UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2006 OR [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______________ to ______________ Commission file number: 0-20167 MACKINAC FINANCIAL CORPORATION (Exact name of registrant as specified in its charter) MICHIGAN 38-2062816 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 130 SOUTH CEDAR STREET, MANISTIQUE, MI 49854 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (888) 343-8147 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, (or for such shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large Accelerated Filer Accelerated Filer Non-accelerated Filer X --- --- --- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes No X --- --- As of October 31, 2006, there were outstanding 3,428,695 shares of the registrant's common stock, no par value. MACKINAC FINANCIAL CORPORATION INDEX Page No. ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets - September 30, 2006 (Unaudited), December 31, 2005 and September 30, 2005 (Unaudited) ............................................... 1 Condensed Consolidated Statements of Operations - Three and Nine Months Ended September 30, 2006 (Unaudited) and September 30, 2005 (Unaudited) ............................ 2 Condensed Consolidated Statements of Changes in Shareholders' Equity - Three and Nine Months Ended September 30, 2006 (Unaudited) and September 30, 2005 (Unaudited) ............ 3 Condensed Consolidated Statements of Cash Flows - Nine Months Ended September 30, 2006 (Unaudited) and September 30, 2005 (Unaudited) ............................................... 4 Notes to Condensed Consolidated Financial Statements (Unaudited) ............................................... 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ................................. 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk ... 24 Item 4. Controls and Procedures ...................................... 27 PART II. OTHER INFORMATION Item 1. Legal Proceedings ............................................ 28 Item 6. Exhibits and Reports on Form 8-K ............................. 33 SIGNATURES ........................................................... 34 MACKINAC FINANCIAL CORPORATION PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CONDENSED CONSOLIDATED BALANCE SHEETS (Dollars in Thousands) September 30, December 31, September 30, 2006 2005 2005 ------------- ------------ ------------- (Unaudited) (Unaudited) ASSETS Cash and due from banks $ 5,537 $ 4,833 $ 5,333 Federal funds sold 11,949 3,110 4,849 -------- -------- -------- Cash and cash equivalents 17,486 7,943 10,182 Interest-bearing deposits in other financial institutions 889 1,025 1,282 Securities available for sale 36,129 34,210 35,506 Federal Home Loan Bank stock 4,152 4,855 4,855 Total loans 292,614 239,771 218,462 Allowance for loan losses (5,316) (6,108) (6,589) -------- -------- -------- Net loans 287,298 233,663 211,873 Premises and equipment 12,643 11,987 11,268 Other real estate held for sale 26 945 1,948 Other assets 4,568 4,094 3,676 -------- -------- -------- Total assets $363,191 $298,722 $280,590 ======== ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Non-interest-bearing deposits $ 22,826 $ 19,684 $ 19,690 Interest-bearing deposits 270,668 212,948 193,578 -------- -------- -------- Total deposits 293,494 232,632 213,268 Borrowings 38,307 36,417 36,417 Other liabilities 3,164 3,085 3,005 -------- -------- -------- Total liabilities 334,965 272,134 252,690 Shareholders' equity: Preferred stock - no par value: Authorized - 500,000 shares, no shares outstanding -- -- -- Common stock and additional paid in capital - no par value Authorized - 18,000,000 shares Issued and outstanding - 3,428,695 shares 42,646 42,412 42,412 Accumulated deficit (14,083) (15,461) (14,434) Accumulated other comprehensive income (loss) (337) (363) (78) -------- -------- -------- Total shareholders' equity 28,226 26,588 27,900 -------- -------- -------- Total liabilities and shareholders' equity $363,191 $298,722 $280,590 ======== ======== ======== See accompanying notes to condensed consolidated financial statements. 