, all unpaid
accrued interest is reversed. Loans are returned to accrual status when all
principal and interest amounts contractually due are brought current and future
payments are reasonably assured. Interest income on impaired and nonaccrual
loans is recorded on the cash basis. Loan-origination fees are credited to
income when received and the related loan-origination costs are expensed as
incurred. Management has determined that the deferral of loan fees and costs
would not be material.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses includes specific allowances related to commercial
loans, which have been judged to be impaired. A loan is impaired when, based on
current information, it is probable that the Corporation will not collect all
amounts due in accordance with the contractual terms of the loan agreement.
These specific allowances are based on discounted cash flows of expected future
payments using the loan's initial effective interest rate or the fair value of
the collateral if the loan is collateral dependent.
The Corporation continues to maintain a general allowance for loan losses for
loans not considered impaired. The allowance for loan losses is maintained at a
level which management believes is adequate to provide for possible loan losses.
Management periodically evaluates the adequacy of the allowance using the
Corporation's past loan loss experience, known and inherent risks in the
portfolio, composition of the portfolio, current economic conditions, and other
factors. The allowance does not include the effects of expected losses related
to future events or future changes in economic conditions. This evaluation is
inherently subjective since it requires material estimates that may be
susceptible to significant change. Loans are charged against the allowance for
loan losses when management believes the collectability of the principal is
unlikely. In addition, various regulatory agencies periodically review the
allowance for loan losses. These agencies may require additions to the allowance
for loan losses based on their judgments of collectability.
In management's opinion, the allowance for loan losses is adequate to cover
probable losses relating to specifically identified loans, as well as probable
losses inherent in the balance of the loan portfolio as of the balance sheet
date.
15
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
OTHER REAL ESTATE HELD FOR SALE
Other real estate held for sale consists of assets acquired through, or in lieu
of, foreclosure and other long-lived assets to be disposed of by sale, whether
previously held and used or newly acquired. Other real estate held for sale is
initially recorded at the lower of cost or fair value, less costs to sell,
establishing a new cost basis. Valuations are periodically performed by
management, and the assets' carrying value is adjusted to the lower of cost
basis or fair value less costs to sell. Impairment losses are recognized for any
initial or subsequent write-downs. Net revenue and expenses from operations of
other real estate held for sale is included in other expense.
PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated depreciation.
Maintenance and repair costs are charged to expense as incurred. Gains or losses
on disposition of premises and equipment are reflected in income. Depreciation
is computed on the straight-line method over the estimated useful lives of the
assets.
INTANGIBLE ASSETS AND GOODWILL
Intangible assets attributable to the value of core deposits and the excess of
purchase price over fair value of net assets (goodwill) acquired are stated at
cost less accumulated amortization. The core deposit premium is amortized on a
straight-line basis over a period of ten years and is subject to an annual
impairment test based on the change in deposit base. Prior to 2002, goodwill was
being amortized over a period of 15 years. During 2002 goodwill, (Note 10) was
written off in its entirety.
The Corporation reviews intangible assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. The evaluation includes assessing the estimated fair value of
the intangible asset based on market prices for similar assets, where available,
and the present value of the estimated future cash flows associated with the
intangible asset. Adjustments are recorded if it is determined that the benefit
of the intangible asset has decreased.
EARNINGS PER COMMON SHARE
Basic earnings per common share is net income divided by the weighted average
number of common shares outstanding during the period. Diluted earnings per
common share includes the dilutive effect of additional potential common shares
issuable under stock option agreements.
STOCK OPTION PLANS
The Corporation sponsors three stock option plans. One plan was approved during
2000 and applies to officers, employees, and nonemployee directors. This plan
was amended as a part of the recently completed stock offering and
recapitalization. The amendment, approved by shareholders, increased the shares
available under this plan by 428,587 shares from the original 25,000 (adjusted
for the 1:20 split), to a total authorized share balance of 453,587. The other
two plans, one for officers and employees and the other for nonemployee
directors, were approved in 1997. A total of 30,000 (adjusted for the 1:20
split), were made available for grant under these plans. Options under all of
the plans are granted at the discretion of a committee of the Corporation's
Board of Directors. Options to purchase shares of the Corporation's stock are
granted at a price equal to the market price of the stock at the date of grant.
The committee determines the vesting of the options when they are granted as
established under the plan.
16
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The fair value of each option granted is estimated on the grant date using the
Black-Scholes methodology. The following assumptions were made in estimating
fair value for options granted for the years ended December 31, 2004 and 2003.
There were no options granted in 2002.
2004 2003 2002
---- ---- ----
Dividend yield 0.00% 0.00% N/A
Risk-free interest rate 3.25% 1.25%
Weighted average expected life (years) 4.0 7.0
Expected volatility 30.00% 29.85%
The weighted average fair value of options granted as of their grant date, using
the assumptions shown above, was computed at $2.80 per share for options granted
in 2004 and $.72 per share in 2003. Options granted in 2003 were forfeited as a
result of the grantee's resignation.
The Corporation accounts for stock options using the intrinsic value method. For
all options granted, the intrinsic value was zero; therefore, no compensation
cost has been recognized for the plans. Had compensation cost been determined on
the basis of fair value, net income and earnings per share would have been
reduced for the years ended December 31 (dollars in thousands, except per share
data) as follows:
2004 2003 2002
----------- ----------- -----------
Net (loss):
As reported $ (1,595) $ (9,588) $ (26,713)
Total stock-based compensation expense
determined under fair value-based method (6) (36) (94)
----------- ----------- -----------
Pro forma $ (1,601) $ (9,624) $ (26,807)
=========== =========== ===========
(Loss) per share - Basic:
As reported $ (3.23) $ (27.32) $ (76.11)
=========== =========== ===========
Pro forma $ (3.24) $ (27.42) $ (76.40)
=========== =========== ===========
(Loss) per share - Diluted:
As reported $ (3.23) $ (27.32) $ (76.11)
=========== =========== ===========
Pro forma $ (3.26) $ (27.42) $ (76.38)
=========== =========== ===========
Weighted average shares outstanding $ 494,305 $ 350,958 $ 350,958
=========== =========== ===========
COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) consists of net income (loss) and other
comprehensive income (loss). Other comprehensive income (loss) includes
unrealized gains and losses on securities available for sale, which are
recognized as a separate component of equity and accumulated other comprehensive
income (loss).
17
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Earnings (loss) per share are based upon the weighted average number of shares
outstanding. The following shows the computation of basic and diluted earnings
(loss) per share for the years ended December 31 (dollars in thousands, except
per share data):
Weighted
Average Earnings
Net Number of (Loss)
Income (Loss) Shares per Share
------------- --------- -----------
2004
Earnings per share - Basic and diluted $ (1,595) 494,305 $ (3.23)
============ ======= ==========
2003
Loss per share - Basic and diluted $ (9,588) 350,958 $ (27.32)
============ ======= ==========
2002
Earnings per share - Basic and diluted $ (26,713) 350,958 $ (76.11)
============ ======= ==========
In the above disclosure the dilutive effect of additional shares outstanding, as
a result of stock options exercisable, was not taken into account since
additional shares outstanding have an antidilutive effect on loss calculated per
share.
INCOME TAXES
Deferred income taxes have been provided under the liability method. Deferred
tax assets and liabilities are determined based upon the difference between the
financial statement and tax bases of assets and liabilities as measured by the
enacted tax rates which will be in effect when these differences are expected to
reverse. Deferred tax expense (credit) is the result of changes in the deferred
tax asset and liability. A valuation allowance is provided against deferred tax
assets when it is more likely than not that some or all of the deferred asset
will not be realized.
OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS
In the ordinary course of business, the Corporation has entered into
off-balance-sheet financial instruments consisting of commitments to extend
credit, commitments under credit card arrangements, commercial letters of
credit, and standby letters of credit.
In November 2002, FASB issued FASB Interpretation No. 45 ("FIN 45"),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others." FIN 45 elaborates on the
existing disclosure requirements for most guarantees, including loan guarantees
such as standby letters of credit and indemnifications. It also clarifies that
at the time a company issues a guarantee, the company must recognize an initial
liability for the fair or market value of the obligations it assumes under that
guarantee and must disclose that information in its interim and annual financial
statements. The provisions related to recognizing a liability at inception of
the guarantee for the fair value of the guarantor's obligations would not apply
to guarantees accounted for as derivatives. The initial recognition and
measurement provisions apply on a prospective basis to guarantees issued or
modified after December 31, 2002. Adoption of this interpretation did not have a
material effect on the Corporation's financial statements. See Note 22 for the
disclosures currently required under FIN 45.
RECLASSIFICATIONS
Certain amounts in the 2003 and 2002 consolidated financial statements have been
reclassified to conform to the 2004 presentation.
18
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 2 - RECENT ACCOUNTING PRONOUNCEMENTS
SFAS No. 142 supersedes APB Opinion No. 17, "Intangible Assets." SFAS No. 142
addresses how intangible assets acquired outside of a business combination
should be initially recognized. SFAS No. 142 eliminates the amortization for
goodwill and other intangible assets with indefinite lives. Other intangible
assets with a finite life will be amortized over their useful life. Goodwill and
other intangible assets with indefinite useful lives shall be tested for
impairment annually or more frequently if events or changes in circumstances
indicate that the asset may be impaired. The effect of the adoption of SFAS No.
142 and SFAS No. 147 is detailed in Note 10.
SFAS No 149 - In April 2003, the FASB issued SFAS No. 149, "Amendment of
Statement 133 on `Derivative Instruments and Hedging Activities.' This Statement
amends and clarifies financial accounting and reporting for derivative
instruments, including certain embedded derivatives, and for hedging activities
under SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities." This Statement amends SFAS No. 133 to reflect the decisions made as
part of the Derivatives Implementation Group (DIG) and in other FASB projects or
deliberations. SFAS No. 149 is effective for contracts entered into or modified
after June 30, 2003, and for hedging relationships designated after June 30,
2003. Adoption of this Standard did not have a material effect on the
Corporation's financial statements.
SFAS No. 150 - In May 2003, the FASB issued SFAS No. 150, "Accounting for
Certain Financial Instruments with Characteristics of Both Liabilities and
Equity". This Statement establishes standards for how an entity classifies and
measures certain financial instruments with characteristics of both liabilities
and equity. This Statement is effective for financial instruments entered into
or modified after May 31, 2003. Adoption of this Standard had no financial
statement impact to the Corporation.
FIN 46 - In January 2003, the FASB issued Interpretation No. 46 (FIN 46),
"Consolidation of Variable Interest Entities". This Interpretation clarifies the
application of ARB No. 51, "Consolidated Financial Statements", for certain
entities in which equity investors do not have the characteristics of a
controlling financial interest or do not have sufficient equity at risk for the
entity to finance its activities without additional subordinated support from
other parties. The Corporation early adopted the provisions of FIN 46 related to
the consolidation of one wholly-owned finance entity involved in the issuance of
trust preferred securities. Effective July 1, 2003, the Corporation
de-consolidated the wholly-owned issuing trust entity. The result of the
de-consolidation had no impact to the financial statements of the Corporation.
SFAS No. 123 R - In December 2004, the FASB re-issued SFAS No. 123 "Accounting
for Stock-Based Compensation" which becomes effective for interim periods
beginning after June 15, 2005. This Statement supersedes APB Opinion No. 25
"Accounting for Stock Issued to Employees" and its related implementation
guidance. Under Opinion No. 25, issuing stock options to employees generally
resulted in recognition of no compensation cost. This Statement requires
entities to recognize the cost of employee services received in exchange for
these stock options. This Statement applies to all unvested awards outstanding
as of the effective date. The Corporation plans to adopt SFAS No. 123 for the
period beginning after June 15, 2005 and does not expect a material impact on
the Corporation's Consolidated Financial Statements.
NOTE 3 - ACQUISITIONS AND DIVESTITURES
During 2004, the Corporation sold the deposits and the premises and equipment of
five branch offices. The total deposits sold amounted to $26,471,000 and the net
book value of premises and equipment was $1,442,000. Other assets and
liabilities divested in these branch sales were immaterial. The Corporation
realized a gain of $205,000 on the sale of these branches.
In November 2002, the Corporation sold deposits and certain assets of the branch
in Menominee. Deposits of $7,547,000, other liabilities of $23,000, and assets
of $669,000 were divested in the transaction which resulted in a net gain on
sale of $464,000. In July 2001, the Corporation sold deposits and certain assets
of the St. Ignace and Mackinac Island branches and in November 2001, sold
deposits and certain assets of the Curtis and Naubinway branches. Deposits of
$22,720,000, other liabilities of $36,000, and assets of $805,000 were divested
in transactions that resulted in gain on sale of $1,386,000.
19
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 4 - RESTRICTIONS ON CASH AND CASH EQUIVALENTS
Cash and cash equivalents in the amount of $604,000 were restricted on December
31, 2004 to meet the reserve requirements of the Federal Reserve System.
In the normal course of business, the Corporation maintains cash and due from
bank balances with correspondent banks. Balances in these accounts may exceed
the Federal Deposit Insurance Corporation's insured limit of $100,000.
Management believes that these financial institutions have strong credit ratings
and the credit risk related to these deposits is minimal.
NOTE 5 - SECURITIES AVAILABLE FOR SALE
The carrying value and estimated fair value of securities available for sale are
as follows (dollars in thousands):
Gross Gross
Amortized Unrealized Unrealized Estimated
Cost Gains Losses Fair Value
---------- ---------- ---------- ----------
DECEMBER 31, 2004
U S Agencies $ 21,980 $ 1 $ 138 $ 21,843
Obligations of states and political subdivisions 3,711 318 -0- 4,029
Corporate securities 667 14 -0- 681
Mortgage-related securities 30,225 299 2 30,522
---------- ---------- ---------- ----------
Total securities available for sale $ 56,583 $ 632 $ 140 $ 57,075
========== ========== ========== ==========
DECEMBER 31, 2003
U S Agencies $ 36,017 208 -0- 36,225
Obligations of states and political subdivisions 3,772 333 -0- 4,105
Corporate securities 666 42 -0- 708
Mortgage-related securities 43,292 446 2 43,736
---------- ---------- ---------- ----------
Total securities available for sale $ 83,747 $ 1,029 $ 2 $ 84,774
========== ========== ========== ==========
20
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 5 - SECURITIES AVAILABLE FOR SALE (CONTINUED)
Following is information pertaining to securities with gross unrealized losses
at December 31, 2004 and 2003 aggregated by investment category and length of
time these individual securities have been in a loss position (dollars in
thousands):
Less Than Twelve Months Over Twelve Months
-------------------------- --------------------------
Gross Gross
Unrealized Fair Unrealized Fair
Losses Value Losses Value
---------- ---------- ---------- ----------
DECEMBER 31, 2004
US Agencies $ 138 $ 19,842 $ -0- $ -0-
Mortgage-related securities 2 8,238 -0- -0-
---------- ---------- ---------- ----------
Total securities available for sale $ 140 $ 28,080 $ -0- $ -0-
========== ========== ========== ==========
DECEMBER 31, 2003
Mortgage-related securities $ 2 $ 9,662 $ -0- $ -0-
---------- ---------- ---------- ----------
Total securities available for sale $ 2 $ 9,662 $ -0- $ -0-
========== ========== ========== ==========
Following is a summary of the proceeds from sales of securities available for
sale, as well as gross gains and losses for the years ended December 31 (dollars
in thousands):
2004 2003 2002
---------- ---------- ----------
Proceeds from sales/calls of securities $ 35,997 $ 36,601 $ 95,245
Gross gains on sales -0- 588 799
Gross losses on sales -0- 161 53
The carrying value and estimated fair value of securities available for sale at
December 31, 2004, by contractual maturity, are shown below (dollars in
thousands). Contractual maturities may differ from expected maturities because
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties.
Amortized Estimated
Cost Fair Value
---------- ----------
Due in one year or less $ 7,712 $ 7,709
Due after one year through five years 15,300 15,198
Due after five years through ten years 1,091 1,263
Due after ten years 2,255 2,383
---------- ----------
Subtotal 26,358 26,553
Mortgage-related securities 30,225 30,522
---------- ----------
Total $ 56,583 $ 57,075
========== ==========
The carrying value and estimated fair value of securities pledged to secure
treasury deposits was $1.0 million, as of December 31 , 2004. See Note 12 for
information on securities pledged to secure borrowings from the Federal Home
Loan Bank.
21
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 6 - LOANS
The composition of loans at December 31 (dollars in thousands) is as follows:
2004 2003
---------- ----------
Commercial real estate $ 105,619 $ 161,976
Commercial, financial, and agricultural 47,446 80,988
One to four family residential real estate 45,292 51,120
Consumer 2,379 3,195
Construction 3,096 567
---------- ----------
Total loans $ 203,832 $ 297,846
========== ==========
An analysis of the allowance for loan losses for the years ended December 31
(dollars in thousands) is as follows:
2004 2003 2002
---------- ---------- ----------
Balance, January 1 $ 22,005 $ 24,908 $ 10,444
Provision for loan losses -0- -0- 26,658
Recoveries on loans 719 4,053 376
Loans charged off (15,758) (6,956) (12,570)
---------- ---------- ----------
Balance, December 31 $ 6,966 $ 22,005 $ 24,908
========== ========== ==========
The allowance for loan losses was significantly impacted by loan charge-offs
during 2004. The Corporation sold $25.2 million of loans, primarily
nonperforming, during the first quarter of 2004 which resulted in a previously
allocated specific reserve charge off of $7.4 million on these loans being
recognized as a charge-off. The Corporation also sold $14.1 million of primarily
nonperforming loans in December, which resulted in a $3.5 million charge to the
reserve.
The aggregate amount of nonperforming residential and consumer loans was
approximately $888,000 and $2,047,000 at December 31, 2004 and December 31,
2003, respectively. Nonperforming loans are those which are contractually past
due 90 days or more as to interest or principal payments, on nonaccrual status,
or loans, the terms of which have been renegotiated to provide a reduction or
deferral of interest or principal. The interest income recorded and that which
would have been recorded had residential and consumer nonaccrual and
renegotiated loans been current, or not troubled, are not material to the
consolidated financial statements for the year ended December 31, 2004 and 2003.
The nonperforming commercial loans are reflected in the information regarding
impaired loans.
22
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 6 - LOANS (CONTINUED)
IMPAIRED LOANS
A loan is considered impaired, based on current information and events, if it is
probable that the Corporation will be unable to collect the scheduled payments
of principal or interest when due, according to the contractual terms of the
loan agreement.
The following is a summary of impaired loans and their effect on interest income
(dollars in thousands):
Impaired Loans Valuation Reserve
------------------------------ ------------------------------
December 31, December 31, December 31, December 31,
2004 2003 2004 2003
------------ ------------ ------------ ------------
Balances, at period end
Impaired loans with valuation reserve $ 608 $ 39,993 $ 136 $ 5,350
Impaired loans with no valuation reserve 3,699 5,848 -0- -0-
------------ ------------ ------------ ------------
Total impaired loans $ 4,307 $ 45,841 $ 136 $ 5,350
============ ============ ============ ============
Impaired loans on nonaccrual basis $ 4,307 $ 38,660 $ 136 $ 4,720
Impaired loans on accrual basis -0- 7,181 -0- 630
------------ ------------ ------------ ------------
Total impaired loans $ 4,307 $ 45,841 $ 136 $ 5,350
============ ============ ============ ============
Average investment in impaired loans $ 17,036 $ 46,700
Interest income recognized during impairment 1,053 1,307
Interest income that would have been recognized
on an accrual basis 803 2,793
Cash-basis interest income recognized 863 718
INSIDER LOANS
The Bank, in the ordinary course of business, grants loans to the Corporation's
executive officers and directors, including their families and firms in which
they are principal owners. Activity in such loans is summarized below (dollars
in thousands).