1. MACKINAC FINANCIAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in Thousands, Except per Share Data) (Unaudited) Three Months Nine Months Ended Ended September 30, September 30, --------------- ----------------- 2006 2005 2006 2005 ------ ------ ------- ------- INTEREST INCOME: Interest and fees on loans: Taxable $5,635 $3,547 $15,316 $ 9,807 Tax-exempt 189 222 575 694 Interest on securities Taxable 306 282 852 1,178 Tax-exempt 5 42 87 126 Other interest 268 177 631 470 ------ ------ ------- ------- Total interest income 6,403 4,270 17,461 12,275 ------ ------ ------- ------- INTEREST EXPENSE: Deposits 2,951 1,338 7,540 3,666 Borrowings 500 425 1,355 1,509 ------ ------ ------- ------- Total interest expense 3,451 1,763 8,895 5,175 ------ ------ ------- ------- Net interest income before provision for loan losses 2,952 2,507 8,566 7,100 Provision for loan losses -- -- (600) -- ------ ------ ------- ------- Net interest income after provision for loan losses 2,952 2,507 9,166 7,100 ------ ------ ------- ------- OTHER INCOME: Service fees 133 137 365 470 Loan and lease fees 23 5 59 11 Net security gains (1) (1) (1) 96 Net gains on sale of loans 66 17 149 37 Other 19 96 135 194 ------ ------ ------- ------- Total other income 240 254 707 808 ------ ------ ------- ------- OTHER EXPENSE: Salaries and employee benefits 1,487 1,555 4,577 4,665 Occupancy 333 275 943 748 Furniture and equipment 159 133 470 430 Data processing 176 234 512 726 Accounting, legal, and consulting fees 341 204 955 750 Loan and deposit 78 153 305 696 Telephone 55 66 155 203 Advertising 70 314 247 696 Penalty on prepayment of FHLB borrowings -- -- -- 4,320 Other 303 345 856 1,010 ------ ------ ------- ------- Total other expense 3,002 3,279 9,020 14,244 ------ ------ ------- ------- Income (loss) before income taxes 190 (518) 853 (6,336) Provision for (benefit of) income taxes (500) -- (525) -- ------ ------ ------- ------- NET INCOME (LOSS) $ 690 $ (518) $ 1,378 $(6,336) ====== ====== ======= ======= INCOME (LOSS) PER COMMON SHARE: Basic $ .20 $ (.15) $ .40 $ (1.85) ====== ====== ======= ======= Diluted $ .20 $ (.15) $ .40 $ (1.85) ====== ====== ======= ======= See accompanying notes to condensed consolidated financial statements. 2. MACKINAC FINANCIAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Dollars in Thousands) (Unaudited) Three Months Nine Months Ended Ended September 30, September 30, ----------------- ----------------- 2006 2005 2006 2005 ------- ------- ------- ------- Balance, beginning of period $27,179 $28,517 $26,588 $34,730 Stock option compensation 78 -- 234 -- Net income (loss) for period 690 (518) 1,378 (6,336) Change in minority interest of consolidated subsidiary -- -- -- 76 Net unrealized gain (loss) on securities available for sale 279 (99) 26 (570) ------- ------- ------- ------- Total comprehensive income (loss) 1,047 (617) 1,638 (6,830) ------- ------- ------- ------- Balance, end of period $28,226 $27,900 $28,226 $27,900 ======= ======= ======= ======= See accompanying notes to condensed consolidated financial statements. 3. MACKINAC FINANCIAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in Thousands) (Unaudited) Nine Months Ended September 30, ------------------- 2006 2005 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) $ 1,378 $ (6,336) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 762 707 (Gain) on sales of securities -- (96) (Gain) on sales of premises, equipment, and other real estate (60) (64) FHLB stock dividend -- (101) Stock option compensation 234 -- Change in other assets (568) 1,950 Change in other liabilities 79 (1,073) -------- -------- Net cash provided by (used in) operating activities 1,825 (5,013) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Net (increase) decrease in interest-bearing deposits in other financial institutions 136 17,253 Purchase of securities available for sale (5,000) (16,009) Proceeds from sales of securities available for sale -- 30,811 Proceeds from maturities, calls or paydowns of securities available for sale 3,079 6,218 FHLB repurchase of stock 703 -- Net (increase) in loans (53,658) (15,563) Capital expenditures (1,307) (1,088) Proceeds from sale of premises, equipment, and other real estate 1,013 423 Purchase of minority interest in subsidiary of bank -- 76 -------- -------- Net cash provided by (used in) investing activities (55,034) 22,121 -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase (decrease) in deposits 60,862 (2,382) Proceeds from issuance of debt 1,959 1,651 Principal payments on borrowings (69) (50,273) -------- -------- Net cash provided by (used in) financing activities 62,752 (51,004) -------- -------- Net increase (decrease) in cash and cash equivalents 9,543 (33,896) Cash and cash equivalents at beginning of period 7,943 44,078 -------- -------- Cash and cash equivalents at end of period $ 17,486 $ 10,182 ======== ======== SUPPLEMENTAL CASH FLOW INFORMATION: Cash paid during the year for: Interest $ 8,764 $ 5,338 Income taxes -- -- NONCASH INVESTING AND FINANCING ACTIVITIES: Transfers of Foreclosures from Loans to Other Real Estate Held for Sale 23 556 See accompanying notes to condensed consolidated financial statements. 