2004 2003
---------- ---------
Loans outstanding, January 1 $ 6,514 $ 10,987
New loans 365 -0-
Repayment (765) (4,480)
Increase related to new executive officers and directors -0- 98
Decrease related to retired executive officers and directors (6,051) (91)
---------- ---------
Loans outstanding, December 31 $ 63 $ 6,514
========== =========
No related party loans were classified substandard as of December 31, 2004 and
2003.
23
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 7 - PREMISES AND EQUIPMENT
Details of premises and equipment at December 31 (dollars in thousands) are as
follows:
2004 2003
------------- -------------
Land $ 2,121 $ 2,503
Buildings and improvements 11,624 13,424
Furniture, fixtures, and equipment 8,083 9,705
------------- -------------
Totals 21,828 25,632
Less - Accumulated depreciation and amortization 11,089 11,885
------------- -------------
Net book value $ 10,739 $ 13,747
============= =============
During 2004, the Bank sold the deposits and premises and equipment of five
branch locations. The sales price of the premises and equipment, $1.442 million,
was equal to the net book value at the date of sale, therefore no gain or loss
was recognized.
Depreciation of premises and equipment charged to operating expenses amounted to
$1,038,000 in 2004, $1,378,000 in 2003, and $1,633,000 in 2002.
NOTE 8 - OTHER REAL ESTATE HELD FOR SALE
An analysis of other real estate held for sale for the years ended December 31
(dollars in thousands) is as follows:
2004 2003 2002
------------ ------------ -----------
Balance, January 1 $ 4,356 $ 5,409 $ 4,211
Additions:
Through, or in lieu of, foreclosure 4,762 4,340 4,705
Previously held -0- -0- 1,226
Impairment write-downs and payments applied (265) (848) (2,418)
Other real estate sold (7,123) (4,545) (2,315)
------------ ------------ -----------
Balance, December 31 $ 1,730 $ 4,356 $ 5,409
============ ============ ===========
NOTE 9 - INTANGIBLE ASSET
Included in other assets are core deposit premiums acquired through
acquisitions. These core deposit premiums are considered an intangible asset.
The carrying amount of the intangible asset for the years ended December 31
(dollars in thousands) is as follows:
2004 2003
--------------------------------- -------------------------------
Gross Gross
Carrying Accumulated Carrying Accumulated
Amount Amortization Amount Amortization
------------- ------------ ------------ ------------
Core deposit premium $ 3,734 $ 3,279 $ 5,403 $ 4,336
============= ============ ============ ============
24
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 9 - INTANGIBLE ASSET (CONTINUED)
During 2004, the Bank sold five branch offices with deposits of $26.471 million.
Two of the branch offices sold had unamortized core deposit premiums of $304,000
at the time of the sale. The write-off of this core deposit premium reduced the
gain on the sale of these branch locations.
The aggregate amortization expense for the years ended December 31, 2004, 2003,
and 2002 was $308,000, $460,000, and $420,000, respectively.
The following table shows the estimated future amortization expense for the
intangible asset. The projections of amortization expense are based on existing
asset balances as of December 31, 2004 (dollars in thousands).
2005 $ 125
2006 125
2007 82
2008 78
2009 45
----------
Total $ 455
==========
NOTE 10 - GOODWILL
The changes in the carrying amount of goodwill for the year ended December 31
(dollars in thousands) are as follows:
2002
---------------
Balance, January 1 $ 3,647
Goodwill acquired -0-
Amortization -0-
Impairment loss (3,647)
---------------
Balance, December 31 $ -0-
===============
As required by SFAS No. 142, adopted January 1, 2002, the Corporation is
required to perform an annual impairment test on goodwill. The impairment test
is based in large part on a comparison of the fair value of the Corporation's
outstanding stock, with the carrying value of its net assets. During the fourth
quarter of 2002, events occurred which were determined to, more likely than not,
reduce the fair value of the Corporation. Therefore, as required by SFAS No.
142, an additional impairment test was completed. This test resulted in an
identified potential impairment. Based on the size of the identified potential
impairment, the entire balance of goodwill determined to be impaired and the
impairment loss shown in the table above was recorded.
NOTE 11 - DEPOSITS
The distribution of deposits at December 31 (dollars in thousands) is as
follows:
2004 2003
-------- --------
Non-interest-bearing demand deposits $ 20,956 $ 26,179
Savings, money market, and interest-bearing demand deposits 72,103 91,835
Time deposits 122,591 187,780
-------- --------
Total deposits $215,650 $305,794
======== ========
25
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 11 - DEPOSITS (CONTINUED)
As of December 31, 2004, $1.7 million of deposits are from Canadian customers.
Non-brokered time deposits of $100,000 or more were $16,329,000 and $18,599,000
at December 31, 2004 and 2003, respectively. Interest expense on non-brokered
time deposits of $100,000 or more was $514,000, $785,000, and $1,510,000, for
the years ended December 31, 2004, 2003, and 2002, respectively.
Maturities of time deposits outstanding at December 31, 2004, (dollars in
thousands) are as follows:
2005 $ 83,907
2006 25,322
2007 10,672
2008 1,780
2009 152
Thereafter 758
--------
$122,591
========
NOTE 12 - BORROWINGS
Borrowings consist of the following at December 31 (dollars in thousands):
2004 2003
---------------- ---------------------
FEDERAL HOME LOAN BANK:
Fixed-rate advance at 7.37%, maturing April 15, 2004 $ -0- $ 64
Fixed-rate advance at 7.59%, maturing May 17, 2004 -0- 112
Fixed-rate advance at 6.35%, maturing July 7, 2004 -0- 1,000
* Fixed-rate advance at 6.50%, maturing October, 17, 2005 473 904
* Fixed-rate advance at 7.06%, maturing May 15, 2006 3,082 3,395
* Convertible - Fixed-rate advance at 5.49%, callable quarterly,
maturing June 23, 2008 10,000 10,000
* Convertible - Fixed-rate advance at 5.66%, callable quarterly,
maturing October 21, 2009 10,000 10,000
* Convertible - Fixed-rate advance at 6.22%, callable quarterly,
maturing February 22, 2010 10,000 10,000
* Convertible - Fixed-rate advance at 6.50%, callable quarterly,
maturing June 22, 2010 10,000 10,000
* Convertible - Fixed-rate advance at 5.99%, callable quarterly,
maturing June 23, 2010 5,000 5,000
Convertible - Fixed-rate advance at 4.98%, callable quarterly,
maturing December 20, 2010 5,000 5,000
Convertible - Fixed-rate advance at 5.16%, callable quarterly,
maturing December 28, 2010 10,000 10,000
Convertible - Fixed-rate advance at 4.50%, callable quarterly,
maturing January 10, 2011 10,000 10,000
Convertible - Fixed-rate advance at 4.35%, callable quarterly,
maturing February 5, 2011 10,000 10,000
---------------- ---------------------
83,555 85,475
FARMERS HOME ADMINISTRATION:
Fixed-rate note payable to Farmers Home Administration, maturing August 24,
2024, interest payable at 1% 1,484 1,551
---------------- ---------------------
Total borrowings $ 85,039 $ 87,026
================ =====================
26
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 12 - BORROWINGS (CONTINUED)
* The Corporation prepaid $48,555 of the Federal Home Loan Bank borrowings
in the first quarter of 2005. The Corporation incurred a $4.3 million
penalty as a result of this prepayment.
The FHLB has the option to convert the above listed convertible - fixed-rate
advances to adjustable rate advances, repricing quarterly at three month LIBOR
Flat, on the original call date and quarterly thereafter.
Maturities of borrowings outstanding at December 31, 2004, (dollars in
thousands) are as follows:
2005 $ 473
2006 3,082
2007 -0-
2008 10,000
2009 10,000
Thereafter 61,484
------------
Total $ 85,039
============
The Federal Home Loan Bank borrowings are collateralized at December 31, 2004,
by the following: a collateral agreement on the Corporation's one- to
four-family residential real estate loans with a book value of approximately
$32,269,000; commercial real estate leases with a book value of approximately
$11,838,000; U.S. government agency and mortgage-backed securities with an
amortized cost and estimated fair value of $52,205,000 and $52,365,000,
respectively; an interest-bearing deposit in the amount of $18,490,400; and
Federal Home Loan Bank stock owned by the Bank totaling $4,754,100. Prepayment
of the advances is subject to the provisions and conditions of the credit policy
of the Federal Home Loan Bank of Indianapolis in effect as of December 31, 2004.
The U.S.D.A. Rural Development borrowing is collateralized by loans totaling
$568,000 originated and held by the Corporation's wholly owned subsidiary, First
Rural Relending and an assignment of a demand deposit account in the amount of
$1,053,000, and guaranteed by the Corporation.
NOTE 13 - INCOME TAXES
The components of the federal income tax provision (credit) for the years ended
December 31 (dollars in thousands) are as follows:
2004 2003 2002
------- ------- -------
Current tax expense (credit) $ 147 $ (111) $(4,290)
Deferred tax credit (2,257) (543) (6,580)
Change in valuation allowance 2,257 2,983 7,000
------- ------- -------
Total provision (credit) for income taxes $ 147 $ 2,329 $(3,870)
======= ======= =======
27
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 13 - INCOME TAXES (CONTINUED)
A summary of the source of differences between income taxes at the federal
statutory rate and the provision (credit) for income taxes for the years ended
December 31 (dollars in thousands) is as follows:
2004 2003 2002
-------- -------- --------
Tax expense (credit) at statutory rate $ (492) $ (2,468) $(10,398)
Increase (decrease) in taxes resulting from:
Tax-exempt interest (415) (540) (777)
Intangible asset amortization and impairment 105 10 690
Change in valuation allowance 2,257 2,983 7,000
Minimum Tax -0- 1,313 -0-
Other (1,308) 1,031 (385)
-------- -------- --------
Provision (credit) for income taxes $ 147 $ 2,329 $ (3,870)
======== ======== ========
Included in the total provision for income taxes are expenses of $-0-, $145,000,
and $254,000 for the years ended December 31, 2004, 2003, and 2002,
respectively, related to security transactions.
Deferred income taxes are provided for the temporary differences between the
financial reporting and tax bases of the Corporation's assets and liabilities.
The major components of net deferred tax assets at December 31 (dollars in
thousands) are as follows:
2004 2003
-------- --------
Deferred tax assets:
Allowance for loan losses $ 2,369 $ 7,482
Deferred compensation 453 436
Intangible assets 580 638
Other real estate 388 173
Alternative Minimum Tax Credit 1,463 1,313
NOL carryforward 8,281 2,208
Depreciation 194 -0-
Tax credit carryovers 672 138
Other 48 24
-------- --------
Total deferred tax assets 14,448 12,412
-------- --------
Valuation allowance (14,448) (12,191)
-------- --------
Deferred tax liabilities:
Depreciation -0- (221)
Total deferred tax liabilities -0- (221)
-------- --------
Net deferred tax asset (liability) $ -0- $ -0-
======== ========
A valuation allowance is provided against deferred tax assets when it is more
likely than not that some or all of the deferred tax asset will not be realized.
At December 31, 2004 and 2003, the Corporation established a valuation allowance
against the net deferred tax asset which would require future taxable income in
order to be utilized. The Corporation has a net operating loss carryforward for
tax purposes of approximately $24.4 million which could only be benefited if the
Corporation returns to profitability. This net operating loss carryforward will
expire in the 2024 tax year.
28
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 14 - OPERATING LEASES
The Corporation leases space at three branch offices. The leases, expiring
during the next two years, are classified as operating leases. Future minimum
payments, by year and in the aggregate, under the noncancelable operating leases
with initial or remaining terms in excess of one year consisted of the following
(dollars in thousands):
Operating Leases
----------------
2005 $ 54
2006 23
---------------
Total $ 77
===============
Rent expense for all operating leases amounted to $108,000 in 2004, $232,000 in
2003, and $295,000 in 2002.
NOTE 15 - RETIREMENT PLAN
The Corporation has established a 401(k) profit sharing plan. Employees who have
completed three months of service and attained the age of 18 are eligible to
participate in the plan. Eligible employees can elect to have a portion, not to
exceed 15%, of their annual compensation paid into the plan. In addition, the
Corporation may make discretionary contributions into the plan. Retirement plan
contributions charged to operations totaled $146,000, $78,000, and $140,000 for
2004, 2003, and 2002, respectively.
NOTE 16 - DEFERRED COMPENSATION PLANS
As an incentive to retain key members of management and directors, the
Corporation has a deferred compensation plan, with benefits based on the number
of years the individuals have served the Corporation. A liability is recorded on
a present value basis and discounted using the rates in effect at the time the
deferred compensation agreement is entered into. The liability may change
depending upon changes in long-term interest rates. The liability at December
31, 2004 and 2003, for vested benefits under this plan was $1,338,000 and
$1,335,000 respectively. The Corporation maintains life insurance policies on
the plan participants. Death benefits received from the life insurance policies
will be used to offset the obligations under the plan. The cash surrender value
of the policies was $1,601,000 and $1,635,000 at December 31, 2004 and 2003,
respectively. Deferred compensation expense for the plan was $194,000, $157,000
and $266,000 for 2004, 2003, and 2002 respectively.
NOTE 17 - SUBORDINATED DEBENTURES
The Corporation owns a Delaware business trust, North Country Capital Trust (the
"Trust"). The Trust exists solely to issue capital securities. Prior to the
adoption of FIN 46, the Corporation consolidated this entity as a result of its
ownership of the outstanding common securities. This entity meets the FIN 46
definition of a VIE, but the Corporation is not the primary beneficiary in the
entity. As such, the Corporation deconsolidated this entity in 2003. The Trust
has issued trust preferred securities and invested the net proceeds in
subordinated debentures issued to the Trust by the Corporation. The subordinated
debentures are the sole asset of the Trust. The Corporation, through guarantees
and agreements, has fully and unconditionally guaranteed all of the Trust's
obligations under the trust preferred securities. The Federal Reserve Board has
accorded the trust preferred securities Tier I capital status up to 25% of Tier
I capital.
As part of the recapitalization through the issuance of $30 million in common
stock in a private placement, the subordinated debentures were paid off. This
payoff settlement was negotiated with all of the holders of the subordinated
debentures. The payment for the debentures was in settlement of $12,450,000 in
principal and accrued interest. The total settlement price was $6,500,000 and
resulted in the Corporation recording a gain on the settlement of $6,617,000.
Distributions on the trust preferred securities were payable quarterly on
February 14, May 14, August 14, and November 14. The trust preferred
subordinated debentures agreement allowed for the suspension of these payments
for up to 20 quarters. Management deferred the quarterly payments due from
November 14, 2002 through December 15, 2004.
29
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 18 - CAPITAL
On December 16, 2004, the Corporation consummated a recapitalization through the
issuance of $30 million of common stock in a private placement. The net proceeds
of this offering amounted to $26.2 million. This recapitalization provided the
funding to enable the Corporation to recapitalize the Bank with a $15.5 million
capital infusion. This capital infusion provided the Bank with enough capital to
be deemed a "well capitalized" institution by regulatory standards. The
Corporation used $6.5 million of the proceeds to settle the $12,450,000
liability of the subordinated debentures. The settlement of this liability also
included the accrued interest of approximately $1.2 million. The Corporation
recognized a gain from the settlement of the subordinated debentures of $6.6
million.
NOTE 19 - REGULATORY MATTERS
The Corporation is subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory -- and possibly additional
discretionary -- actions by regulators that, if undertaken, could have a direct
material effect on the Corporation's consolidated financial statements. Under
capital adequacy guidelines and the regulatory framework for prompt corrective
action, the Corporation must meet specific capital guidelines that involve
quantitative measures of the Corporation's assets, liabilities, and certain
off-balance-sheet items as calculated under regulatory accounting practices. The
Corporation's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Corporation to maintain minimum amounts and ratios (set forth in the
table below) of total and Tier I capital to risk-weighted assets and of Tier I
capital to average assets. Management has determined that, as of December 31,
2004, the Corporation is well capitalized.
To be categorized as well capitalized, the Bank must maintain minimum total
risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the
table. In addition, federal banking regulators have established capital
classifications beyond the minimum requirements in order to risk-rate deposit
insurance premiums and to provide trigger points for prompt corrective action.
Although the Bank was well capitalized, it was still operating under a Cease and
Desist order as of December 31, 2004 which is discussed further below. As a
result of this classification, the Bank has been paying increased premiums on
FDIC deposit insurance.
30
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 19 - REGULATORY MATTERS (CONTINUED)
The Corporation's and the Bank's actual and required capital amounts and ratios
as of December 31 (dollars in thousands) are as follows:
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
-------------------- ---------------------------- -----------------------------
Amount Ratio Amount Ratio Amount Ratio
-------- ----- --------------- ----------- --------------- -----------
2004
Total capital (to risk-weighted assets):
Consolidated $ 36,779 16.0% > or = $ 18,348 > or = 8.0% N/A
North Country Bank & Trust $ 34,855 15.2% > or = $ 18,303 > or = 8.0% > or = $ 22,879 > or = 10.0%
Tier I capital (to risk- weighted assets):
Consolidated $ 33,861 14.8% > or = $ 9,174 > or = 4.0% N/A
North Country Bank & Trust $ 31,943 14.0% > or = $ 9,151 > or = 4.0% > or = $ 13,727 > or = 6.0%
Tier I capital (to average assets):
Consolidated $ 33,861 10.7% > or = 13,045 > or = 4.0% N/A
North Country Bank & Trust $ 31,943 9.8% > or = 13,081 > or = 4.0% > or = $ 16,351 > or = 5.0%
2003
Total capital (to risk- weighted assets):
Consolidated $ 21,730 7.2% > or = $ 24,144 > or = 8.0% N/A
North Country Bank & Trust $ 24,973 8.3% > or = $ 24,070 > or = 8.0% > or = $ 30,088 > or = 10.0%
Tier I capital (to risk- weighted assets):
Consolidated $ 10,865 3.6% > or = $ 17,244 > or = 4.0% N/A
North Country Bank & Trust $ 20,967 6.9% > or = $ 12,155 > or = 4.0% > or = $ 18,232 > or = 6.0%
Tier I capital (to average assets):
Consolidated $ 10,865 2.5% > or = $ 23,837 > or = 4.0% N/A
North Country Bank & Trust $ 20,967 4.8% > or = $ 17,472 > or = 4.0% > or = $ 21,840 > or = 5.0%
The Bank is restricted, by banking regulations, from making dividend
distributions above prescribed amounts. At December 31, 2004, the Bank was not
authorized to pay dividends to the Corporation without prior regulatory approval
because of a negative retained earnings balance due to cumulative losses and as
a restriction of the Order.
HISTORY
In October 2001, the Bank was notified by the FDIC that it was a "troubled
institution" within the meaning of FDIC regulations. As a troubled institution,
the Bank is required to notify the FDIC 30 days prior to the addition or
replacement of a Board member and the employment or changes in responsibilities
of a senior executive officer.
31
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 19 - REGULATORY MATTERS (CONTINUED)
In September 2002, a regularly-scheduled safety and soundness examination of the
Bank was conducted by its principal regulators, the Michigan Office of Financial
and Insurance Services ("OFIS"), and the FDIC. During the course of that
examination, the FDIC, the OFIS, and the Federal Reserve Bank of Chicago ("FRB")
requested that the Corporation and the Bank take certain actions, including
suspending the payment of dividends and conserving the liquidity of the
Corporation.
In response to the concerns expressed by the regulators, the Board of Directors
of the Corporation and the Bank adopted resolutions providing for prior
regulatory approval of the declaration or payment of any dividend by the
Corporation or the Bank, and suspension of interest payments by the Corporation
in connection with its trust preferred securities. The agreements relating to
the trust preferred securities allow for the suspension of payments for up to 20
quarters. Therefore, the suspension of the interest payments did not violate the
agreement.
Following the completion of the regularly-scheduled safety and soundness
examination of the Bank by the FDIC and the OFIS in November 2002, and the
Bank's receipt of the related Report of Examination ("Report"), the FDIC and the
OFIS, with the consent of the Bank, on March 26, 2003, entered a formal order
(the "Order") under Federal and State banking laws. The Order became effective
on April 5, 2003, and was to remain in effect until modified or terminated by
action of the FDIC and the OFIS. The Order identified deficiencies in the Bank's
policies and procedures for safe and sound operation, including its directorate
and management personnel and practices, credit underwriting, credit
administration, and policies regarding asset/liability management, liquidity,
funds management and investments, and its compliance with all applicable laws
and regulations, including Regulations O and U of the Board of Governors of the
Federal Reserve System (the "Board"), the FDIC Rules and Regulations, and the
Michigan Banking Code of 1999. The Order also required the Bank to maintain
specified capital ratios during the life of the Order.
The Order required the Bank and its directors to take specific steps, within
time periods specified in the Order, to address the operational deficiencies,
including certain violations of law and regulations, identified by the FDIC and
the OFIS in the Order and the Report.
Significant progress was made by the Corporation in addressing all of the
deficiencies of the Order. The most significant event, which occurred in
mid-December 2004, was the consummation of a $30 million stock offering through
a private placement that resulted in net proceeds of $26.2 million. This
recapitalization allowed the Corporation to inject $15.5 million of capital into
the Bank which satisfied all of the capital requirements of the Order.
On February 8, 2005, the Order was formally removed, however, the Bank entered
into an informal agreement which requires the Bank to maintain a Tier 1 Capital
ratio of at least 8%. The Bank is also required to have regulatory approval
before paying dividends.
NOTE 20 - STOCK OPTION PLANS
The Corporation sponsors three stock option plans. All historical information
presented below has been adjusted to reflect the 1 for 20 reverse stock split
which occurred on December 15, 2004. One plan was approved during 2000 and
applies to officers, employees, and nonemployee directors. A total of 25,000
shares were made available for grant under this plan. This plan was amended as a
part of the recapitalization to provide for additional authorized shares equal
to 12 1/2% of all outstanding shares subsequent to the recapitalization, which
amounted to 428,587 shares. The other two plans, one for officers and employees
and the other for nonemployee directors, were approved in 1997. A total of
30,000 shares were made available for grant under these plans. Options under all
of the plans are granted at the discretion of a committee of the Corporation's
Board of Directors. Options to purchase shares of the Corporation's stock are
granted at a price equal to the market price of the stock at the date of grant.
The committee determines the vesting of the options when they are granted as
established under the plan.
32
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 20 - STOCK OPTION PLANS (CONTINUED)
A summary of stock option transactions for the years ended December 31 is as
follows:
Number of Shares
----------------------------------
2004 2003 2002
-------- -------- --------
Outstanding shares at beginning of year 27,483 38,616 44,736
Granted during the year 257,152 2,500 -0-
Expired / forfeited during the year (1,636) (13,633) (6,120)
-------- -------- --------
Outstanding shares at end of year 282,999 27,483 38,616
======== ======== ========
Weighted average exercise price per share
at end of year $ 34.55 $ 278.80 $ 282.20
======== ======== ========
Shares available for grant at end of year 138,899 17,912 6,779
======== ======== ========
As part of the recapitalization of the Corporation, options were granted to two
new senior executives of the Corporation and Bank. These options, totaling
257,152 shares, were granted at an exercise price of $9.75 per share or market
value. The market value was based upon the offering price of the common stock in
the private placement.
Options in 2003 were granted at $59.00 per share (as adjusted for the 1 for 20
reverse stock split). These same options expired in 2003 as a result of the
grantee's resignation. No options were granted in 2002. Under these plans,
options expire ten years after the date of grant.
Following is a summary of the options outstanding and exercisable at December
31, 2004:
Weighted
Average Weighted
Number Remaining Average
Exercise -------------------------------- Contractual Exercise
Price Range Outstanding Exercisable Life-Years Price
- ----------------- ----------- ----------- ----------- ---------
$9.75 257,152 120,861 10.0 $ 9.75
$156.00 - $240.00 11,850 11,850 4.3 182.07
$300.00 - $406.60 13,997 13,997 3.1 365.34
----------- ----------- ----------- ---------
282,999 146,708 9.4 $ 34.55
=========== =========== =========== =========
NOTE 21 - OTHER COMPREHENSIVE INCOME (LOSS)
Other comprehensive income (loss) components and related taxes for the years
ended December 31 (dollars in thousands) were as follows:
2004 2003 2002
------ ------ ------
Unrealized holding gains on
available for sale securities $ (535) $ 212 $2,338
Less reclassification adjustments for gains
later recognized in income -0- 427 746
------ ------ ------
Net unrealized gains (losses) (535) (215) 1,592
Tax effect -0- -0- 510
------ ------ ------
Other comprehensive income (loss) $ (535) $ (215) $1,082
====== ====== ======
33
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 22 - COMMITMENTS, CONTINGENCIES, AND CREDIT RISK
Financial Instruments With Off-Balance-Sheet Risk
The Corporation is a party to financial instruments with off-balance-sheet risk
in the normal course of business to meet the financing needs of its customers.
These financial instruments include commitments to extend credit and standby
letters of credit. Those instruments involve, to varying degrees, elements of
credit risk in excess of the amount recognized in the consolidated balance
sheets.
The Corporation's exposure to credit loss, in the event of nonperformance by the
other party to the financial instrument for commitments to extend credit and
standby letters of credit, is represented by the contractual amount of those
instruments. The Corporation uses the same credit policies in making commitments
and conditional obligations as it does for on-balance-sheet instruments. These
commitments at December 31 (dollars in thousands) are as follows:
2004 2003
------------------ ------------------
Commitments to extend credit:
Fixed rate $ 638 $ 3,870
Variable rate 10,889 73,651
Standby letters of credit - Variable rate 17,970 14,498
Credit card commitments - Fixed rate 2,995 3,381
------------------ ------------------
$ 32,492 $ 95,400
================== ==================
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. Since many of the commitments are expected to expire
without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements. The Corporation evaluates each customer's
creditworthiness on a case-by-case basis. The amount of collateral obtained, if
deemed necessary by the Corporation upon extension of credit, is based on
management's credit evaluation of the party. Collateral held varies, but may
include accounts receivable; inventory; property, plant, and equipment; and
income-producing commercial properties.
Standby letters of credit are irrevocable commitments issued by the Corporation
to guarantee the performance of a customer to a third party. Those guarantees
are primarily issued to support public and private borrowing arrangements. The
credit risk involved in issuing letters of credit is essentially the same as
that involved in extending loan facilities to customers. The commitments are
structured to allow for 100% collateralization on all standby letters of credit.
Credit card commitments are commitments on credit cards issued by the
Corporation's subsidiary and serviced by other companies. These commitments are
unsecured.
Contingencies
In the normal course of business, the Corporation is involved in various legal
proceedings. For expanded discussion on the Corporation's legal proceedings, see
Note 25.
Concentration of Credit Risk
The Bank grants commercial, residential, agricultural, and consumer loans
throughout Michigan. The Bank's most prominent concentration in the loan
portfolio relates to commercial loans to entities within the hospitality and
tourism industry. This concentration represents $52.7 million, or 34.4%, of the
commercial loan portfolio as compared to $76.1 million or 31.3% of the
commercial loan portfolio on December 31, 2003. The remainder of the commercial
loan portfolio is diversified in such categories as gaming, petroleum, forestry,
and agriculture. Due to the diversity of the Bank's locations, the ability of
debtors of residential and consumer loans to honor their obligations is not tied
to any particular economic sector.
34
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 23 - FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair value estimates, methods, and assumptions are set forth below for the
Corporation's financial instruments:
Cash, cash equivalents, and interest-bearing deposits - The carrying values
approximate the fair values for these assets.
Securities - Fair values are based on quoted market prices where available. If a
quoted market price is not available, fair value is estimated using quoted
market prices for similar securities.
Federal Home Loan Bank stock - Federal Home Loan Bank stock is carried at cost,
which is its redeemable value and approximates its fair value, since the market
for this stock is limited.
Loans - Fair values are estimated for portfolios of loans with similar financial
characteristics. Loans are segregated by type such as commercial, residential
mortgage, and other consumer. The fair value of loans is calculated by
discounting scheduled cash flows using discount rates reflecting the credit and
interest rate risk inherent in the loan.
The methodology in determining fair value of nonaccrual loans is to average them
into the blended interest rate at 0% interest. This has the effect of decreasing
the carrying amount below the risk-free rate amount and, therefore, discounts
the estimated fair value.
Impaired loans are measured at the estimated fair value of the expected future
cash flows at the loan's effective interest rate or the fair value of the
collateral for loans which are collateral dependent. Therefore, the carrying
values of impaired loans approximate the estimated fair values for these assets.
Deposits - The fair value of deposits with no stated maturity, such as
non-interest-bearing demand deposits and savings, is equal to the amount payable
on demand at the reporting date. The fair value of time deposits is based on the
discounted value of contractual cash flows applying interest rates currently
being offered on similar time deposits.
Borrowings - Rates currently available for debt with similar terms and remaining
maturities are used to estimate the fair value of existing debt. The fair value
of borrowed funds due on demand is the amount payable at the reporting date.
Accrued interest - The carrying amount of accrued interest approximates fair
value.
Subordinated debentures - The carrying value is considered to estimate fair
value as this financial instrument reprices frequently and fully.
Off-balance-sheet instruments - The fair value of commitments is estimated using
the fees currently charged to enter into similar agreements, taking into account
the remaining terms of the agreements, the current interest rates, and the
present creditworthiness of the counterparties. Since the differences in the
current fees and those reflected to the off-balance-sheet instruments at
year-end are immaterial, no amounts for fair value are presented.
35
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 23 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
The following table presents information for financial instruments at December
31 (dollars in thousands):
2004 2003
------------------------------------------ -----------------------------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
------------------ ------------------ ------------------ ------------------
Financial assets:
Cash and cash equivalents $ 44,078 $ 44,078 $ 23,033 $ 23,033
Interest-bearing deposits 18,535 18,535 6,048 6,048
Securities available for sale 57,075 57,075 84,774 84,774
Federal Home Loan Bank stock 4,754 4,754 4,544 4,544
Net loans 196,866 199,551 275,841 272,093
Accrued interest receivable 1,909 1,909 2,811 2,811
Directors deferred compensation 1,629 1,629 1,635 1,635
CSV of life insurance 1,338 1,338 1,336 1,336
------------------ ------------------ ------------------ ------------------
Total financial assets $ 324,846 $ 327,531 $ 398,686 $ 394,038
================== ================== ================== ==================
Financial liabilities:
Deposits $ 215,650 $ 215,835 $ 305,794 $ 306,847
Borrowings 85,039 89,142 87,026 95,244
Accrued interest payable 794 794 2,090 2,090
Subordinated debentures -0- -0- 12,450 12,450
------------------ ------------------ ------------------ ------------------
Total financial liabilities $ 302,821 $ 307,109 $ 408,696 $ 417,967
================== ================== ================== ==================
Limitations - Fair value estimates are made at a specific point in time based on
relevant market information and information about the financial instrument.
These estimates do not reflect any premium or discount that could result from
offering for sale at one time the Corporation's entire holdings of a particular
financial instrument. Because no market exists for a significant portion of the
Corporation's financial instruments, fair value estimates are based on judgments
regarding future expected loss experience, current economic conditions, risk
characteristics of various financial instruments, and other factors. These
estimates are subjective in nature and involve uncertainties and matters of
significant judgment and therefore cannot be determined with precision. Changes
in assumptions could significantly affect the estimates. Fair value estimates
are based on existing on- and off-balance-sheet financial instruments without
attempting to estimate the value of anticipated future business and the value of
assets and liabilities that are not considered financial instruments.
Significant assets and liabilities that are not considered financial assets or
liabilities include premises and equipment, other assets, and other liabilities.
In addition, the tax ramifications related to the realization of the unrealized
gains and losses can have a significant effect on fair value estimates and have
not been considered in the estimates.
36
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 24 - PARENT COMPANY ONLY FINANCIAL STATEMENTS
BALANCE SHEETS
December 31, 2004 and 2003
(Dollars in Thousands)
2004 2003
------------------ ------------------
ASSETS
Cash and cash equivalents $ 2,313 $ 423
Investment in subsidiaries 33,288 23,328
Other assets 26 590
------------------ ------------------
TOTAL ASSETS $ 35,627 $ 24,341
================== ==================
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities $ 897 $ 805
Subordinated debentures -0- 12,836
------------------- ------------------
Total liabilities 897 13,641
------------------ ------------------
Total shareholders' equity 34,730 10,700
------------------ ------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 35,627 $ 24,341
================== ==================
37
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 24 - PARENT COMPANY ONLY FINANCIAL STATEMENTS (CONTINUED)
STATEMENTS OF OPERATIONS
Years Ended December 31, 2004, 2003, and 2002
(Dollars in Thousands)
2004 2003 2002
---------- ------------ -------------
Income:
Dividends received from subsidiaries $ -0- $ -0- $ 2,704
Security gains -0- 102 -0-
Gain on settlement of subordinated debentures 6,617 -0- -0-
Other 13 17 44
---------- ------------ -------------
Total income 6,630 119 2,748
---------- ------------ -------------
Expenses:
Salaries and benefits 1,568 66 68
Interest 458 504 562
Accounting, legal and consulting fees 1,031 746 261
Other 183 126 150
---------- ------------ -------------
Total expenses 3,240 1,442 1,041
---------- ------------ -------------
Income (loss) before credit for income
taxes and equity in undistributed net
income (loss) of subsidiaries 3,390 (1,323) 1,707
Credit for income taxes -0- -0- (349)
---------- ------------ -------------
Income before equity in undistributed
net income (loss) of subsidiaries 3,390 (1,323) 2,056
Equity in undistributed net (loss) of
subsidiaries (4,985) (8,265) (28,769)
---------- ------------ -------------
Net (loss) $ (1,595) $ (9,588) $ (26,713)
========== ============ =============
38
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 24 - PARENT COMPANY ONLY FINANCIAL STATEMENTS (CONTINUED)
STATEMENTS OF CASH FLOWS
Years Ended December 31, 2004, 2003, and 2002
(Dollars in Thousands)
2004 2003 2002
--------- --------- ---------
Increase (decrease) in cash and cash equivalents:
Cash flows from operating activities:
Net (loss) $ (1,595) $ (9,588) $ (26,713)
--------- --------- ---------
Adjustments to reconcile net (loss) to net cash provided by operating
activities:
Provision for depreciation and amortization 26 28 29
Net gain on settlement of subordinated debentures (6,617) -0- -0-
Equity in undistributed net loss of subsidiaries 4,985 8,265 28,769
Change in other assets 59 486 178
Change in other liabilities 872 518 164
--------- --------- ---------
Total adjustments (675) 9,297 29,140
---------- --------- ---------
Net cash provided by (used in) operating activities (2,270) (291) 2,427
---------- --------- ---------
Cash flows from financing activities:
Proceeds from issuance of common stock 26,160 -0- -0-
Payment in settlement of subordinated debentures (6,500) -0- -0-
Investments in subsidiaries (15,500 -0- -0-
Dividends paid -0- -0- (1,755)
---------- --------- ---------
Net cash used in financing activities 4,160 -0- (1,755)
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents 1,890 (291) 672
Cash and cash equivalents at beginning 423 714 42
--------- --------- ---------
Cash and cash equivalents at end $ 2,313 $ 423 $ 714
========= ========= =========
NOTE 25 - LEGAL PROCEEDINGS
The Corporation and its subsidiaries are subject to routine litigation
incidental to the business of banking. In addition, the Corporation or the Bank
are subject to the Order referred to below, and the litigation and arbitration
described below. Information regarding the Order is contained in "Management's
Discussion and Analysis of Financial Condition and Results of Operations" under
the caption "Capital and Regulatory" in this report, and is incorporated here by
reference. The litigation and arbitration that is not routine and incidental to
the business of banking is described below.
Securities Litigation
In an action styled Lanctot v. Littlejohn, et al., filed in the U.S. District
Court for the Western District of Michigan on June 13, 2003, a shareholder of
the Corporation brought a class action against the Corporation, its former
chairman, chief executive
39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 25 - LEGAL PROCEEDINGS (CONTINUED)
officer and director, Ronald G. Ford, and its former chief executive officer and
director, Sherry L. Littlejohn, for alleged violations of Federal securities
laws.
In another action styled Rosen v. North Country Financial Corporation, et al.,
filed in the U.S. District Court for the Western District of Michigan on June
23, 2003, a former shareholder of the Corporation brought a class action against
the Corporation, its former chairman, chief executive officer and director,
Ronald G. Ford, and its former chief executive officer and director, Sherry L.
Littlejohn, for alleged violations of Federal securities laws.
On September 2, 2003, pursuant to 15 U.S.C. Section 78-u-4(a)(3)(B), plaintiff
Charles Lanctot filed a motion requesting the Court to consolidate the two
securities class action cases (Lanctot and Rosen) under the caption In re North
Country Financial Corporation Securities Litigation, to appoint him as "Lead
Plaintiff" in the consolidated cases, and to approve the selection of his
counsel as "Lead Plaintiff's Counsel." In an Order dated September 29, 2003, the
Court among other things consolidated the Lanctot and Rosen actions, designated
Charles D. Lanctot and John F. Stevens as "Lead Plaintiffs," and designated
"Co-Lead Counsel" and "Liaison Counsel" for the class.
On December 1, 2003, the plaintiffs filed their Corrected Consolidated Amended
Class Action Complaint ("Amended Complaint"), which added John F. Stevens as a
plaintiff. The Amended Complaint, which demanded a jury trial, was brought on
behalf of all persons, subject to certain exceptions, who purchased the
Corporation's common stock during the period from November 13, 2000, through
April 15, 2003. It alleged that the Corporation and the individual defendants
violated section 10(b) of the Securities Exchange Act of 1934 (the "Exchange
Act") and Rule 10b-5 of the Securities and Exchange Commission (the "SEC")
issued under the Exchange Act, by disseminating materially false and misleading
statements and/or concealing material adverse facts concerning the financial
condition and operations of the Corporation, with knowledge, or in reckless
disregard, of the materially false and misleading character thereof. The Amended
Complaint also alleged violations of Section 20 of the Exchange Act by the
individual defendants, by reason of their control, at relevant times, of the
Corporation. Among other things, the Amended Complaint was based upon
allegations of deficiencies in the Corporation's policies and procedures for
safe and sound operation, including its directorate and management personnel and
practices, credit underwriting, credit administration, and policies regarding
asset/liability management, liquidity, funds management, and investments, and
its compliance with all applicable laws and regulations, including Regulations O
and U of the Board of Governors of the Federal Reserve System (the "Board"), the
Federal Deposit Insurance Corporation ("FDIC") Rules and Regulations, and the
Michigan Banking Code of 1999. The Amended Complaint further alleged that the
Corporation's acquisition of American Financial Mortgage, which had an
"unusually large number of defaulted loans . . . which triggered the attention
of banking regulators"; that a Cease and Desist Order, dated March 26, 2002,
which was attached as Exhibit 1 to the Amended Complaint, demonstrated how
defendants made "false statements" in public filings and other communications,
and were required to take "corrective actions;" that various public filings were
"false because the Company's operations resulted in an excessive level of
adversely classified assets, delinquent loans, and nonaccrual loans as well as
an inadequate level of capital protection for the kind and quality of assets
held;" that, "according to former employees, loans for Company insiders and
their related entities were often approved regardless of the quality of the
loan;" and, that the Corporation incorrectly attributed its performance to the
World Trade Center disaster and other factors impacting tourism and hospitality
businesses, instead of disclosing "insider loans," a "disproportionately high
loan concentration" in the hospitality industry, and information about the
Corporation's banking practices and loan loss reserves. The Amended Complaint
sought certification of a class consisting of all persons who purchased the
common stock of the Corporation on the open market between the dates noted
above, compensatory damages on a joint and several basis against all defendants,
including the Corporation, plus interest and costs, including attorney's fees
and expert's fees.