4. MACKINAC FINANCIAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The unaudited condensed consolidated financial statements of Mackinac Financial Corporation (the "Corporation") have been prepared in accordance with generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine month period ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. The unaudited consolidated financial statements and footnotes thereto should be read in conjunction with the audited consolidated financial statements and footnotes thereto included in the Corporation's Annual Report on Form 10-K for the year ended December 31, 2005. The preparation of financial statements in conformity with generally accepted accounting principles 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. In order to properly reflect some categories of other income and other expenses, reclassifications of expense and income items have been made to prior period numbers. The "net" other income and other expenses were not changed due to these classifications. 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 collectibility 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 collectibility. In management's opinion, the allowance for loan losses is adequate to cover probable losses relating to specifically identified loans, as well as probable losses inherent in the balance of the loan portfolio as of the balance sheet date. STOCK OPTION PLANS The Corporation sponsors three stock option plans. One plan was approved in 2000 and applies to officers, employees, and nonemployee directors. This plan was amended as a part of the December 2004 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 reverse stock split), to a total authorized share balance of 453,587. The other two plans, one for officers and employees and the other for nonemployee 5. MACKINAC FINANCIAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) directors, were approved in 1997. A total of 30,000 shares (adjusted for the 1:20 reverse stock 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. The Corporation adopted SFAS No. 123 (Revised) "Share Based Payments" in the first quarter of 2006. 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 adoption resulted in the recognition of after tax compensation expense in the amount of $234,000 for the nine months ended September 30, 2006. The expense recorded recognizes the current period vesting of options outstanding. The after tax compensation expense, using this same accounting treatment would have amounted to $81,000 in the first nine months of 2005. The per share impact of this accounting change was approximately $.02 per share in each quarter and $.07 per share for the nine months ended September 30, 2006. 2. RECENT ACCOUNTING PRONOUNCEMENT The Corporation adopted SFAS No. 123 (revised) "Share Based Payments" in the first quarter of 2006. The Corporation does not expect a material impact on the results of operations for 2006 as a result of this change, with $78,000 reported as expense in the third quarter. 3. EARNINGS (LOSS) PER SHARE 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 three and nine months ended September 30, 2006 and 2005 (dollars in thousands, except per share data): Additional shares issued as a result of option exercises would not be dilutive in either period. Three Months Ended Nine Months Ended September 30, September 30, ----------------------- ----------------------- 2006 2005 2006 2005 ---------- ---------- ---------- ---------- Income (loss) per common share-Basic: Net income (loss) $ 690 $ (518) $ 1,378 $ (6336) ========== ========== ========== ========== Weighted average common shares outstanding 3,428,695 3,428,695 3,428,695 3,428,695 ========== ========== ========== ========== Income (loss) per common share-Basic $ .20 $ (.15) $ .40 $ (1.85) ========== ========== ========== ========== Income (loss) per common share-Diluted: Net income (loss) $ 690 $ (518) $ 1,378 $ (6336) ========== ========== ========== ========== Weighted average common shares outstanding for basic loss per common share 3,428,695 3,428,695 3,428,695 3,428,695 Add: Dilutive effect of assumed exercise of stock options -- -- -- -- ---------- ---------- ---------- ---------- Average shares and dilutive potential common shares 3,428,695 3,428,695 3,428,695 3,428,695 ========== ========== ========== ========== Income (loss) per common share-Diluted $ .20 $ (.15) $ .40 $ (1.85) ========== ========== ========== ========== 