On January 23, 2004, the Corporation and the other defendants filed their Joint
Motion to Dismiss the Corrected Consolidated Amended Class Action Complaint,
principally based on the ground that plaintiffs had not adequately plead that
the Corporation, through its officers and directors, acted with the intent to
defraud the investing public under the standard articulated in Helwig v. Vencor,
Inc., 251 F.3d 540 (6th Cir. 2001), cert. dismissed, 536 U.S. 935, 122 S.Ct.
2616 (2002). During the pendency of the motion to dismiss, a stay of "all
discovery and other proceedings" automatically was imposed under 15 U.S.C.
Section 78u-4(b)(3)(B). Plaintiffs filed their Brief in Opposition to
Defendants' Motion to Dismiss on March 8, 2004. Defendants filed a reply brief
in support of their Motion to Dismiss on March 23, 2004. The Court scheduled an
oral argument on the Motion to Dismiss for May 17, 2004.
40
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 25 - LEGAL PROCEEDINGS (CONTINUED)
Shortly before the hearing on the Motion to Dismiss, Plaintiffs, the Corporation
and the individual Defendants and their insurer reached a settlement in
principle of all claims asserted in the consolidated actions. On June 18, 2004,
the parties submitted to the Court their Stipulation of Settlement, which
described in detail the terms and conditions of the settlement. The parties
subsequently modified the Stipulation, which was reflected in the Revised and
Amended Stipulations of Settlement submitted to the Court.
On August 23, 2004, the Court granted conditional approval of the settlement as
set forth in the Second Revised and Amended Stipulation of Settlement. On
October 15, 2004, the Court preliminarily certified a class for purposes of
settlement only, approved a form of notice of hearing to be distributed to class
members, and scheduled a hearing concerning final approval of the settlement. As
modifed by a Stipulated Order entered on October 29, 2004, the plaintiffs were
allowed to mail notice of the proposed settlement to members of the class.
Members of the class were permitted to opt out of the class by written request
postmarked no later than November 29, 2004. Members of the class who did not opt
out and who filed written notice no later than November 24, 2004, were permitted
to object to approval of the settlement at the hearing concerning final approval
before the Court.
On December 1, 2004, the Court held the hearing concerning final approval of the
settlement. At the conclusion of the hearing, the Court entered its Order and
Final Judgment, in which the Court (i) certified the action as a class action,
(ii) certified the plaintiff class, (iii) determined the settlement (as modified
by the Order and Final Judgment) to be fair, reasonable, adequate, and in the
best interests of the plaintiff class, (iv) approved the settlement, (v)
specified the claims procedure for members of the plaintiff class, (vi) awarded
fees to counsel for the plaintiff class, and (vii) dismissed the action as to
the plaintiff class and all defendants with prejudice. Under the terms of the
settlement approved by the Court, the settlement fund for the plaintiff class
and its counsel aggregated $750,000, of which the Corporation contributed
$250,000, and the individual defendants contributed $500,000. The amount
contributed by the individual defendants was covered by insurance.
Shareholder's Derivative Litigation
Damon Trust v. Bittner, et al.
In an action styled Virginia M. Damon Trust v. North Country Financial
Corporation, Nominal Defendant, and Dennis Bittner, Bernard A. Bouschor, Ronald
G. Ford, Sherry L. Littlejohn, Stanley J. Gerou II, John D. Lindroth, Stephen
Madigan, Spencer Shunk, Michael Henrickson, Glen Tolksdorf, and Wesley Hoffman,
filed in the U.S. District Court for the Western District of Michigan on July 1,
2003, a shareholder of the Corporation has brought a shareholder's derivative
action under Section 27 of the Exchange Act against the Corporation and certain
of its current and former directors and senior executive officers. The
Complaint, which demands a jury trial, is brought on behalf of the Corporation
against the individual defendants. It alleges that the individual defendants
have caused loss and damage to the Corporation through breaches of their
fiduciary duties of oversight and supervision by failing (i) adequately to
safeguard the assets of the Corporation, (ii) to ensure that adequate
administrative, operating, and internal controls were in place and implemented,
(iii) to ensure that the Corporation was operated in accordance with
legally-prescribed procedures, and (iv) to oversee the audit process to ensure
that the Corporation's assets were properly accounted for and preserved. The
Complaint further alleges that the individual defendants violated Section 14(a)
of the Exchange Act by making materially false and misleading statements in the
proxy statement mailed to shareholders in connection with the annual meeting of
the Corporation held May 29, 2000, and the adoption by the shareholders at that
meeting of the Corporation's 2000 Stock Incentive Plan. The Complaint also
alleges that Mr. Ford and Ms. Littlejohn, through a series of compensation
arrangements, stock options, and employment agreements obtained by them through
improper means resulting from the offices they held with the Corporation,
received excessive compensation, to the injury of the Corporation. Among other
things, the Complaint is based upon allegations of material misstatements or
omissions in filings made by the Corporation with the SEC, and deficiencies in
the Corporation's policies and procedures for safe and sound operation,
including its directorate and management personnel and practices, credit
underwriting, credit administration, and policies regarding asset/liability
management, liquidity, funds management, and investments, and its compliance
with all applicable laws and regulations, including Regulations O and U of the
Board, FDIC Rules and Regulations, and the Michigan Banking Code of 1999. The
Complaint seeks (i) rescission of the approval of the 2000 Stock Incentive Plan
and return of all stock and options granted under
41
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 25 - LEGAL PROCEEDINGS (CONTINUED)
the Plan, (ii) a declaration that the individual defendants breached their
fiduciary duty to the Corporation, (iii) an order to the individual defendants
to account to the Corporation for all losses and/or damages by reason of the
acts and omissions alleged, (iv) an order to each of the individual defendants
to remit to the Corporation all salaries and other compensation received for
periods during which they breached their fiduciary duties, (v) compensatory
damages in favor of the Corporation, (vi) injunctive relief, and (vii) interest,
costs, and attorney's and expert's fees.
By letter dated September 17, 2003, and expressly without prejudice to the
argument that any such written demand is not required, plaintiff's counsel
purported to make a written demand that the Corporation pursue a number of
indicated putative claims against: (1) present and former officers and directors
of the Corporation who also are the individual defendants in the Damon action,
and (2) the certified public accounting firm of Wipfli, Ullrich, Bertelson, LLP.
On September 18, 2003, the Corporation filed a motion to dismiss the Damon
action because plaintiff did not satisfy the mandatory precondition, under
Section 493a of the Michigan Business Corporation Act ("MBCA"), M.C.L.Section
450.1493a, for filing a shareholder derivative action that the shareholder must
first have submitted a written demand that the Corporation pursue in its own
right the claims asserted by the shareholder (the plaintiff here). Certain of
the individual defendants in the Damon action filed their own motion to dismiss
on November 25, 2003, in which motion the other individual defendants later
joined. The plaintiff filed an Opposition to both motions to dismiss on January
9, 2004, and on January 30, 2004, the defendants filed reply briefs in support
of their motions to dismiss.
On March 22, 2004, the Court issued an Opinion and Order granting in part and
denying in part the motions to dismiss in the Damon case. The Court dismissed
the Section 14(a) claim against all of the defendants as barred by the statute
of limitations and, as further grounds, dismissed that claim as to those who
were not directors at the time of the mailing of the proxy statement. The Court
has permitted the plaintiff to proceed with its breach of fiduciary duty claims
against the Directors on the grounds that the plaintiff cured its procedural
failings by subsequently transmitting a demand letter as required by Section 493
of the MBCA.
On April 19, 2004, the Court entered an Order Granting Stipulation to Grant
Plaintiff Leave to File Amended Complaint and to Grant Related Relief to All
Parties. On May 14, 2004, the plaintiff filed an Amended Complaint and,
thereafter, all Defendants timely filed Answers to the Amended Complaint. In its
Answer, the Corporation averred that the plaintiff's claims are asserted for and
on behalf of the Corporation, that the plaintiff does not assert any claims
against the Corporation and, therefore, the Corporation properly should be
realigned as a plaintiff in the action.
During the above described proceedings, on November 11, 2003, the Corporation
filed a motion, as permitted by section 495 of the MBCA, M.C.L.Section 450.1495,
requesting the Court to appoint a disinterested person to conduct a reasonable
investigation of the claims made by the plaintiff and to make a good faith
determination whether the maintenance of the derivative action is in the best
interests of the Corporation. After additional written submissions to the Court
by the defendants and the plaintiff concerning the issues presented by this
motion, and after several conferences with the Court, on May 20, 2004, the Court
entered an Order adopting the parties' written stipulations concerning the
appointment of a disinterested person and the manner of conducting the
investigation of the claims made by the plaintiff and making recommendations as
to whether the maintenance of the derivative action is in the best interests of
the Corporation.
On July 14, 2004, the Court convened a settlement conference among counsel for
all parties and counsel for the individual defendants' insurer. Although a
settlement was not achieved, at the direction of the Court, the parties'
respective counsel agreed to continue settlement discussions.
By Order of the Court dated November 2, 2004, the report of the disinterested
person was timely filed with the Corporation on October 23, 2004, and the action
was stayed until November 22, 2004. On December 22, 2004, the plaintiff filed a
motion with the Court seeking a scheduling conference among the Court and the
parties. The Court granted the plaintiff's motion on January 10, 2005. On
January 13, 2005, the parties to the action and the individual defendants'
insurer entered into an agreement regarding limited disclosure of the report of
the disinterested person to the insurer and counsel for the parties on the terms
and conditions set forth in the agreement. Also on January 13, 2005, a
scheduling conference was held with the Court, and was adjourned to February 14,
2005.
42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 25 - LEGAL PROCEEDINGS (CONTINUED)
On February 9, 2005, the parties filed a joint status report with the Court. A
further status conference was held on February 14, 2005. At that time, the Court
entered a Stipulated Protective Order regarding limited dissemination of the
report of the disinterested person. Also on February 14, in a separate Order,
the Court required the parties to complete their respective review of the report
and communicate among themselves regarding their positions. Absent a negotiated
resolution, the Corporation was given the opportunity until March 21, 2005, to
file an appropriate motion to dismiss. On March 21, 2005, consistently with the
determinations of the disinterested person in his report, the Corporation filed
with the Court a motion to dismiss (i) all the breach of fiduciary duty claims
against defendants Bittner, Bouschor, Gerou, Lindroth, Madigan, Shunk,
Hendrickson, and Tolksdorf, (ii) the breach of fiduciary duty claims against
defendant Hoffman, except for one claim identified by the disinterested person
in his report, and (iii) the excess compensation claims against defendants Ford
and Littlejohn. The plaintiff has advised the Corporation that it intends to
oppose the motion to dismiss.
Damon Trust v. Wipfli
On August 27, 2004, a second shareholder's derivative action, styled Virginia M.
Damon Trust v. Wipfli Ullrich Bertelson, LLP, and North Country Financial
Corporation, Nominal Defendant, was filed in the Michigan Circuit Court for
Grand Traverse County by the same shareholder which brought the derivative
action discussed above. The complaint, which demands a jury trial, is brought on
behalf of the Corporation against Wipfli Ullrich Bertelson, LLP ("Wipfli") under
the Michigan Accountant Liability statute, M.C.L. 600.2962. It alleges that
Wipfli damaged the Corporation by (i) failing to conduct and oversee, with the
due care and competence required of professional accountants, the annual audit
of the Corporation's financial statements for its fiscal years ending December
31, 2000 and December 31, 2001, (ii) failing to provide, with requisite due care
and competence, the internal audit, regulatory compliance, and financial
reporting services Wipfli had agreed to provide the Corporation after August 28,
2002, when Wipfli resigned as its auditors to undertake such consulting
services, (iii) failing to exercise due care and competence required to ensure
that the Corporation's financial statements conformed to applicable regulatory
accounting principles ("RAP") and generally accepted accounting principles
("GAAP"), (iv) failing to make full disclosure that the Corporation's
administrative, operating, and internal controls were inadequate to prevent loss
and damage to its assets, and (v) failing to conduct a diligent and careful
"review" of the Corporation's quarterly financial statements during its fiscal
years 2000 and 2001 and the first and second quarters of 2002.
The complaint further alleges that Wipfli undertook in writing (i) to provide
professional services, including auditing services, accounting services for
preparation of audited financial statements, advice regarding financial
statement disclosure, and preparation of annual reports for regulators,
including the annual report required by section 36 of the Federal Deposit
Insurance Act, and (ii) to ensure that the Corporation had sufficient systems in
place to determine whether it was in compliance with RAP and other regulations
of the FDIC and the OFIS. The complaint alleges that Wipfli (i) failed to
conduct its audits of the Corporation's financial statements in accordance with
generally accepted auditing standards ("GAAS"), (ii) negligently represented
that the Corporation's audited annual financial statements for the year ended
December 31, 2000 were fairly presented in all material respects, (iii)
negligently conducted reviews of the Corporation's quarterly financial
statements for the interim quarters of 2000, 2001 and 2002, and (iv) negligently
audited the Corporation's financial statements for the fiscal years 2000 and
2001 by failing to obtain or review sufficient documentation, failing to limit
the scope of the audit in light of such failure to obtain or review sufficient
documentation, failing to verify the accuracy of information obtained from the
Corporation for the audit, failing to limit the scope of the audit in light of
such failure to verify the accuracy of the information obtained from the
Corporation, and substantially underestimating the Corporation's liabilities and
misrepresenting its solvency.
The complaint also alleges that Wipfli is a party responsible for the
Corporation's liability in any securities fraud action arising out of a material
overstatement of its financial results. The complaint claims contribution and
indemnification from Wipfli on behalf of the Corporation under the Private
Securities Litigation Reform Act of 1995 for any liability it may incur in any
such securities fraud action.
On October 12, 2004, Wipfli removed the second shareholder's derivative action
to the U.S. District Court for the Western District of Michigan. By stipulation
between the respective counsel for the Corporation and the plaintiff, the
Corporation was initially granted until December 10, 2004, to file its first
response to the Complaint, which period was extended by a Stipulated Order until
January, 2005.
43
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
NOTE 25 - LEGAL PROCEEDINGS (CONTINUED)
On January 10, 2005, the Corporation filed its Answer to the Complaint in the
second shareholder's derivative action. Also on that date, a joint status report
was filed with the Court by all parties. A scheduling conference was held with
the Court on January 13, 2005. On that date, the Court entered a Preliminary
Case Management Order, affording the Corporation the opportunity until February
3, 2005, to make a motion to realign the Corporation in, or to dismiss, the
litigation.
On February 3, 2005, the Corporation filed a Motion to realign the Corporation
as the plaintiff, and to dismiss the Virginia M. Damon Trust as a party, in the
second shareholder's derivative action. The plaintiff, Virginia M. Damon Trust,
filed a brief opposing the Corporation's motion. Oral argument on the
Corporation's motion was held before the Court on March 7, 2005. The Court took
the matter under advisement.
Employment Agreement Arbitration
On September 16, 2003, Ronald G. Ford, the former chairman and chief executive
officer and a former director of the Corporation, initiated an arbitration
proceeding with the American Arbitration Association ("AAA") against the
Corporation seeking monetary damages for alleged breach by the Corporation of
his Amended and Restated Employment Agreement, Chairman Agreement, and Amended
and Restated Consulting Agreement, each with the Corporation. The Corporation
denied the alleged breach and asserted a counterclaim to recover all amounts
paid to Mr. Ford under the Chairman Agreement, as required by the Cease and
Desist Order entered by the FDIC and the OFIS, in addition to other amounts.
On March 19, 2004, at the request of Mr. Ford, AAA reactivated the arbitration
proceeding. Pursuant to its procedures, on June 17, 2004, AAA appointed an
arbitrator to preside over the adjudication of these claims and counterclaims.
On July 13, 2004, the arbitrator convened a scheduling conference at which the
arbitrator adopted the parties' stipulation to stay the arbitration until the
conclusion in the Damon action of the court-appointed disinterested person's
investigation and recommendations concerning the claims of the Virginia M. Damon
Trust, asserted in the name and on behalf of the Corporation, against the
Corporation's former and present officers and directors, including Mr. Ford. At
a further conference held on October 27, 2004, the arbitrator adopted the
parties' stipulation to stay the arbitration until another conference, scheduled
for November 18, 2004.
Following a further stipulated stay of the arbitration proceeding, the
Corporation and Mr. Ford entered into a Release and Settlement Agreement as of
December 7, 2004. The Corporation and Mr. Ford each released certain claims
against the other specified in the Release and Settlement Agreement, and the
Bank paid Mr. Ford $20,000 for his minority ownership interest in two
subsidiaries of the Bank. The Release and Settlement Agreement, the terms of
which were consented to by the FDIC and the Michigan Office of Financial and
Insurance Services, resulted in the termination with prejudice of the AAA
arbitration proceeding.
Litigation of the types involved in the actions described above can be complex,
time-consuming, and often protracted. The Corporation has incurred substantial
expense for legal and other professional fees as a result of these actions. The
Corporation anticipates that it will incur additional such expenses in
connection with the two shareholder's derivative actions described above.
NOTE 26 - SUBSEQUENT EVENTS
Subsequent to December 31, 2004, the following events occurred. In the first
quarter of 2005, the Bank prepaid $48.6 million of the Federal Home Loan Bank
borrowings and incurred a $4.3 million prepayment penalty. This prepayment will
better position the Bank for proper asset liability matching. On February 8,
2005, the Corporation received formal notification from the FDIC and the
Michigan Office of Financial and Insurance Services that the Cease and Desist
Order issued March 26, 2003 had been terminated.
44
SELECTED FINANCIAL DATA
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
SELECTED FINANCIAL DATA
(Unaudited)
(Dollars in Thousands, Except Per Share Data)
Years Ended December 31,
2004 2003 2002 2001 2000
--------- ---------- ---------- --------- ---------
Selected Financial Condition Data:
Total assets $ 339,497 $ 422,539 $ 565,306 $ 636,629 $ 666,996
Loans 203,832 297,846 435,043 504,412 541,689
Securities 57,075 84,774 67,955 61,885 72,066
Deposits 215,650 305,794 437,494 482,524 531,883
Borrowings 85,039 87,026 87,815 88,549 69,235
Total equity 34,730 10,700 20,503 47,889 44,617
Selected Operations Data:
Interest income $ 18,853 $ 23,641 $ 35,969 $ 50,475 $ 54,500
Interest expense 10,615 (14,015) (18,089) (26,842) (29,421)
--------- ---------- ---------- --------- ---------
Net interest income 8,238 9,626 17,880 23,633 25,079
Provision for loan losses -0- -0- (26,658) (3,200) (5,875)
Net security gains -0- 427 746 1,073 110
Other income 8,542 2,804 4,512 9,363 6,891
Impairment loss on intangibles -0- (60) (3,647) -0- -0-
Other expenses (18,228) (20,056) (23,416) (24,307) (20,077)
--------- ---------- ---------- --------- ---------
Income (loss) before income taxes (1,448) (7,259) (30,583) 6,562 6,128
Provision (credit) for income taxes 147 2,329 (3,870) 788 945
--------- ---------- ---------- --------- ---------
Net income (loss) $ (1,595) $ (9,588) $ (26,713) $ 5,774 $ 5,183
========= ========== ========== ========= =========
Per Share Data:
Earnings (loss) - Basic $ (3.23) $ (27.32) $ (76.11) $ 16.40 $ 14.80
Earnings (loss) - Diluted (3.23) (27.32) (76.11) 16.40 14.60
Cash dividends declared -0- -0- 5.00 6.00 6.80
Book value 10.13 30.40 58.40 136.40 127.60
Market value - closing price at year end 17.97 35.00 48.40 147.84 124.70
Financial Ratios:
Return on average equity (.44)% (59.15)% (61.07)% 12.48% 12.13%
Return on average assets (18.64)% (1.96)% (4.31)% 0.89% 0.84%
Dividend payout ratio N/A N/A NM 36.48% 45.42%
Average equity to average assets 2.34% 3.32% 7.05% 7.10% 6.92%
45
SUMMARY QUARTERLY FINANCIAL INFORMATION
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
SUMMARY QUARTERLY FINANCIAL INFORMATION
(Unaudited)
(Dollars in Thousands, Except per Share Data)
Three Months Ended
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
-------- --------- ------------ -----------
2004
Selected Operations Data:
Interest income $ 4,976 $ 5,153 $ 4,408 $ 4,316
Interest expense 2,965 2,686 2,548 2,416
-------- --------- ------------ -----------
Net interest income 2,011 2,467 1,860 1,900
Other income 663 63 867 6,949
Other expenses 4,341 4,130 3,488 6,269
-------- --------- ------------ -----------
Income (loss) before income taxes (1,667) (1,600) (761) 2,580
Provision for income taxes -0- -0- -0- 147
-------- --------- ------------ -----------
Net income (loss) $ (1,667) $ (1,600) $ (761) $ 2,433
======== ========= ============ ===========
Per Share Data:
Earnings (loss) - Basic $ (4.75) $ (4.56) $ (2.17) $ 8.25
Earnings (loss) - Diluted (4.75) (4.56) (2.17) 8.25
2003
Selected Operations Data:
Interest income $ 6,973 $ 6,246 $ 5,318 $ 5,104
Interest expense 3,866 3,469 3,422 3,258
-------- --------- ------------ -----------
Net interest income 3,107 2,777 1,896 1,846
Provision for loan losses -0- -0- -0- -0-
Net security gains (losses) (23) 214 44 192
Other income 925 831 508 540
Other expenses (5,194) (5,120) (4,760) (5,042)
-------- --------- ------------ -----------
Income (loss) before income taxes (1,185) (1,298) (2,312) (2,464)
Provision for income taxes 320 1,359 650 -0-
-------- --------- ------------ -----------
Net income (loss) $ (1,505) $ (2,657) $ (2,962) $ (2,464)
======== ========= ============ ===========
Per Share Data:
Earnings (loss) - Basic $ (4.29) $ (7.57) $ (8.44) $ (7.02)
Earnings (loss) - Diluted (4.29) (7.57) (8.44) (7.02)
46
MARKET INFORMATION
MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES
MARKET INFORMATION
(Unaudited)
During 2001, the Corporation's stock began trading on the NASDAQ Small Cap
Market; effective on August 31, 2001, the Corporation changed its trading symbol
from "NCUF" to "NCFC." As part of the recapitalization, the Corporation changed
its name from North Country Financial Corporation to Mackinac Financial
Corporation and changed its trading symbol from "NCFC" to "MFNC".
The following table sets forth the range of high and low bid prices of the
Corporation's common stock from January 1, 2002 through December 31, 2004, as
reported by NASDAQ. Quotations for the NASDAQ Small Cap Market reflect
interdealer prices, without retail mark-up, markdown, or commission, and may not
reflect actual transactions. All historical stock prices have been adjusted for
the 1 for 20 reverse stock split.
Three Months Ended
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
-------- --------- ------------ -----------
2004
High $ 44.60 $ 52.80 $ 41.00 $ 21.80
Low 31.00 28.00 14.40 7.00
2003
High $ 66.00 $ 62.00 $ 59.80 $ 52.00
Low 48.00 29.60 44.00 28.60
2002
High $ 151.40 $ 157.60 $ 160.00 $ 115.80
Low 140.00 144.40 109.60 41.00
The Corporation had 1,858 shareholders of record as of March 28, 2005.
47
FORWARD-LOOKING STATEMENTS
This report contains certain forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. The Corporation intends such
forward-looking statements to be covered by the safe harbor provisions for
forward-looking statements contained in the Private Securities Litigation Reform
Act of 1995 and is including this statement for purposes of these safe harbor
provisions. Forward-looking statements which are based on certain assumptions
and describe future plans, strategies, or expectations of the Corporation, are
generally identifiable by use of the words "believe", "expect", "intend",
"anticipate", "estimate", "project", or similar expressions. The Corporation's
ability to predict results or the actual effect of future plans or strategies is
inherently uncertain. Factors that could cause actual results to differ from the
results in forward-looking statements include, but are not limited to:
- Impact of continued operating losses;
- The highly regulated environment in which the Corporation operates could
adversely affect its ability to carry out its strategic plan due to
restrictions on new products, funding opportunities or new market
entrances;
- General economic conditions, either nationally or in the state(s) in which
the Corporation does business;
- Legislation or regulatory changes which affect the business in which the
Corporation is engaged;
- Changes in the interest rate environment which increase or decrease
interest rate margins;
- Changes in securities markets with respect to the market value of
financial assets and the level of volatility in certain markets such as
foreign exchange;
- Significant increases in competition in the banking and financial services
industry resulting from industry consolidation, regulatory changes and
other factors, as well as action taken by particular competitors;
- The ability of borrowers to repay loans;
- The effects on liquidity of unusual decreases in deposits;
- Changes in consumer spending, borrowing, and saving habits;
- Technological changes;
- Acquisitions and unanticipated occurrences which delay or reduce the
expected benefits of acquisitions;
- Difficulties in hiring and retaining qualified management and banking
personnel;
- The Corporation's ability to increase market share and control expenses;
- The effect of compliance with legislation or regulatory changes;
- The effect of changes in accounting policies and practices;
- The costs and effects of existing and future litigation and of adverse
outcomes in such litigation.
These risks and uncertainties should be considered in evaluating forward-looking
statements. Further information concerning the Corporation and its business,
including additional factors that could materially affect the Corporation's
financial results, is included in the Corporation's filings with the Securities
and Exchange Commission. All forward-looking statements contained in this report
are based upon information presently available and the Corporation assumes no
obligation to update any forward-looking statements.
48
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion will cover results of operations, asset quality,
financial position, liquidity, interest rate sensitivity, and capital resources
for the years 2002 through 2004. The information included in this discussion is
intended to assist readers in their analysis of, and should be read in
conjunction with, the consolidated financial statements and related notes and
other supplemental information presented elsewhere in this report. Throughout
this discussion, the term "Bank" refers to North Country Bank and Trust, the
principal banking subsidiary of the Corporation.
OVERVIEW
The Corporation, in the past several years, has experienced significant
operating losses and a continued deterioration of its financial condition. In
2003, its external auditors issued a qualified opinion concerning the
Corporation's ability to continue as a going concern. On December 15, 2004, the
Corporation consummated a recapitalization plan through the issuance of $30
million of its common stock in a private placement which resulted in net
proceeds of $26.2 million. The Corporation utilized a portion of these proceeds,
$15.5 million, to infuse capital into the Bank. The Corporation, as a part of
the recapitalization, also reached a settlement for a $6.5 million payment to
retire its $12.5 million of subordinated debentures. Recapitalization occurred
as the culmination of the following historical progression of events.
In March 2003, the Bank entered into a formal Cease and Desist Order (the
"Order") under Federal and State banking laws. As a result of this Order, the
Bank initiated significant management and operational changes along with balance
sheet strategies to comply with the Order. The Bank experienced substantial
adverse publicity as a result of the public notice of this Order and from the
reported financial condition of the Bank. This negative publicity resulted in
substantial deposit runoff. The Bank also incurred an inordinate amount of legal
and accounting fees, along with consulting costs during 2003 in its attempt to
address the financial and operational deficiencies which led to the issuance of
the Order. Early in 2005, the Order was terminated. The Order is discussed in
more detail in the Consolidated Notes to the Financial Statements and later in
Management's Discussion.
The Corporation reported a loss of $1.6 million in 2004, a decrease from the
$9.6 million loss recorded in 2003. The loss per share in 2004 was $3.23,
compared with $27.32 per share in 2003. In 2002, the net loss was $26.7 million,
which amounted to $76.11 per share.
At December 31, 2004, the Corporation had total assets of $339.5 million, a
decrease of $83.0 million from December 31, 2003 assets of $422.5 million.
During 2004, total loans, before the allowance for loan losses, decreased $94.0
million, or 31.6%, to $203.8 million. Commercial loans decreased $89.9 million
and residential real estate loans decreased $5.8 million. The decrease in the
loan portfolio during 2004 was significantly impacted by the sale of
approximately $40 million of primarily nonperforming loans. Other reductions
came as a result of paydowns and nonrenewals due to tighter credit underwriting
practices and management's decision to diversify the inherent risk of the loan
portfolio.
During 2003 and 2002 results of operations were significantly impacted by high
levels of nonperforming assets. Results of operations were also impacted by
reductions in the loan portfolio which reduced interest income. At the same
time, the Corporation's core deposits decreased and had to be replaced with
out-of-market deposits at above market costs. The Corporation also incurred
additional costs for legal and collection efforts as a result of the high level
of nonperforming assets and other professional fees associated with outsourced
services. Finally, management has had to redirect its efforts to address
nonperforming assets and the short-term liquidity and capital needs of the
Corporation; this impacted the results of operations due to management's focus
on the rehabilitation of the Bank. In 2004, new management of the Corporation
made significant progress in addressing the financial condition of the Bank by
significantly reducing nonperforming assets, reducing reliance on outsourced
services, and instituting sound banking policies and procedures.
49
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The table below shows balances of nonperforming assets for the three years ended
December 31, 2004 (dollars in thousands):
2004 2003 2002
-------- -------- --------
NONPERFORMING ASSETS:
Nonaccrual loans $ 4,307 $ 38,660 $ 26,814
Accruing loans past due 90 days or more -0- 241 401
Restructured loans -0- 7,181 11,108
-------- -------- --------
Total nonperforming loans 4,307 46,082 38,323
Other real estate owned 1,730 4,356 5,409
-------- -------- --------
Total nonperforming assets $ 6,037 $ 50,438 $ 43,732
======== ======== ========
Nonperforming loans as a % of loans 2.11% 15.47% 8.81%
-------- -------- --------
Nonperforming assets as a % of assets 1.78% 11.94% 7.74%
-------- -------- --------
RESERVE FOR LOAN LOSSES:
At period end $ 6,966 $ 22,005 $ 24,908
-------- -------- --------
As a % of loans 3.42% 7.39% 5.73%
-------- -------- --------
As a % of nonperforming loans 161.74% 47.75% 65.00%
-------- -------- --------
As a % of nonaccrual loans 161.74% 56.92% 92.89%
======== ======== ========
The following table details the impact of nonperforming loans on interest income
for the three years ended December 31, 2004 (dollars in thousands):
2004 2003 2002
------- ------- -------
Interest income that would have been recorded at
original rate $ 803 $ 2,793 $ 1,653
------- ------- -------
Interest income that was actually recorded 1,053 1,307 1,120
------- ------- -------
Net interest lost (gained) $ (250) $ 1,486 $ 533
======= ======= =======
Total deposits decreased $90.1 million or 29.5% in 2004, to $215.7 million. The
decrease was due in part to management's decision to shrink the deposit
portfolio in order to match the reduction in loans. The Bank also sold $26.5
million of deposits through the sale of five branch offices.
Capital increased $24.0 million in 2004, primarily due to the 2004
recapitalization. As discussed in detail in the Capital and Regulatory section,
the Corporation and the Bank are subject to minimum regulatory capital
requirements. At December 31, 2004, the Bank and the Corporation were well
capitalized as defined by regulatory capital requirements.
FINANCIAL POSITION
LOANS
Recognizing that loans are expected to provide the highest yield for earning
assets, the Corporation has historically operated with a strategy of maximizing
the level of the loan portfolio. In 2004 and 2003, management made strategic
decisions to reduce the size of the loan portfolio and the exposures to certain
industries, particularly the hotel and tourism industry. Management concentrated
its loan portfolio efforts to reduce nonperforming loans and credit
concentrations during 2004. Total loans declined $94.0 million and $137.2
million in 2004 and 2003, respectively. In 2004, the Bank sold $40.0 million of
primarily nonperforming loans. The sale of these loans did not result in any
gain or loss since the total reduced carrying value was previously recognized as
a specific reserve allocation. The Corporation's loans to the hotel and tourism
industry decreased $23.5 million in 2004.
50
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Loans represented 60.0% of total assets at the end of 2004 compared to 70.5% at
the end of 2003. The loan to deposit ratio decreased from 97.4% at December 31,
2003, to 94.5% at December 31, 2004. The loan to deposit ratio is still higher
than the Corporation's peer group, due in part to the utilization of Federal
Home Loan Bank long-term borrowings.
Following is a summary of the Corporation's loan balances at December 31
(dollars in thousands):
Percent Change
-----------------------
2004 2003 2002 2004/2003 2003/2002
--------- --------- --------- --------- ---------
Commercial real estate $ 105,619 $ 161,976 $ 234,618 (34.79) (30.96)
Commercial, financial, and agricultural 47,446 80,988 117,309 (41.42) (30.96)
One to four family residential real estate 45,292 51,120 74,366 (11.40) (31.26)
Consumer 2,379 3,195 5,706 (25.54) (44.01)
Construction 3,096 567 3,044 446.03 (81.37)
--------- --------- --------- --------- ---------
Total $ 203,832 $ 297,846 $ 435,043 (31.56) (31.54)
--------- --------- --------- --------- ---------
Every segment of the loan portfolio, except construction loans, declined in 2004
and 2003. These declines can be attributed to the following factors:
- The continued low interest rate environment made long-term financing
attractive for many borrowers who refinanced with competitors. This is
largely the cause of the decline in the residential real estate portfolio
and was a contributing factor for the decrease in the commercial real
estate portfolio.
- The continued slowdown in the economy has had a significant impact on the
local markets the Corporation serves. This has resulted in very little new
commercial loan growth in these markets and intense competition for new
projects.
- During 2003, the Corporation's lending staff undertook a thorough review
of the portfolio and lending process. As a result of the tightened
underwriting standards and the time devoted to managing the existing
portfolio, the Corporation did not actively compete for new commercial
loans. In 2004, after strengthening the lending staff, the Bank had
limited success in making new loans but was still inhibited largely due to
the restraints of the Order and capital deficiency.
- As a result of the Order and in conjunction with stringent lending
criteria, management has made a conscious effort to direct some borrowers
to refinance with other lenders. Those loans which do not meet current
underwriting standards or desired industry concentrations are directed to
find alternative financing when up for renewal.
The last two factors were the most significant reasons behind the decline in the
commercial and commercial real estate segments of the portfolio. The Corporation
was not aggressively competing for new loans. It was also not willing to meet
the refinancing requests of many existing customers.
Management has strengthened its lending staff and established a central loan
underwriting, documentation, and approval process which will allow the
Corporation to again become an active participant in serving the commercial loan
needs of its local markets. The Corporation continues to feel that a properly
positioned loan portfolio is the most attractive earning asset available and is
the key to returning the Corporation to profitability. The Bank, as a result of
the recapitalization, has initiated its new business plan relative to loan
growth by opening a new loan production office in Oakland County, Michigan and
staffing this office with an experienced commercial lender. The Bank has also
recently hired additional commercial lenders in two of its other markets and
will be adding additional real estate lenders as well.
51
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Following is a table showing the significant industry types in the commercial
loan portfolio as of December 31 (dollars in thousands):
2004 2003
Outstanding Percent of Percent Outstanding Percent of Percent
Balance Commercial Loans of Capital Balance Commercial Loans of Capital
----------- ---------------- ---------- ----------- ---------------- ----------
Hospitality and Tourism $ 52,659 34.40% 151.62% $ 76,131 31.33% 711.50%
Gaming 14,310 9.35 41.20 22,317 9.19 208.57
Petroleum 7,718 5.04 22.22 8,770 3.61 81.96
Forestry 2,245 1.47 6.46 1,911 0.79 17.86
Other 76,133 49.74 219.21 133,835 55.08 1,250.79
----------- ---------------- ---------- ----------- ---------------- ----------
Total Commercial Loans $ 153,065 100.00% $ 242,964 100.00%
=========== ================ =========== ================
Management has recognized the additional risk presented by the concentration in
certain segments of the portfolio, particularly hospitality and gaming. Late in
March 2004, the Corporation completed a loan sale of $25.2 million which
included $17.5 million in nonaccrual loans. This loan sale also included $14.2
million of hospitality and tourism loans which when sold, reduced the Bank's
loan concentration for this industry segment from 31.3% of total commercial
loans at 2003 year-end to approximately 25% after the sale. Management intends
to continue reduction of loan concentrations in hospitality and gaming by
curtailing underwriting of new loans to these industry segments along with
natural attrition through portfolio maturities and tightening of lending
criteria for new and renewal loans. These strategies have been undertaken to
meet the liquidity and capital requirements of the Corporation as well as to
diversify the risk in the overall loan portfolio.
In March 2003, the Corporation made a decision to cease the operations of North
Country Financial Group. This was done in order to refocus the Corporation's
lending efforts and decrease the size of certain segments of the loan portfolio.
The Corporation may pursue new lease opportunities through unrelated entities,
where the credit quality and rate of return on the transactions fit its
strategies.
The Corporation has also funded leases to governmental units, including Native
American organizations. Tax-exempt leases decreased 38.1%, or $7.0 million in
2004, as the Corporation made a decision to reduce its tax-exempt portfolio due
to its lack of current and projected taxable income.
Due to the seasonal nature of many of the Corporation's commercial loan
customers, loan payment terms were historically structured around the customer's
business cycle. The lending staff evaluates the collectability of the past due
loans based on documented collateral values and payment history. The Corporation
discontinues the accrual of interest on loans when, in the opinion of
management, there is an indication that the borrower may be unable to meet the
payments as they become due. Upon such discontinuance, all unpaid accrued
interest is reversed. Loans are returned to accrual status when all principal
and interest amounts contractually due are brought current and future payments
are reasonably assured.
ALLOWANCE FOR LOAN LOSSES
Management analyzes the allowance for loan losses on a monthly basis to
determine whether the losses inherent in the portfolio are properly reserved
for. In conjunction with the Corporation's senior lending staff and the bank
regulatory examinations, management intensified the review of the Corporation's
loans, related collateral evaluations, and the overall lending process during
2003 and 2004. The Corporation also utilized a loan review consultant in 2003
and 2004 to perform a review of the loan portfolio. The opinion of this
consultant upon completion of the independent review provided findings similar
to management on the overall adequacy of the reserve. The Corporation
anticipates utilization of this same consultant for loan review during 2005.
52
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
As a result of these changes in the Corporation's monitoring of delinquent
credits and more rigorous collection efforts, management believes that credit
problems will be identified and resolved earlier, at which time there may be
more opportunities for favorable resolution.