6. MACKINAC FINANCIAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 4. INVESTMENT SECURITIES The amortized cost and estimated fair value of investment securities available for sale as of September 30, 2006, December 31, 2005 and September 30, 2005 are as follows (dollars in thousands): September 30, 2006 December 31, 2005 September 30, 2005 ---------------------- ---------------------- ---------------------- Amortized Estimated Amortized Estimated Amortized Estimated Cost Fair Value Cost Fair Value Cost Fair Value --------- ---------- --------- ---------- --------- ---------- US Agencies $35,954 $35,536 $30,980 $30,354 $31,990 $31,568 Obligations of states and political subdivisions 512 593 3,593 3,856 3,594 3,938 ------- ------- ------- ------- ------- ------- Total securities available for sale $36,466 $36,129 $34,573 $34,210 $35,584 $35,506 ======= ======= ======= ======= ======= ======= The amortized cost and estimated fair value of investment securities pledged to secure FHLB borrowings and customer relationships were $26.939 million and $26.577 million, respectively, at September 30, 2006. 5. LOANS The composition of loans at September 30, 2006, December 31, 2005 and September 30, 2005 is as follows (dollars in thousands): September 30, December 31, September 30, 2006 2005 2005 ------------- ------------ ------------- Commercial real estate $146,838 $118,637 $123,429 Commercial, financial, and agricultural 58,548 56,686 36,297 One to four family residential real estate 51,341 44,660 42,490 Consumer 2,792 2,285 2,108 Construction 33,095 17,503 14,138 -------- -------- -------- Total loans $292,614 $239,771 $218,462 ======== ======== ======== LOANS - ALLOWANCE FOR LOAN LOSSES An analysis of the allowance for loan losses for the nine months ended September 30, 2006, the year ended December 31, 2005, and the nine months ended September 30, 2005 is as follows: (dollars in thousands): September 30, December 31, September 30, 2006 2005 2005 ------------- ------------ ------------- Balance at beginning of period $6,108 $6,966 $6,966 Recoveries on loans 59 134 107 Loans charged off (251) (992) (484) Provision (600) -- -- ------ ------ ------ Balance at end of period $5,316 $6,108 $6,589 ====== ====== ====== In the first nine months of 2006, net charge off activity was minimal at $192,000, or .07% of average loans outstanding compared to net charge-offs of $377,000, or .19% of average loans, in the same period in 2005. In the first quarter of 2006, the Corporation reduced the allowance for loan losses by recording a negative provision amounting to $600,000. This reduction in the reserve was made in recognition of the improved credit quality existent in the loan portfolio and is discussed in more detail under "Management's Discussion and Analysis." 7. MACKINAC FINANCIAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 5. LOANS (Continued) LOANS - IMPAIRED LOANS 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 on interest or principal. The interest income recorded and that which would have been recorded had nonaccrual and renegotiated loans been current, or not troubled was not material to the consolidated financial statements for the nine months ended September 30, 2006 and 2005. Information regarding impaired loans as of September 30, 2006, December 31, 2005 and September 30, 2005 is as follows (dollars in thousands): Valuation Reserve -------------------------------- September December September September December September 30, 2006 31, 2005 30, 2005 30, 2006 31, 2005 30, 2005 ----------- -------- ----------- --------- -------- --------- (Unaudited) (Unaudited) Balances, at period end Impaired loans with specific valuation reserve $1,803 $ -- $1,071 $164 $-- $321 Impaired loans with no specific valuation reserve 262 114 886 -- -- -- ------ ------ ------ ---- --- ---- Total impaired loans $2,065 $ 114 $1,957 $164 $-- $321 ====== ====== ====== ==== === ==== Impaired loans on nonaccrual basis $2,065 $ 15 $1,957 $164 $-- $321 Impaired loans on accrual basis -- 99 -- -- -- -- ------ ------ ------ ---- --- ---- Total impaired loans $2,065 $ 114 $1,957 $164 $-- $321 ====== ====== ====== ==== === ==== Average investment in impaired loans $ 713 $1,922 $2,374 Interest income recognized during impairment 4 78 76 Interest income that would have been recognized on an accrual basis 56 134 132 Cash-basis interest income recognized 3 76 76 The average investment in impaired loans was approximately $.713 million for the nine months ended September 30, 2006, $1.922 million for the year ended December 31, 2005, and $2.374 million for the nine months ended September 30, 2005, respectively. Impacting the impaired loan balances in 2005 was a sale of nonperforming assets in late December which included $1.0 million of nonaccrual loans. LOANS - RELATED PARTIES 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): September 30, December 31, September 30, 2006 2005 2005 ------------- ------------ ------------- Loans outstanding beginning of period $ 578 $ 63 $ 63 New loans 1,647 56 52 Net activity on revolving lines of credit 271 578 514 Repayment (865) (119) (115) ------ ----- ----- Loans outstanding end of period $1,631 $ 578 $ 514 ====== ===== ===== 8. MACKINAC FINANCIAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 5. LOANS (Continued) There were no loans to related-parties classified substandard at September 30, 2006, December 31, 2005 or September 30, 2005, respectively. In addition to the outstanding balances above, there were no unused commitments to related parties at September 30, 2006. 6. BORROWINGS Borrowings consist of the following at September 30, 2006, December 31, 2005 and September 30, 2005 (dollars in thousands): September 30, December 31, September 30, 2006 2005 2005 ------------- ------------ ------------- Federal Home Loan Bank advances at rates ranging from 4.98% to 5.53% maturing in 2010 and 2011 $35,000 $35,000 $35,000 Farmers Home Administration, fixed-rate note payable, maturing August 24, 2004, interest payable at 1% 1,348 1,417 1,417 Advance outstanding on line of credit with a correspondent bank, interest payable at the prime rate, 8.25% as of September 30, 2006 1,959 -- -- ------- ------- ------- $38,307 $36,417 $36,417 ======= ======= ======= In the first quarter of 2005, the Corporation prepaid $48.555 million of the Federal Home Loan Bank ("FHLB") borrowings and incurred a prepayment penalty of $4.320 million. This early payoff of FHLB borrowings reduced interest rate risk and better positions the Corporation for future match funding of loan growth. The Federal Home Loan Bank borrowings are collateralized at September 30, 2006, by the following: a collateral agreement on the Corporation's one to four family residential real estate loans with a book value of approximately $19.361 million; U.S. government agency securities with an amortized cost and estimated fair value of $26.328 million and $25.966 million, respectively; and Federal Home Loan Bank stock owned by the Bank totaling $4.152 million. Prepayment of the remaining advances is subject to the provisions and conditions of the credit policy of the Federal Home Loan Bank of Indianapolis in effect as of September 30, 2006. In the second quarter of 2006, the Corporation established a $6 million line of credit with a correspondent bank. This line of credit, which is priced at the prime rate, will be utilized by the Corporation to infuse capital into the Bank in order to support the regulatory required 8% Tier 1 capital. The U.S.D.A. Rural Development borrowing is collateralized by loans totaling $1.036 million 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 $.460 million, and guaranteed by the Corporation. 9. MACKINAC FINANCIAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 7. STOCK OPTION PLANS A summary of stock option transactions for the nine months ended September 30, 2006 and 2005, and the year ended December 31, 2005, is as follows: (Historical stock option information has been adjusted for the 1:20 reverse stock split which occurred in December 2004). September 30, December 31, September 30, 2006 2005 2005 ------------- ------------ ------------- Outstanding shares at beginning of year 375,417 282,999 282,999 Granted during the period -- 112,500 100,000 Expired during the period 1,500 20,082 19,442 -------- -------- -------- Outstanding shares at end of period 373,917 375,417 363,557 ======== ======== ======== Weighted average exercise price per share at end of period $ 12.60 $ 14.15 $ 14.73 ======== ======== ======== Shares available for grant at end of period 90,988 89,488 108,974 ======== ======== ======== There were no options granted in the first nine months of 2006. In the first nine months of 2005, the Corporation issued 60,000 option shares at a price of $12.00 per share and 40,000 option shares priced at $11.50 per share. Following is a summary of the options outstanding and exercisable at September 30, 2006: Weighted Average Number Remaining Exercise ------------------------- Contractual Weighted Average Price Range Outstanding Exercisable Life-Years Exercise Price ----------- ----------- ----------- ---------------- ---------------- $9.16 12,500 2,500 9.25 $ 9.16 $9.75 257,152 120,861 8.21 9.75 $11.50 40,000 8,000 9.00 11.50 $12.00 60,000 12,000 8.71 12.00 $156.00 - $240.00 3,545 3,545 4.51 186.75 $300.00 - $406.60 720 720 2.79 345.00 ------- ------- ---- ------- 373,917 147,626 8.36 $ 12.60 ======= ======= ==== ======= 8. 