The Corporation's credit quality history is demonstrated in the following table
(dollars in thousands):
2004 2003 2002
---------- ---------- ---------
Total loans, at period end $ 203,832 $ 297,846 $ 435,043
Average loans for the year $ 244,730 $ 361,144 $ 484,889
Allowance for loan losses $ 6,966 $ 22,005 $ 24,908
Allowance to total loans at end of year 3.4% 7.4% 5.7%
Net charge-offs during the year $ 15,039 $ 2,903 $ 12,194
Net charge-offs to average loans 6.1% 0.8% 2.5%
Net charge-offs to beginning allowance balance 68.3% 11.7% 116.8%
Nonaccrual loans at end of year $ 4,307 $ 38,660 $ 26,814
Loans past due 90 days or more -0- 241 401
Restructured loans -0- 7,181 11,108
---------- ---------- ---------
Total nonperforming loans $ 4,307 $ 46,082 $ 38,323
Nonperforming loans to total loans at end of year 2.1% 15.5% 8.8%
Nonaccrual loans have decreased $34.4 million from December 31, 2003 to December
31, 2004, while loans 90 days or more past due and still accruing have decreased
$.2 million and restructured loans decreased $7.2 million during the year. In
2004, the Bank sold $40.0 million of primarily nonperforming loans of which
$22.9 were in a nonaccrual status. There was no gain or loss on these sales of
loans since the sale proceeds were equal to the net carrying value of the loans
sold.
The computation of the required allowance for loan losses as of any point in
time is one of the critical accounting estimates made by management in the
financial statements. As such, factors used to establish the allowance could
change significantly from the assumptions made and impact future earnings
positively or negatively. The future of the national and local economies and the
resulting impact on borrowers' ability to repay their loans and the value of
collateral are examples of areas where assumptions must be made for individual
loans, as well as the overall portfolio.
The Corporation's computation of the allowance for loan losses follows the
Interagency Policy Statement on Allowance for Loan and Lease Losses
Methodologies and Documentation for Banks and Savings Associations issued by the
Federal Financial Institutions Examination Council (FFIEC) in July 2001. The
computation of the allowance for loan losses considers prevailing local and
national economic conditions as well as past and present underwriting practices.
53
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ALLOWANCE FOR LOAN AND LEASE LOSSES - THREE YEAR SUMMARY (dollars in thousands)
2004 2003 2002
--------- --------- ---------
Balance at beginning of period $ 22,005 $ 24,908 $ 10,444
Loans charged off:
Commercial, Financial & Agricultural 10,187 5,068 11,925
One-to-four family residential real estate 3,118 1,683 504
Consumer 2,453 205 141
--------- --------- ---------
Total loans charged off 15,758 6,956 12,570
--------- --------- ---------
Recoveries of loans previously charged off:
Commercial, Financial & Agricultural 312 2,926 314
One-to-four family residential real estate 148 931 3
Consumer 259 196 59
--------- --------- ---------
Total recoveries of loans previously charged off 719 4,053 376
--------- --------- ---------
Net loans charged off 15,039 2,903 12,194
--------- --------- ---------
Provision charged to expense -0- -0- 26,658
Balance at end of period $ 6,966 $ 22,005 $ 24,908
========= ========= =========
Reserve as a percent of loans 3.42% 7.39% 5.73%
Net loans charged off as a percent of average loans 6.15% 0.80% 2.51%
Loans outstanding at period end $ 203,832 $ 297,846 $ 435,043
--------- --------- ---------
Average loans outstanding during period $ 244,730 $ 361,144 $ 484,889
--------- --------- ---------
As part of the management of the loan portfolio, risk ratings are assigned to
all commercial loans. Through the loan review process ratings are modified as
believed to be appropriate to reflect changes in the credit. Using a historical
average loss by loan type as a base, each loan graded as higher risk is assigned
a specific percentage. Within the commercial loan portfolio, the historical loss
rates are used for specific industries such as hospitality, gaming, petroleum,
and forestry. The residential real estate and consumer loan portfolios are
assigned a loss percentage as a homogenous group. If, however, on an individual
loan the projected loss based on collateral value and payment histories is in
excess of the computed allowance, the allocation is increased for the higher
anticipated loss. These computations provide the basis for the allowance for
loan losses as recorded by the Corporation.
Following is a table showing the specific loan allocation of the allowance for
loan losses at December 31, 2004 (dollars in thousands):
Commercial, financial and agricultural loans $ 1,419
One-to-four family residential real estate loans 97
Consumer loans -0-
Unallocated and general reserves 5,450
-------
Total $ 6,966
=======
At the end of 2004, the allowance for loan losses represented 3.4% of total
loans. In management's opinion, the allowance for loan losses is adequate to
cover probable losses related to specifically identified loans, as well as
probable losses inherent in the balance of the loan portfolio.
As part of the process of resolving problem credits, the Corporation may acquire
ownership of real estate collateral which secured such credits. The Corporation
carries this collateral in other real estate on the balance sheet.
54
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following table represents the activity in other real estate (dollars in
thousands):
Balance at January 1, 2003 $ 5,409
Other real estate transferred from loans 4,340
Other real estate transferred from premises -0-
Impairment write-downs and payments applied (848)
Other real estate sold (4,545)
-------
Balance at December 31, 2003 4,356
Other real estate transferred from loans 4,762
Other real estate transferred from premises -0-
Impairment write-downs and payments applied (265)
Other real estate sold (7,123)
-------
Balance at December 31, 2004 $ 1,730
=======
Other real estate is initially valued at the lower of cost or the fair value
less selling costs. After the initial receipt, management periodically
re-evaluates the recorded balance and any additional reductions in the fair
value result in a write-down of other real estate.
SECURITIES
During 2004, the securities portfolio continued to be an important component of
the Corporation's strategy to diversify its asset base and increase liquidity.
Securities decreased $27.7 million in 2004, from $84.8 million at December 31,
2003 to $57.1 million at December 31, 2004.
The carrying value of the Corporation's securities is as follows at December 31
(dollars in thousands):
2004 2003
------- -------
U S agencies $21,843 $36,225
Obligations of states and political subdivisions 4,029 4,105
Corporate securities 681 708
Mortgage-related securities 30,522 43,736
------- -------
Total securities $57,075 $84,774
======= =======
Securities as a percent of year end assets 16.81% 20.06%
55
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Corporation's policy is to purchase securities of high credit quality,
consistent with its asset/liability management strategies. During the year
securities were purchased and others matured or were called as steps in the
process of managing the interest-rate-risk profile of the portfolio. No gains or
losses on sales or securities were recognized in 2004. A net gain of
approximately $427,000 was recognized during the year 2003 with the proceeds
from the sale of securities used to purchase new securities and increase
liquidity. The Corporation classifies all securities as available for sale, in
order to maintain adequate liquidity and to maximize its ability to react to
changing market conditions.
DEPOSITS
Total deposits at December 31, 2004, were $215.7 million compared to $305.8
million at the end of 2003. The table below shows the deposit mix for the
periods indicated (dollars in thousands)
2004 Mix 2003 Mix 2002 Mix
--------- ------ --------- ------ -------- ------
Non-interest bearing accounts $ 20,956 9.72 % $ 26,179 8.56 % $ 40,797 9.33 %
Savings 72,103 33.44 91,835 30.03 159,297 36.41
Time Deposits
Internet 51,831 24.03 74,405 24.33 65,094 14.88
Brokered -0- -0- 29,964 9.80 54,964 12.56
Other 70,760 32.81 83,411 27.28 117,342 26.82
--------- ------ --------- ------ -------- ------
Total Time Deposits 122,591 56.84 187,780 61.41 237,400 54.26
--------- ------ --------- ------ -------- ------
Total Deposit Liabilities $ 215,650 100.00 % $ 305,794 100.00 % 437,494 100.00 %
========= ====== ========= ====== ======== ======
In 2004 the Corporation, due to the significant reduction in loans and leases,
was able to reduce its reliance on brokered and noncore certificates of deposits
over $100,000. Brokered deposits decreased by $30.0 million.
During 2002 and 2003, the Corporation experienced a reduction in local deposits
in part due to the adverse publicity concerning the financial condition of the
Bank. This deposit runoff continued during 2004. In addition to the deposit
runoff, the Corporation closed five branch locations and sold the deposits of
five branch locations. Deposits sold amounted to $26.5 million. To offset this
deposit runoff the Corporation increased its reliance on Internet certificates
of deposit. As of December 31, 2004 Internet deposits amounted to 24.0% of total
deposits. The Bank had no brokered deposits. This, combined with retail
deposits, brought time deposits to 56.84% of total deposits at December 31,
2004, compared to 61.41% at December 31, 2003 and 54.26% at December 31, 2002.
The funding through Internet time deposits, along with a $5.2 million decrease
in noninterest-bearing deposits, had a negative effect on the Corporation's net
interest margin, as noncore out-of-market deposits carry higher interest costs.
Management is introducing new deposit products to its local markets during 2005.
The plan is to increase core deposits sufficiently to reduce the dependence on
out-of-market deposits.
Borrowings
The Corporation historically used alternative funding sources to provide
long-term, stable sources of funds. Borrowings have remained relatively stable
from December 31, 2003 to December 31, 2004, decreasing $2.0 million to $85.0
million, of which $83.6 million were from the Federal Home Loan Bank of
Indianapolis (FHLB). The borrowings carry fixed interest rates and stated
maturities ranging through 2011. Fixed rate borrowings totaling $80.0 million
are callable quarterly at the option of the FHLB and can also be converted to
variable rates, at the option of the FHLB, should rates rise above certain index
levels. These borrowings are secured by a blanket collateral agreement on the
Bank's residential mortgage loans and specific assignment of securities, loans
and cash. In the first quarter of 2005, the Bank prepaid $48.6 million in FHLB
borrowings and incurred a $4.3 million prepayment penalty. This prepayment was
done to utilize excess liquidity and to better position the Bank's funding in
relation to earning assets.
56
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
SHAREHOLDERS' EQUITY
Changes in shareholders' equity are discussed in detail in the "Capital and
Regulatory" section of this report.
RESULTS OF OPERATIONS
SUMMARY
The Corporation incurred a loss of $1.6 million in 2004, compared to a loss of
$9.6 million and $26.7 million in 2003 and 2002, respectively. The reduction in
the pretax loss of $8.0 million in 2004 compared to 2003 is primarily a result
of a gain of $6.6 million on the settlement of the subordinated debentures and a
decrease in noninterest expense of $1.9 million. Basic earnings per share was a
loss of $3.23 in 2004 compared to a loss of $27.32 and a loss of $76.11 in 2003
and 2002, respectively.
The following table details changes in earnings and earnings per share for the
three years ended December 31, 2004 (dollars in thousands except for per share
data):
Income/Expense Change
------------------------------- ---------------------------------------------
2004 2003 2002 2004/2003 2003/2002
Dollars Dollars Dollars Dollars Per Share Dollars Per Share
-------- -------- --------- --------- --------- --------- ---------
Net Income, prior period N/A N/A N/A $ (9,588) $ (27.32) $ (26,731) $ (76.11)
Interest Income $ 18,853 $ 23,641 $ 35,969 (4,788) (9.69) (12,328) (35.12)
Interest Expense 10,615 14,015 18,089 (3,400) (6.88) (4,074) (11.61)
-------- -------- --------- --------- --------- --------- ---------
Net Interest Income 8,238 9,626 17,880 (1,388) (2.81) (8,254) (23.52)
Provision for Loan Losses -0- -0- 26,658 -0- -0- (26,658) (75.95)
-------- -------- --------- --------- --------- --------- ---------
Net interest income (loss) after provision 8,238 9,626 (8,778) (1,388) (2.81) 18,404 52.43
Noninterest Income:
Service fees 982 1,529 1,899 (547) (1.11) (370) (1.05)
Loan and lease fees 17 58 1,095 (41) (0.08) (1,037) (2.95)
Net security gains -0- 427 746 (427) (0.86) (319) (0.91)
Gain on sales of loans 39 136 506 (97) (0.20) (370) (1.05)
Gain on sales of branches 205 -0- 464 205 0.41 (464) (1.32)
Gain on settlement of subordinated debentures 6,617 -0- -0- 6,617 13.39 -0- -0-
Other noninterest 682 1,081 548 (399) (0.81) 533 1.52
-------- -------- --------- --------- --------- --------- ---------
Total noninterest income 8,542 3,231 5,258 5,311 10.75 (2,027) (5.77)
-------- -------- --------- --------- --------- --------- ---------
Noninterest Expense:
Salaries and employee benefits 8,032 5,973 7,589 2,059 4.17 (1,616) (4.60)
Furniture and equipment 887 1,367 1,437 (480) (0.97) (70) (0.20)
Occupancy 994 1,387 1,629 (393) (0.80) (242) (0.69)
Data processing 1,220 1,517 1,894 (297) (0.60) (377) (1.07)
Accounting, legal and consulting fees 1,836 3,145 1,800 (1,309) (2.65) 1,345 3.83
Loan and deposit 1,718 1,992 1,111 (274) (0.55) 881 2.51
Telephone 382 1,382 1,305 (1,000) (2.02) 77 0.22
Impairment of intangibles -0- 60 3,647 (60) (0.12) (3,587) (10.22)
ORE writedowns/impairment 265 400 2,418 (135) (0.81) (2,018) (5.75)
Loss on sale of prop & equip & ORE 459 362 648 97 (0.73) (286) (0.81)
Advertising 115 182 545 (67) (0.31) (363) (1.03)
Amortization of intangibles 308 460 420 (152) (0.31) 40 0.11
Other Operating 2,012 1,889 2,620 123 1.35 (731) (2.08)
-------- -------- --------- --------- --------- --------- ---------
Total noninterest expense 18,228 20,116 27,063 (1,888) (3.82) (6,947) (19.79)
-------- -------- --------- --------- --------- --------- ---------
Income (loss) before provision for income taxes (1,448) (7,259) (30,583) 5,811 11.76 23,324 66.45
Provision (credit) for income taxes 147 2,329 (3,870) (2,182) 4.42 6,199 17.66
-------- -------- --------- --------- --------- --------- ---------
Change due to increase in outstanding shares N/A N/A N/A N/A 7.91 N/A -0-
Net Change -0- -0- -0- 7,993 24.09 17,125 48.79
-------- -------- --------- --------- --------- --------- ---------
Net Income (loss), current period $ (1,595) $ (9,588) $ (26,713) (1,595) (3.23) $ (9,588) (27.32)
======== ======== ========= ========= ========= ========= =========
Net interest income is the Corporation's primary source of core earnings. Net
interest income decreased $1.4 million to $8.2 million in 2004. In 2003, net
interest income decreased $8.3 million, from $17.9 million in 2002.
57
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The decrease in rates in 2003 and 2002 was a significant factor in the
decreasing trend in net interest income, as the Corporation's balance sheet was
asset sensitive. In 2003 and 2004, the net interest income was further impacted
by the decrease in loans, the increased level of nonaccrual loans, and liquidity
strategies which resulted in higher costs for deposits and lower earnings on
investments. In 2004 rates increased, which had a favorable impact on the Bank's
net interest margin since the Bank is asset sensitive.
The decrease in the provision for loan losses of $26.7 million in 2003 is
discussed in detail in the loans section.
Noninterest income increased $5.3 million in 2004 due to a $6.6 million gain in
the settlement of the subordinated debentures. Noninterest expenses in general
declined for 2004, however, salaries, commissions, and benefits increased by
$2.1 million in 2004 due primarily from contractual payouts in December as
result of the change of control from the recapitalization.
NET INTEREST INCOME
Net interest income represents the difference between the average yield earned
on interest-earning assets and the average rate paid on interest-bearing
obligations. The net interest income is impacted by economic and competitive
factors that influence rates, loan demand, and the availability of funding.
Because the Corporation has a significant portion of its commercial loans at
rates that adjust with changes to the prime rate, these rate changes have a
significant impact on the Corporation's interest income.
In 2004, the Corporation's net interest margin was 2.57%, an increase of 32
basis points from the 2003 net interest margin of 2.25%. This reversed the trend
from the 2003 decline of 111 basis points and 2002 when the net interest margin
declined 82 basis points from the 2001 margin of 4.18%. Management believes that
its interest margin has stabilized and expects to show continued future
improvement from the decline in nonaccrual loans as a result of the loan sale
discussed elsewhere in this report. The Bank is also well positioned in an asset
sensitive position to benefit from expected rate increases in 2005.
The following table details sources of net interest income for the three years
ended December 31, 2004 (dollars in thousands):
2004 Mix 2003 Mix 2002 Mix
-------- ----- -------- ----- -------- -----
Interest Income
Loans $ 16,303 83.4 % $ 21,323 86.9 % $ 33,032 88.6 %
Funds sold 210 1.1 312 1.3 204 0.6
Taxable securities 2,776 14.2 2,566 10.4 3,628 9.7
Nontaxable securities 259 1.3 348 1.4 403 1.1
-------- ----- -------- ----- -------- -----
Total earning assets $ 19,548 100.0 % $ 24,549 100.0 % $ 37,267 100.0 %
-------- ----- -------- ----- -------- -----
Interest Expense
NOW and money market deposits $ 870 8.2 % $ 1,433 10.2 % $ 3,484 19.3 %
Savings deposits 187 1.8 208 1.5 368 2.0
Time deposits 4,386 41.3 7,053 50.3 8,592 47.5
Borrowings 4,730 44.6 4,832 34.5 5,100 28.2
Subordinated debentures 442 4.1 489 3.5 545 3.0
-------- ----- -------- ----- -------- -----
Total interest-bearing funds $ 10,615 100.0 % $ 14,015 100.0 % $ 18,089 100.0 %
-------- ----- -------- ----- -------- -----
Net interest income-
taxable equivalent basis $ 8,933 $ 10,534 $ 19,178
======== ======== ========
Average Rates
Earning assets 5.63 % 5.25 % 6.53 %
-------- -------- --------
Interest-bearing funds 3.33 3.15 3.42
-------- -------- --------
Net yield on earning assets 2.57 2.25 3.36
======== ======== ========
58
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
While a majority of the Corporation's loan portfolio is repriced with each prime
rate change due to floating rate loans and the refinancing of residential real
estate loans into the long-term secondary market, similar rate changes do not
impact the pricing of interest-bearing liabilities to nearly the same degree.
The mix of time deposits was also impacted by the Corporation's need to utilize
the brokered and Internet certificate of deposit markets in 2003 and 2004 to
replace deposit withdrawals in its local markets which resulted in a higher cost
source of funds.
The cost of interest-bearing obligations also declined less than the rates on
interest-earning assets due to the fact that the Corporation's borrowings from
the FHLB, all of which were entered into prior to 2003, are at fixed rates and,
therefore, did not decrease in 2003. The future impact of FHLB borrowings will
be somewhat mitigated as a result of the prepayment of $45 million of these
borrowings early in 2005.
One final factor that negatively impacted the Corporation's net interest margin
in 2004, 2003 and 2002 was the high level of nonaccrual loans. The average
balance of nonaccrual loans was $16.4 million in 2004, $36.4 million in 2003 and
$11.8 million in 2002.
59
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following table presents the amount of interest income from average
interest-earning assets and the yields earned on those assets, as well as the
interest expense on average interest-bearing obligations and the rates paid on
those obligations. All average balances are daily average balances.
Years ended December 31,
------------------------------------------------------------------------------------------------
2004 2003 2002
------------------------------- ---------------------------- ------------------------------
Average Interest Average Interest Average Interest
Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ Outstanding Earned/ Yield/
Balance Paid Rate Balance Paid Rate Balance Paid Rate
----------- -------- ------ ----------- -------- ------ ----------- -------- ------
(Dollars in Thousands)
Interest-earning assets:
Loans (1,2,3) $ 244,730 $ 16,303 6.66% $ 361,144 $ 21,323 5.90% $ 484,889 $ 33,032 6.81%
Taxable securities 66,847 2,401 3.59 68,850 2,277 3.31 63,116 3,360 5.32
Nontaxable securities(2) 3,729 259 6.95 3,997 348 8.71 4,609 403 8.74
Federal funds sold 16,415 210 1.28 27,991 312 1.11 13,469 204 1.51
Other interest-earning assets 15,723 375 2.39 5,829 289 4.96 4,618 268 5.80
----------- -------- ---- ----------- -------- ---- ----------- -------- -----
Total interest-
earning assets 347,444 19,548 5.63 467,811 24,549 5.25 570,701 37,267 6.53
----------- -------- ---- ----------- -------- ---- ----------- -------- -----
Interest-bearing obligations:
Savings deposits 80,930 1,056 1.30 134,126 1,642 1.22 215,980 3,852 1.78
Time deposits 140,497 4,386 3.12 210,993 7,053 3.34 212,015 8,592 4.05
Borrowings 86,109 4,731 5.49 87,496 4,832 5.52 88,671 5,100 5.75
Subordinated debentures 11,518 442 3.84 12,450 488 3.93 12,450 545 4.38
----------- -------- ---- ----------- -------- ---- ----------- -------- -----
Total interest-bearing
obligations 319,054 10,615 3.33 445,065 14,015 3.15 529,116 18,089 3.42
----------- -------- ---- ----------- -------- ---- ----------- -------- -----
Net interest income $ 8,933 $ 10,534 $ 19,178
======== ======== ========
Net interest rate spread 2.30% 2.10% 3.11%
==== ==== =====
Net earning assets $ 28,390 $ 22,746 $ 41,585
=========== =========== ===========
Net yield on average interest-
earning assets 2.57% 2.25% 3.36%
==== ==== =====
Average interest-earning assets
to average interest-bearing
obligations 109% 105% 108%
=========== =========== ===========
(1) For purposes of these computations, non-accruing loans are included in the
daily average loan amounts outstanding.
(2) The amount of interest income on nontaxable securities and loans has been
adjusted to a tax equivalent basis using a 34% tax rate.
(3) Interest income on loans includes loan fees.
60
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following table presents the dollar amount, in thousands, of changes in
interest income and interest expense for major components of interest-earning
assets and interest-bearing obligations. It distinguishes between changes
related to higher or lower outstanding balances and changes due to the levels
and fluctuations in interest rates. For each category of interest-earning assets
and interest-bearing obligations, information is provided for changes
attributable to (i) changes in volume (i.e. changes in volume multiplied by old
rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume).
For purposes of this table, changes attributable to both rate and volume are
shown as a separate variance.
Years ended December 31,
--------------------------------------------------------------------------------------
2004 vs. 2003 2003 vs. 2002
----------------------------------------- ------------------------------------------
Increase (Decrease) Increase (Decrease)
Due to Due to
---------------------------- ------------------------------
Rate Total Total
and Increase Rate Increase
Volume Rate Volume (Decrease) Volume Rate and Volume (Decrease)
-------- ------- ------- ---------- ------- ------- ---------- ---------
Interest earning assets:
Loans $ (6,873) $ 2,735 $ (882) $ (5,020) $(8,429) $(4,402) $ 1,124 $ (11,707)
Taxable securities (66) 196 (6) 124 305 (1,273) (116) (1,084)
Nontaxable securities (23) (71) 5 (89) (54) (2) -0- (56)
Federal funds sold (129) 46 (19) (102) 220 (54) (58) 108
Other interest earning assets 491 (150) (255) 86 70 (39) (10) 21
-------- ------- ------- ---------- ------- ------- ---------- ---------
Total interest earning assets $ (6,600) $ 2,756 $(1,157) $ (5,001) $(7,888) $(5,770) $ 940 $ (12,718)
======== ======= ======= ========== ======= ======= ========== =========
Interest bearing obligations
Savings deposits $ (651) $ 109 $ (43) $ (585) $(1,460) $(1,209) $ 458 $ (2,211)
Time deposits (2,356) (466) 156 (2,666) (41) (1,505) 7 (1,539)
Borrowings (77) (25) -0- (102) (68) (203) 3 (268)
Subordinated debentures (37) (11) 1 (47) -0- (56) -0- (56)
-------- ------- ------- ---------- ------- ------- ---------- ---------
Total interest bearing obligations $ (3,121) $ (393) $ 114 (3,400) $(1,569) $(2,973) $ 468 (4,074)
======== ======= ======= ---------- ======= ======= ========== ---------
Net interest income $ (1,601) $ (8,644)
========== =========
As discussed in the Deposits section, the Corporation is developing new deposit
products for its local markets to raise funds to be used to replace the higher
rate out-of-market certificates. This, coupled with the decrease in the level of
nonperforming assets and increased lending in its local markets, is anticipated
to increase the net interest margin. The Bank will also benefit from additional
rate increases due to its existing asset sensitive position, provided that it is
successful with generation of in-market deposit growth to fund new loan
production.
PROVISION FOR LOAN LOSSES
The Corporation records a provision for loan losses when it believes it is
necessary to adjust the allowance for loan losses to maintain an adequate level
after considering factors such as loan charge-offs and recoveries, changes in
identified levels of risk in the loan portfolio, changes in the mix of loans in
the portfolio, loan growth, and other economic factors. There was no provision
for loan losses for the year ended December 31, 2004 and 2003. In 2002, the
provision for loan losses was $26.7 million. The provision expense during 2002
was due to increased charge-offs, along with significant increases in all areas
of nonperforming loans and a high degree of uncertainty pertaining to the credit
quality of the total loan portfolio. The provision for loan losses, as a
percentage of average loans for the year ended December 31, 2002, was 5.5%.
Management will continue to monitor the loan portfolio for changes which may
impact the required allowance for loan losses.
61
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
NONINTEREST INCOME
Noninterest income was $8.7 million, $3.2 million, and $5.3 million in 2004,
2003, and 2002, respectively. The principal recurring sources of noninterest
income are fees for services related to deposit and loan accounts. In 2004, the
Corporation realized a $6.6 million gain from the settlement of the subordinated
debentures as a part of the recapitalization. Gains of $205,000 from branch
sales and $258,000 from the sale of a limited partnership also benefited
noninterest income in 2004.
The most significant reason for the $2.0 million decrease in 2003 relates to
other loan and lease income, which decreased $1.0 million in 2003. This can be
attributed entirely to the fee income generated during the first three quarters
of 2002 by the Corporation's mortgage subsidiary. The mortgage subsidiary ceased
operations during the third quarter of 2002.
The following table details noninterest income for the three years ended
December 31, 2004 (dollars in thousands):
% Increase (Decrease)
2004 2003 2002 2004-2003 2003-2002
------- ------- ------- ---------- ----------
Service fees $ 982 $ 1,529 $ 1,899 (35.78) (19.48)
Loan and lease fees 17 58 1,095 (70.69) (94.70)
Net gains on sale of loans 39 136 506 (71.32) (73.12)
Gain on sale of branches 205 -0- 464 100.00 (100.00)
Gain on settlement of subordinated debentures 6,617 -0- -0- 100.00 0.00
Other 682 1,081 548 (36.91) 97.26
------- ------- ------- ------ -------
Subtotal 8,542 2,804 4,512 204.64 (37.85)
------- ------- ------- ------ -------
Net security gains -0- 427 746 (100.00) (42.76)
------- ------- ------- ------ -------
Total noninterest income $ 8,542 $ 3,231 $ 5,258 164.38 (38.55)
======= ======= ======= ====== =======
Service fees on customer accounts have continued to decline over the three year
period of 2002 through 2004, due to significant declines in deposit balances.
Service fees as a percentage of average non-interest-bearing deposits for the
year ended December 31, 2004, was 4.7%, compared to 5.8% and 4.7% for 2003 and
2002, respectively. Management continually reviews the pricing on its deposit
products in relation to competition and alternative sources of funds. Management
expects to continue to fairly price its fees for services rendered.
NONINTEREST EXPENSE
Noninterest expense was $18.2 million in 2004 compared to $20.1 million and
$27.1 million in 2003 and 2002, respectively.
Noninterest expense declined $1.9 million from 2003 to 2004. In 2004, operating
expenses decreased in all areas except for salaries and benefits. In 2004, as a
part of the recapitalization and the change in control contract provisions of
certain executive officers, contractual payouts totaling $1.4 million were
expensed. Significant decreases in furniture and equipment, occupancy and data
processing were attributed to the branch closures and sales which took place in
2004. In 2004, five branch offices were sold and five branch offices were
closed. The Corporation also had significant expense reductions in accounting,
legal and consulting fees due to less reliance on external outsourcing of
professional services. Telephone expenses were reduced as a result of the
reduced branch locations along with management's successful efforts in managing
long distance and local source telephone costs. Increases in accounting, legal
and consulting fees of $1.3 million from 2002 to 2003 are from the increased
level of outside expertise that the Corporation utilized in its attempt to
address all areas of concern related to the Order. Management is currently
reviewing all areas of noninterest expense to determine areas of cost reduction.
Areas that are expected to decline in future periods include but are not limited
to accounting, legal and consulting fees, data processing and telephone expense.
These areas of noninterest expense will decrease as a result of less reliance on
outside consultants due to more capable management, lower levels of
nonperforming loans and overall reduction in the number of existing branch
locations.
62
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following table details noninterest expense for the three years ended
December 31, 2004 (dollars in thousands):
NONINTEREST EXPENSE
% Increase (Decrease)
2004 2003 2002 2004-2003 2003-2002
-------- -------- -------- ---------- -----------
Salaries and employee benefits $ 8,032 $ 5,973 $ 7,589 34.47 (21.29)
Furniture and equipment 887 1,367 1,437 (35.11) (4.87)
Occupancy 994 1,387 1,629 (28.33) (14.86)
Data processing 1,220 1,517 1,894 (19.58) (19.90)
Accounting, legal and consulting fees 1,836 3,145 1,800 (41.62) 74.72
Loan and deposit 1,718 1,992 1,111 (13.76) 79.30
Telephone 382 1,382 1,305 (72.36) 5.90
Impairment of acquisition intangibles -0- 60 3,647 (100.00) (98.35)
ORE writedowns/impairment 265 400 2,418 (33.75) (83.46)
Loss (Gain) on sale of prop & equip & ORE 459 362 648 26.80 (44.14)
Advertising 115 182 545 (36.81) (66.61)
Amortization of intangibles 308 460 420 (33.04) 9.52
Other operating expenses 2,012 1,889 2,620 6.51 27.90
-------- -------- -------- ------ ------
Total noninterest expense $ 18,228 $ 20,116 $ 27,063 (9.39) (25.67)
======== ======== ======== ====== ======
FEDERAL INCOME TAXES
The income tax expense recorded in 2004 was $147,000, compared to an income tax
expense of $2.3 million in 2003 and an income tax benefit of $3.9 million in
2002. The differences in each year between the tax provision or benefit and the
federal corporate income tax rate of 34% are primarily due to permanent and
temporary differences between book and taxable income. The loss generated for
tax purposes in 2004 will be carried over to future tax years. The 2003 and 2002
tax benefits were reduced by valuation allowances against the net deferred tax
assets. A valuation allowance is provided against deferred tax assets when it is
more likely than not that some or all of the deferred tax assets will not be
realized. The $2.3 million provision in 2003 was recorded to write off all
remaining deferred tax benefits of the Corporation. The provision of $147,000 in
2004 was to recognize further limitations of the 2003 NOL carryback due to
alternative minimum tax. As of December 31, 2004, the Corporation had an NOL
carryforward of approximately $24.4 million along with various credit
carryforwards of $1.5 million. This NOL and credit carryforward benefit is
dependent upon the future profitability of the Corporation, therefore no future
benefit has been recorded.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
In general, the Corporation attempts to manage interest rate risk by investing
in a variety of assets which afford it an opportunity to reprice assets and
increase interest income at a rate equal to or greater than the interest expense
associated with repricing liabilities.
Interest rate risk is the exposure of the Corporation to adverse movements in
interest rates. The Corporation derives its income primarily from the excess of
interest collected on its interest-earning assets over the interest paid on its
interest-bearing obligations. The rates of interest the Corporation earns on its
assets and owes on its obligations generally are established contractually for a
period of time. Since market interest rates change over time, the Corporation is
exposed to lower profitability if it cannot adapt to interest rate changes.
Accepting interest rate risk can be an important source of profitability and
shareholder value; however, excess levels of interest rate risk could pose a
significant threat to the Corporation's earnings and capital base. Accordingly,
effective risk management that maintains interest rate risk at prudent levels is
essential to the Corporation's safety and soundne
Loans are the most significant earning asset. Management offers commercial and
real estate loans priced at interest rates which fluctuate with various indices
such as the prime rate or rates paid on various government issued securities.
When loans are made with longer-term fixed rates, the Corporation attempts to
match these balances with sources of funding with similar maturities in order to
mitigate interest rate risk. In addition, the Corporation prices loans so it has
an opportunity to reprice the loan within 12 to 36 months.
63
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Bank has $57.1 million of securities, of which $30.5 million are mortgage
backed securities providing for scheduled monthly principal and interest
payments as well as unanticipated prepayments of principal. These cash flows are
then reinvested into other earning assets at current market rates. The
Corporation also has investments in federal funds sold to correspondent banks,
as well as other interest bearing deposits with correspondent banks. These funds
are generally repriced on a daily basis.
The Corporation offers deposit products with a variety of terms ranging from
deposits whose interest rates can change on a weekly basis to certificates of
deposit with repricing terms of up to five years. Longer-term deposits generally
include penalty provisions for early withdrawal.
Beyond general efforts to shorten the loan pricing periods and extend deposit
maturities, management can manage interest rate risk by the maturity periods of
securities purchased, selling securities available for sale, and borrowing funds
with targeted maturity periods, among other strategies. Also, the rate of
interest rate changes can impact the actions taken, since the speed of change
affects borrowers and depositors differently.
Exposure to interest rate risk is reviewed on a regular basis. Interest rate
risk is the potential of economic losses due to future interest rate changes.
These economic losses can be reflected as a loss of future net interest income
and/or a loss of current fair market values. The objective is to measure the
effect of interest rate changes on net interest income and to structure the
composition of the balance sheet to minimize interest rate risk and, at the same
time, maximize income.
Management realizes certain risks are inherent and that the goal is to identify
and minimize the risks. Tools used by management include maturity and repricing
analysis and interest rate sensitivity analysis. The Bank has monthly asset/
liability meetings with an outside consultant to review its current position and
strategize about future opportunities on risks relative to pricing and
positioning of assets and liabilities.
The difference between repricing assets and liabilities for a specific period is
referred to as the GAP. An excess of repricable assets over liabilities is
referred to as a positive gap. An excess of repricable liabilities over assets
is referred to as a negative gap. The cumulative gap is the summation of the gap
for all periods to the end of the period for which the cumulative gap is being
measured.
Assets and liabilities scheduled to reprice are reported in the following
timeframes. Those instruments with a variable interest rate tied to an index and
considered immediately repricable are reported in the 1 to 90 day timeframe. The
estimates of principal amortization and prepayments are assigned to the
following timeframes.
The following is the Corporation's repricing opportunities at December 31, 2004
(dollars in thousands):
1 - 90 91 - 365 >1 - 5 Over 5
Days Days Years Years Total
------------ ------------- ------------- ------------- -----------
Interest-earning assets:
Loans $ 146,851 $ 2,590 $ 32,774 $ 21,617 $ 203,832
Securities 3,229 4,480 45,720 3,646 57,075
Other 63,137 -0- -0- -0- 63,137
------------ -------------- ------------- ------------- -----------
Total interest-earning assets 213,217 7,070 78,494 25,263 324,044
------------ ------------- ------------- ------------- -----------
Interest-bearing obligations:
Savings deposits 72,103 -0- -0- -0- 72,103
Time deposits 17,978 65,929 37,926 758 122,591
Borrowings -0- 473 23,082 61,484 85,039
Subordinated debentures -0- -0- -0- -0- -0-
------------ ------------- ------------- ------------- -----------
Total interest-bearing obligations 90,081 66,402 61,008 62,242 279,733
------------ ------------- ------------- ------------- -----------
GAP $ 123,136 $ (59,332) $ 17,486 $ (36,979) $ 44,311
============ ============= ============= ============= ===========
Cumulative GAP $ 123,136 $ 63,804 $ 81,290 $ 44,311
============ ============= ============= =============
64
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The above analysis indicates that at December 31, 2004, the Corporation had a
cumulative asset sensitivity GAP position of $63.8 million within the one-year
timeframe. The Corporation's cumulative asset sensitive GAP suggests that if
market interest rates continue to increase in the next twelve months, the
Corporation has the potential to earn more net interest income. Conversely, if
market interest rates decrease in the next twelve months, the above GAP position
suggests the Corporation's net interest income would decrease.
A limitation of the traditional GAP analysis is that it does not consider the
timing or magnitude of noncontractual repricing or unexpected prepayments. In
addition, the GAP analysis treats savings, NOW and money market accounts as
repricing within 90 days, while experience suggests that these categories of
deposits are actually comparatively resistant to rate sensitivity.
The borrowings in the table above and on the next page include FHLB advances as
fixed-rate advances. A significant portion of these advances give the FHLB the
option to convert from a fixed-rate advance to an adjustable rate advance with
quarterly repricing at three month LIBOR Flat. The exercise of this conversion
feature by the FHLB would impact the maturity dates currently assumed in the
tables. The Bank, in recognition of the interest rate risk exposure of the FHLB
borrowings, prepaid $48.6 million of the borrowings in the first quarter of
2005. This prepayment better positions the Corporation to manage future asset
growth through a better matching of asset and liability maturities.
The Corporation's primary market risk exposure is interest rate risk and, to a
lesser extent, liquidity risk and foreign exchange risk. The Corporation has no
market risk sensitive instruments held for trading purposes. The Corporation has
limited agricultural-related loan assets and therefore has minimal significant
exposure to changes in commodity prices. Any impact that changes in foreign
exchange rates and commodity prices would have on interest rates are assumed to
be insignificant.
Evaluating the exposure to changes in interest rates includes assessing both the
adequacy of the process used to control interest rate risk and the quantitative
level of exposure. The Corporation's interest rate risk management process seeks
to ensure that appropriate policies, procedures, management information systems
and internal controls are in place to maintain interest rate risk at prudent
levels with consistency and continuity. In evaluating the quantitative level of
interest rate risk, the Corporation assesses the existing and potential future
effects of changes in interest rates on its financial condition, including
capital adequacy, earnings, liquidity, and asset quality.
The table below measures current maturity levels of interest-earning assets and
interest-bearing obligations, along with average stated rates and estimated fair
values at December 31, 2004 (dollars in thousands). Nonaccrual loans of $4.3
million are included in the table at an average interest rate of 0.0% and a
maturity greater than five years.