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. 10. MACKINAC FINANCIAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 9. 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 are as follows (dollars in thousands): September 30, December 31, September 30, 2006 2005 2005 ------------- ------------ ------------- Commitments to extend credit: Fixed rate $ 4,628 $ 2,118 $ 1,709 Variable rate 44,142 31,557 27,827 Standby letters of credit - Variable rate 6,422 10,493 10,933 Credit card commitments - Fixed rate 2,488 3,135 3,145 ------- ------- ------- $57,680 $47,303 $43,614 ======= ======= ======= Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management's credit evaluation of the party. Collateral held varies but may include accounts receivable; inventory; property, plant, and equipment; and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The commitments are structured to allow for 100% collateralization on all standby letters of credit. Credit card commitments are commitments on credit cards issued by the Corporation's subsidiary and serviced by other companies. These commitments are unsecured. 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 Part II, Item 1, "Legal Proceedings" in this report. 11. MACKINAC FINANCIAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 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 $37.287 million, or 15.17%, of the commercial loan portfolio at September 30, 2006. The remainder of the commercial loan portfolio is diversified in such categories as real estate related, car dealers, gaming, and petroleum. 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 locality. 12. MACKINAC FINANCIAL CORPORATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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: - 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. The following discussion will cover results of operations, asset quality, financial position, liquidity, interest rate sensitivity, and capital resources for the periods indicated. The information included in this discussion is intended to assist readers in their analysis of, and should be read in conjunction with, the consolidated financial statements and related notes and other supplemental information presented elsewhere in this report. This discussion should be read in conjunction with the consolidated financial statements and footnotes contained in the Corporation's Annual Report and Form 10-K for the year-ended December 31, 2005. Throughout this discussion, the term "Bank" refers to mBank, formerly known as North Country Bank and Trust, the principal banking subsidiary of the Corporation. 13. MACKINAC FINANCIAL CORPORATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) FINANCIAL OVERVIEW Year-to-date consolidated net income was $1.378 million through September 30, 2006, or $.40 per share, compared to a loss of $6.336 million, $1.85 per share, for the same period in 2005. The income for the three months ended September 30, 2006 amounted to $.690 million, or $.20 per share, compared to a loss of $.518 million, or $.15 per share for the same period in 2005. The 2006 nine months operations include a $600,000 negative provision, recorded in the first quarter, in recognition of improved credit quality and a $500,000 deferred tax benefit recorded in the third quarter. The deferred tax benefit was recorded in accordance with generally accepted accounting principles for recognition of a portion of the benefits to be derived from NOL carry-forwards. The 2005 results include a penalty of $4.320 million on the prepayment of $48.555 million of the FHLB borrowings. Excluding the provision and deferred tax adjustment in 2006 and the prepayment penalty recorded in 2005, the net income in the first nine months of 2006 amounted to $278,000, compared to an adjusted loss of $2.016 million for the same period in 2005. The nine month 2006 results also include $234,000 of stock option expense, required under the new accounting rules for stock compensation plans, as well as $400,000 of expenses incurred to pursue legal action against the Corporation's former accountants. The costs associated with the pursuit of this legal action have surpassed our earlier estimates but management and the Corporation's Board of Directors