65
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Principal/Notional Amount Maturing / Repricing in:
Fair Value
2005 2006 2007 2008 2009 Thereafter Total 12/31/2004
----------- ---------- ---------- ---------- ---------- ----------- ----------- ----------
RATE SENSITIVE ASSETS
Fixed interest rate
securities $ 7,709 $ 72 $ 25,482 $ 18,079 $ 2,087 $ 3,646 $ 57,075 $ 57,075
Average interest rate 2.41 % 5.50 % 4.61 % 4.00 % 4.10 % 6.03 % 4.19 %
Fixed interest rate loans 3,620 7,888 13,485 3,885 7,516 21,617 58,011 60,696
Average interest rate 7.44 8.29 6.50 6.05 6.75 6.83 6.93
Variable interest rate
loans 145,821 -0- -0- -0- -0- -0- 145,821 145,821
Average interest rate 6.20 -0- -0- -0- -0- -0- 6.20
Other assets 63,137 -0- -0- -0- -0- -0- 63,137 63,137
Average interest rate 2.25 -0- -0- -0- -0- -0- 2.25
Total rate sensitive assets $ 220,287 $ 7,960 $ 38,967 $ 21,964 $ 9,603 $ 25,263 $ 324,044 $ 326,729
========= ======== ======== ======== ======== ========= ========= =========
Average interest rate 4.96 % 8.26 % 5.26 % 4.36 % 6.17 % 6.71 % 5.21 %
========= ======== ======== ======== ======== ========= =========
RATE SENSITIVE LIABILITIES
Interest-bearing savings $ 72,103 $ -0- $ -0- $ -0- $ -0- $ -0- $ 72,103 $ 72,103
Average interest rate 1.50 % -0- % -0- % -0- % -0- % -0- % 1.50 %
Time deposits 83,907 25,322 10,672 1,780 152 758 122,591 122,777
Average interest rate 2.83 3.25 3.73 3.42 3.82 6.47 3.03
Fixed interest rate
borrowings 473 3,082 -0- -0- -0- 1,484 5,039 4,424
Average interest rate 6.50 7.06 -0- -0- -0- 1.00 5.22
Variable interest rate
borrowings -0- -0- -0- 10,000 10,000 60,000 80,000 84,718
Average interest rate 0.00 0.00 0.00 5.49 5.66 5.37 5.42
Total rate sensitive
liabilities $ 156,483 $ 28,404 $ 10,672 $ 11,780 $ 10,152 $ 62,242 $ 279,733 $ 284,022
========= ======== ======== ======== ======== ========= ========= =========
Average interest rate 2.23 % 3.66 % 3.73 % 4.66 % 5.63 % 5.28 % 2.97 %
========= ======== ======== ======== ======== ========= =========
66
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In addition to changes in interest rates, the level of future net interest
income is also dependent on a number of variables, including: the growth,
composition and levels of loans, deposits, and other earning assets and
interest-bearing obligations, and economic and competitive conditions; potential
changes in lending, investing and deposit strategies; customer preferences; and
other factors.
FOREIGN EXCHANGE RISK
In addition to managing interest rate risk, management also actively manages
risk associated with foreign exchange. The Corporation provides foreign exchange
services, makes loans to, and accepts deposits from, Canadian customers
primarily at its banking office in Sault Ste. Marie. To protect against foreign
exchange risk, the Corporation monitors the volume of Canadian deposits it takes
in and then invests these Canadian funds in Canadian commercial loans and
securities. As of December 31, 2004, the Corporation had excess Canadian assets
of $2.0 million (or $1.7 million in U.S. dollars). Management believes the
exposure to short-term foreign exchange risk is minimal and at an acceptable
level for the Corporation. Management intends to limit the Corporation's foreign
exchange risk by acquiring deposit liabilities approximately equal to its
Canadian assets.
OFF-BALANCE-SHEET RISK
Derivative financial instruments include futures, forwards, interest rate swaps,
option contracts and other financial instruments with similar characteristics.
The Corporation currently does not enter into futures, forwards, swaps or
options. However, the Corporation is party to financial instruments with
off-balance-sheet risk in the normal course of business to meet the financing
needs of its customers. These financial instruments include commitments to
extend credit and standby letters of credit and involve to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in
the consolidated balance sheets. Commitments to extend credit are agreements to
lend to a customer as long as there is no violation of any condition established
in the contract. Commitments generally have fixed expiration dates and may
require collateral from the borrower if deemed necessary by the Corporation.
Standby letters of credit are conditional commitments issued by the Corporation
to guarantee the performance of a customer to a third party up to a stipulated
amount and with specified terms and conditions.
Commitments to extend credit and standby letters of credit are not recorded as
an asset or liability by the Corporation until the instrument is exercised. See
note 22 to the consolidated financial statements for additional information.
LIQUIDITY
The Corporation, as a result of the recapitalization and in anticipation of
future loan growth, is currently looking at various alternative sources of
liquidity, such as lines of credit from correspondent banks, borrowings from the
Federal Home Loan Bank, and possible brokered deposit acquisition.
During 2004, the Corporation increased cash and cash equivalents by $21.0
million. The primary reason for the high level of liquidity at 2004 year end was
the recapitalization which provided $26.2 million in proceeds. As shown on the
Corporation's Statement of Cash Flows, despite the net loss of $1.6 million in
2004, the Corporation was able to adequately manage liquidity needs. Significant
factors impacting cash flow were the continued reduction in deposit balances of
$64.9 million, which was primarily funded with loan reductions of $74.3 million.
Liquidity continues to be of primary importance to the near term strategies of
the Corporation.
67
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
During the fourth quarter of 2002, the Corporation experienced an unanticipated
decrease in deposits, in part due to the public reaction to the reported
condition of the Bank. In reaction to this occurrence, management developed a
short-term liquidity plan which involved obtaining deposits via the Internet CD
network, and to a lesser degree the sale of unencumbered securities
available-for-sale. The Corporation has continued to use the Internet CDs as a
primary source of funding to maintain liquidity. As of December 31, 2004
balances of Internet CDs amounted to $51.8 million. As a result of the
recapitalization and with the announcement of a new Bank name, along with a
strategic marketing effort to regain market share, the Bank expects less
reliance on Internet deposits.
From a long-term perspective, the Corporation's liquidity plan for 2005 includes
strategies to increase core deposits in the Corporation's local markets. New
products and advertising are expected to commence in April 2005, with a goal of
raising core deposits to reduce the dependency on noncore deposits, while also
reducing interest costs. The Corporation's liquidity plan for 2005 calls for
augmenting local deposit growth efforts with Internet CD funding to the extent
necessary.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
As disclosed in the Notes to the Consolidated Financial Statements, the
Corporation has certain obligations and commitments to make future payments
under contracts. At December 31, 2004, the aggregate contractual obligations and
commitments are:
Payments Due by Period
----------------------------------------------------
Less than 1 1 to 3 4 to 5 After 5
Year Year Year Year Total
----------- -------- -------- -------- ---------
Contractual Obligations
Total deposits $ 176,966 $ 35,994 $ 1,780 $ 910 $ 215,650
Long-term borrowings 473 3,082 -0- 81,484 85,039
Directors' deferred compensation 131 288 548 371 1,338
Annual rental / purchase commitments
under noncancelable leases / contracts 54 23 -0- -0- 77
----------- -------- -------- -------- ---------
TOTAL $ 177,624 $ 39,387 $ 2,328 $ 82,765 $ 302,104
=========== ======== ======== ======== =========
Other Commitments
Letters of credit $ 17,970 -0- -0- -0- $ 17,970
Commitments to extend credit 11,527 -0- -0- -0- 11,527
Credit card commitments 2,995 -0- -0- -0- 2,995
----------- -------- -------- -------- ---------
TOTAL $ 32,492 $ -0- $ -0- $ -0- $ 32,492
=========== ======== ======== ========= =========
68
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CAPITAL AND REGULATORY
During 2004, total capitalization increased by $11.6 million due to the
recapitalization, which resulted in net proceeds of $26.2 million, and the
settlement of the $12.450 million of subordinated debentures.
The following table details sources of capital for the three years ended
December 31, 2004 (dollars in thousands):
2004 2003 2002
--------- -------- --------
CAPITAL STRUCTURE
Long-term debt (1) $ -0- $ 12,450 $ 12,450
Shareholders' equity 34,730 10,700 20,502
--------- -------- --------
Total capitalization $ 34,730 $ 23,150 $ 32,952
--------- -------- --------
Tangible capital $ 34,275 $ 21,557 $ 30,811
--------- -------- --------
INTANGIBLE ASSETS
Subsidiaries:
Core deposit premium $ 455 $ 1,067 $ 1,587
Other identifiable intangibles -0- 526 554
--------- -------- --------
Total intangibles $ 455 $ 1,593 $ 2,141
--------- -------- --------
RISK-BASED CAPITAL
Tier I capital:
Shareholders' equity $ 34,730 $ 10,700 $ 20,502
Net unrealized gains (losses) on
available for sale securities (492) (1,027) (1,242)
Minority interest 78 2,785 5,706
Less: intangibles (455) (1,593) (2,141)
--------- -------- --------
Total Tier I capital $ 33,861 $ 10,865 $ 22,825
--------- -------- --------
Tier II Capital:
Allowable reserve for loan losses $ 2,918 $ 4,016 $ 5,605
Qualifying long-term debt -0- 6,749 6,803
--------- -------- --------
Total Tier II capital 2,918 10,865 12,408
--------- -------- --------
Total risk-based capital $ 36,779 $ 21,730 $ 35,233
========= ======== ========
Risk-adjusted assets $ 229,355 $303,284 $431,067
========= ======== ========
Capital ratios:
Tier I Capital to risk-weighted assets 14.76% 3.58% 5.30%
Total Capital to risk-weighted assets 16.04% 7.16% 8.17%
Tier I Capital to average assets 10.68% 2.48% 3.83%
(1) Long term debt in the Corporation's subordinated debentures.
As a bank holding company, the Corporation is required to maintain certain
levels of capital under government regulation. There are several measurements of
regulatory capital and the Corporation is required to meet minimum requirements
under each measurement. The federal banking regulators have also established
capital classifications beyond the minimum requirements in order to risk-rate
deposit insurance premiums and to provide trigger points for prompt corrective
action in the event an institution becomes financially troubled. As of December
31, 2004, the Corporation and Bank were well capitalized.
69
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Regulatory capital is not the same as shareholders' equity reported in the
accompanying financial statements. Certain assets cannot be considered assets
for regulatory purposes. The Corporation's acquisition intangibles and a portion
of the deferred tax asset are examples of such assets.
Presented below is a summary of the Corporation's consolidated capital position
in comparison to generally applicable regulatory requirements:
Tier I Tier I Total
Capital to Capital to Capital to
Average Risk Weighted Risk Weighted
Assets Assets Assets
---------- ------------- -------------
Regulatory minimum for capital adequacy purposes 4.0% 4.0% 8.0%
The Corporation:
December 31, 2004 10.68% 14.76% 16.04%
December 31, 2003 2.48% 3.58% 7.16%
The capital levels include adjustment for the capital of subordinated debentures
issued in May 1999, subject to certain limitations. Federal Reserve guidelines
limit the amount of subordinated debentures which can be included in Tier I
capital to 25% of total Tier I capital. The Corporation, as a part of the
recapitalization, entered into a settlement agreement for a $6.5 million payment
in full for the $12,450,000 principal outstanding and accrued interest with the
holders of the subordinated debentures, which resulted in a gain of $6.6
million.
REGULATORY AFFAIRS
In October 2001, the Bank was notified by the FDIC that it was a "troubled
institution" within the meaning of FDIC regulations. As a troubled institution,
the Bank is required to notify the FDIC 30 days prior to the addition or
replacement of a Board member and the employment or changes in responsibilities
of a senior executive officer.
In September 2002, a regularly-scheduled safety and soundness examination of the
Bank was conducted by its principal regulators, the Michigan Office of Financial
and Insurance Services ("OFIS") and the FDIC. During the course of that
examination, the FDIC, the OFIS, and the Federal Reserve Bank of Chicago ("FRB")
requested that the Corporation and the Bank take certain actions, including
suspending the payment of dividends and conserving the liquidity of the
Corporation.
In response to the concerns expressed by the regulators, the Board of Directors
of the Corporation and the Bank adopted resolutions providing for prior
regulatory approval of the declaration or payment of any dividend by the
Corporation or the Bank, and suspension of interest payments by the Corporation
in connection with its trust preferred securities. The agreements relating to
the trust preferred securities allowed for the suspension of payments for up to
20 quarters. As mentioned above, as a part of the recapitalization, a settlement
payment of $6.5 million was made to retire the subordinated debentures.
Following the completion of the 2002 regularly-scheduled safety and soundness
examination of the Bank by the FDIC and the OFIS, and the Bank's receipt of the
related Joint Report of Examination ("Report"), the FDIC and the OFIS, with the
consent of the Bank, on March 26, 2003, entered a formal Cease and Desist Order
(the "Order") under Federal and State banking laws. The Order was reported on
the Corporation's Form 8-K filed on April 9, 2003 and became effective on April
5, 2003. The Order identified deficiencies in the Bank's policies and
procedures, including its directorate and management personnel and practices,
credit underwriting, credit administration, and policies regarding
asset/liability management, liquidity, funds management, and investments, and
its compliance with all applicable laws and regulations, including Regulations O
and U of the Board of Governors of the Federal Reserve System (the "Board"), the
FDIC Rules and Regulations, and the Michigan Banking Code of 1999. The Order
also required the Bank to maintain specified capital ratios during the life of
the Order.
70
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Order required the Bank and its directors to take specific steps, within
time periods specified in the Order, to address the operational deficiencies,
including certain violations of law and regulations, identified by the FDIC and
the OFIS in the Order and the Report. Among other things, the Bank must
establish, and submit to the FDIC and the OFIS for comment, written plans (i) to
reduce the Bank's risk position with respect to certain classified loans
identified in the Report or any subsequent Report of Examination during the life
of the Order, (ii) to reduce identified loan concentrations, (iii) to reduce and
collect delinquent loans, (iv) to eliminate the classified amounts of loans to
directors, executive officers, principal shareholders of the Bank and their
respective related interests, (v) to address the Bank's relationship of volatile
liabilities to temporary investments, rate sensitivity objectives, and
asset/liability management, (vi) setting forth the Bank's strategic plan,
including financial goals and strategies to maintain adequate capital and
liquidity, to reduce problem loans, and to attract and keep qualified
management, (vii) covering the policies and procedures for review and approval
of reimbursement of customer entertainment and business development expenses of
the Bank's directors, officers and employees, (viii) for a realistic budget for
calendar year 2003 and each subsequent year during the life of the Order,
including strategies to improve the Bank's net interest margin, (ix) to reduce
the Bank's portfolio of other real estate owned as a result of foreclosure or
surrender of collateral for loans, and (x) to address procedures for the
directors to monitor, and management to implement, the requirements of the
Order.
Addressing the requirements of the Order, carrying out the objectives of the
strategic plan, and attempting to return the Corporation to profitability
required the strengthening of the executive management team. During 2003, the
Corporation added management with experience in turnaround situations, loan
portfolio, credit and problem loan administration, and financial management
expertise commensurate with the issues the Corporation must address. The
addition of management may increase expense in the short term. However, the
additional management expertise is expected to help the Corporation resolve many
of its issues more quickly, and improve customer service and financial
performance.
The Bank adopted new policies for liquidity, investment and asset liability
management. In regards to its lending functions, practices related to credit
underwriting, credit administration and problem loan management were revamped
and current practices and procedures are believed to be operating within the
requirements of the Order. Most of the above changes were initiated by a new
management team which was put in place as a requirement of the Order, during the
second half of 2003.
The Corporation, through the recapitalization which occurred on December 15,
2004 was successful in addressing all issues of the Order with the exception of
loan concentration. The Order was terminated by regulatory authorities on
February 8, 2005. The Corporation is, however, subject to an informal agreement
with the OFIS and FDIC which has the following financial related action
requirements. The Corporation is required to maintain the Bank's Tier 1 equity
at a minimum of 8%. The Bank is also prohibited from payment of dividends
without prior written consent.
IMPACT OF INFLATION AND CHANGING PRICES
The accompanying financial statements have been prepared in accordance with
generally accepted accounting principles, which require the measurement of
financial position and results of operations in historical dollars without
considering the change in the relative purchasing power of money over time due
to inflation. The impact of inflation is reflected in the increased cost of the
Corporation's operations. Nearly all the assets and liabilities of the
Corporation are financial, unlike industrial or commercial companies. As a
result, the Corporation's performance is directly impacted by changes in
interest rates, which are indirectly influenced by inflationary expectations.
The Corporation's ability to match the interest sensitivity of its financial
assets to the interest sensitivity of its financial liabilities tends to
minimize the effect of changes in interest rates on the Corporation's
performance. Changes in interest rates do not necessarily move to the same
extent as changes in the prices of goods and services.
71
GENERAL INFOMATION
BOARD OF DIRECTORS OFFICERS CONTACT INFORMATION
- ------------------ -------- -------------------
WALTER J. ASPATORE MACKINAC FINANCIAL CORPORATION MACKINAC FINANCIAL CORPORATION
Investment Banker 130 South Cedar Street
Amherst Partners PAUL D. TOBIAS Manistique, MI 49854
Director Since: 2004 Chairman and (906) 341-8401
Chief Executive Officer
C. JAMES BESS SHAREHOLDER INFORMATION
President C. JAMES BESS For assistance with questions,
North Country Bank and Trust Vice Chairman please contact Investor Relations
Vice Chairman (800) 200-7032
Mackinac Financial Corporation ELIOT R. STARK
Director Since: 2003 Executive Vice President and DIVIDEND REINVESTMENT PLAN AGENT
Chief Financial Officer Registrar and Transfer Company
DENNIS B. BITTNER (800) 368-5948
Owner and President JOSEPH E. PETTERSON
Bittner Engineering, Inc. Executive Vice President STOCK TRANSFER AGENT
Director Since: 2001 For questions regarding transfer of
ERNIE R. KRUEGER stock, please contact Registrar and
ROBERT H. ORLEY Senior Vice President and Transfer Company (800) 368-5948
Vice President and Secretary Controller
Real Estate Investment Group, Inc.
Director Since: 2004 NORTH COUNTRY BANK AND TRUST
RANDOLPH C. PASCHKE PAUL D. TOBIAS
Chairman, Department of Accounting Chairman
Wayne State University
School of Business Administration C. JAMES BESS
Director Since: 2004 President and
Chief Executive Officer
ELIOT R. STARK
Executive Vice President and KELLY W. GEORGE
Chief Financial Officer Executive Vice President and
Mackinac Financial Corporation and Chief Lending Officer
North Country Bank and Trust
Director Since: 2004 JOSEPH E. PETTERSON
Executive Vice President
PAUL D. TOBIAS
Chairman and ELIOT R. STARK
Chief Executive Officer Executive Vice President and
Mackinac Financial Corporation Chief Financial Officer
Chairman
North Country Bank and Trust JANI L. BLAKE
Director Since: 2004 Senior Vice President
DAVID C. CRIMMINS
Senior Vice President
ERNIE R. KRUEGER
Senior Vice President and
Controller
72
BRANCH LOCATIONS
GAYLORD ONTONAGON
145 North Otsego Avenue 601 River Street
Gaylord, MI 49735 Ontonagon, MI 49953
(989) 732-3750 (906) 884-4115
KALEVA RIPLEY
14429 Wouski Avenue 106 Royce Road
Kaleva, MI 49645 Hancock, MI 49930
(231) 362-3223 (906) 482-1269
MANISTIQUE SAULT STE. MARIE
130 South Cedar Street 138 Ridge Street
Manistique, MI 49854 Sault Ste. Marie, MI 49783
(906) 341-8401 (906) 635-3992
MARQUETTE MAIN SOUTH RANGE
300 North McClellan Street 47 Trimountain Avenue
Marquette, MI 49855 South Range, MI 49963
(906) 226-5000 (906) 482-1170
MARQUETTE PRESQUE ISLE STEPHENSON
1400 Presque Isle S216 Menominee Street
Marquette, MI 49855 Stepenson, MI 49887
(906) 228-3640 (906) 753-2225
NEWBERRY TRAVERSE CITY
414 Newberry Avenue 3530 North Country Drive
Newberry, MI 49868 Traverse City, MI 49684
(906) 293-5165 (231) 929-5253
73
[This page intentionally left blank]
74
[This page intentionally left blank]
75