believe the case has merit and is in the best interests of shareholders. Legal expenses for this action are projected to be $250,000 in the fourth quarter which will carry the case through trial. Total assets increased $64.469 million from December 31, 2005 to September 30, 2006. The loan portfolio increased $52.843 million in the first nine months of 2006, from December 31, 2005 balances of $239.771 million. Deposits totaled $293.494 million at September 30, 2006, an increase of $60.862 million from the $232.632 million at December 31, 2005. FINANCIAL CONDITION CASH AND CASH EQUIVALENTS Cash and cash equivalents increased $9.543 million in 2006. See further discussion of the change in cash and cash equivalents in the Liquidity section. INVESTMENT SECURITIES Available-for-sale securities increased $1.919 million, or 5.61%, from December 31, 2005 to September 30, 2006, with the balance on September 30, 2006, totaling $36.129 million. The increase in securities was primarily due to the combination of an early prepayment of $2.960 million of municipal obligations and the purchase of a $5.0 million US Agency security. Investment securities are utilized in an effort to manage interest rate risk and liquidity. As of September 30, 2006, investment securities with an estimated fair value of $27 million were pledged. LOANS Through the third quarter of 2006, loan balances increased by $52.843, or 22.04%, from December 31, 2005 balances of $239.771 million. During the first nine months of 2006, the Bank experienced loan production of $84 million. This loan production, combined with normal principal reductions of approximately $16 million and $15 million of early payouts of existing loans accounted for the increases in outstanding loan balances. The Corporation has been successful in maintaining loan growth without compromising credit quality. Enhancements to the loan approval process and exception reporting further provide for a more effective management of risk in the loan portfolio. Management continues to actively manage the loan portfolio, seeking to identify and resolve problem assets at an early stage. Management believes a properly positioned loan portfolio provides the most attractive earning asset yield available to the Corporation and, with changes to the loan approval process and exception reporting, management can effectively manage the risk in the loan portfolio. As shown in the table below, all segments of the loan portfolio increased in the first nine months of 2006. Management intends to continue loan growth within its markets for mortgage, consumer, and commercial loan products while concentrating on loan quality, industry concentration issues, and competitive pricing. 14. MACKINAC FINANCIAL CORPORATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Following is a summary of the loan portfolio at September 30, 2006, December 31, 2005 and September 30, 2005 (dollars in thousands): September 30, Percent December 31, Percent September 30, Percent 2006 of Total 2005 of Total 2005 of Total ------------- -------- ------------ -------- ------------- -------- Commercial real estate $146,838 50.18% $118,637 49.48% $123,429 56.50% Commercial, financial, and agricultural 58,548 20.01 56,686 23.64 36,297 16.61 One to four family residential real estate 51,341 17.55 44,660 18.63 42,490 19.45 Consumer 2,792 .95 2,285 .95 2,108 .97 Construction 33,095 11.31 17,503 7.30 14,138 6.47 -------- ------ -------- ------ -------- ------ Total loans $292,614 100.00% $239,771 100.00% $218,462 100.00% ======== ====== ======== ====== ======== ====== LOAN CONCENTRATION Management recognizes that loan concentration within specific industries does increase the risk associated within the Corporation's loan portfolio. Historically, the Corporation had significant concentrations of its loan portfolio composed of hospitality and tourism loans. Management's intent is to monitor loan concentrations and to limit exposure to any one segment of the economy. Following is a table showing the significant industry types in the commercial loan portfolio as of September 30, 2006, December 31, 2005 and September 30, 2005 (dollars in thousands): September 30, 2006 December 31, 2005 September 30, 2005 ------------------------------------ ------------------------------------ ------------------------------------ Percent of Percent of Percent of Percent of Percent of Percent of Outstanding Commercial Shareholders' Outstanding Commercial Shareholders' Outstanding Commercial Shareholders' Balance Loans Equity Balance Loans Equity Balance Loans Equity ----------- ---------- ------------- ----------- ---------- ------------- ----------- ---------- ------------- Hospitality and tourism $ 37,287 18.15% 132.10% $ 37,681 21.49% 141.72% $ 40,424 25.31% 144.89% Real estate operators - nonresidential bldg 35,965 17.51 127.42 28,217 16.10 106.13 24,387 15.27 87.41 Real estate agents & managers 19,744 9.61 69.95 10,588 6.04 39.82 7,837 4.91 28.09 New car dealers 10,049 4.89 35.60 9,995 5.70 37.59 5,005 3.13 17.94 Family housing construction 7,215 3.51 25.56 2,184 1.25 8.21 1,680 1.05 6.02 Operators of nonresidential bldgs 7,035 3.43 24.92 6,218 3.55 23.39 6,638 4.16 23.79 Investors 6,658 3.24 23.59 191 .10 .72 335 .21 1.20 Gaming 6,459 3.15 22.88 7,553 4.31 28.41 9,331 5.84 33.44 Petroleum 6,258 3.05 22.17 6,508 3.71 24.48 6,971 4.36 24.99 Skilled nursing care facilities 5,932 2.89 21.02 5,370 3.06 20.20 5,564 3.48 19.94 Other 62,784 30.57 222.43 60,818 34.69 228.74 51,554 32.28 184.78 -------- ------ -------- ------ -------- ------ Total Commercial Loans $205,386 100.00% $175,323 100.00% $159,726 100.00% ======== ====== ======== ====== ======== ====== Management has made considerable progress in reducing concentrations of hospitality and tourism loans, which reduced exposure to this economic segment and lowered overall loan portfolio risk. Management expects further reductions in concentrations of hospitality and tourism loans through a combination of new loans in other industries and paydowns and maturities of current portfolio loans in this sector. CREDIT QUALITY The allowance for loan losses is maintained by management at a level considered to be adequate to cover probable losses related to specifically identified loans, as well as losses inherent in the balance of the loan portfolio. At September 30, 2006, the allowance for loan losses was 1.82% of total loans outstanding compared to 2.55% at December 31, 2005 and 3.02% at September 30, 2005. Management analyzes the allowance for loan losses in detail on a monthly basis to determine whether the losses inherent in the portfolio are properly reserved for. Net charge-offs for the nine months ended September 30, 2006 amounted to $.192 million, or .07% of average loans outstanding, compared to $.377 million, ..19% of average loans outstanding, for the same period in 2005. The Corporation, in recognition of the continued improvement in credit quality which has occurred since 2004, reduced the reserve for loan loss by $600,000 in the first quarter of 2006. The reduction of the reserve results in a current reserve balance that is more representative of the relevant risk inherent within the Corporation's loan portfolio. The current level of charge-offs is below historical levels and 15. MACKINAC FINANCIAL CORPORATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) projected charge-off activity, based upon current levels of nonperforming loans, is not expected to attain historical levels. Additions or reductions to the reserve in future periods will be dependent upon a combination of future loan growth, nonperforming loan balances and charge-off activity. There were no new significant problem loans or loan downgrades identified during the first or second quarter of 2006. In the third quarter of 2006, one large commercial credit was put into nonaccrual which accounted for the majority of the increase in nonperforming loans. This commercial credit is secured primarily by real estate and no material loss is anticipated. The table below shows period end balances of non-performing assets (dollars in thousands): September 30, December 31, September 30, 2006 2005 2005 ------------- ------------ ------------- NONPERFORMING ASSETS: Nonaccrual Loans $ 2,065 $ 15 $1,957 Loans past due 90 days or more -- 99 -- Restructured Loans -- -- 0 ------- --------- ------ Total nonperforming loans 2,065 114 1,957 Other real estate owned 26 945 1,948 ------- --------- ------ Total nonperforming assets $ 2,091 $ 1,059 $3,905 ======= ========= ====== Nonperforming loans as a % of loans .71% .05% .09% ------- --------- ------ Nonperforming assets as a % of assets .58% .35% 1.39% ------- --------- ------ RESERVE FOR LOAN LOSSES: At period end $ 5,316 $ 6,108 $6,589 ------- --------- ------ As a % of loans 1.82% 2.55% 3.02% ------- --------- ------ As a % of nonperforming loans 257.43% 5,357.89% 336.69% ------- --------- ------ As a % of nonaccrual loans 257.43% N/M% N/M% ======= ========= ====== Following is the allocation of the allowance for loan losses as of September 30, 2006, December 31, 2005 and September 30, 2005 (dollars in thousands): September 30, December 31, September 30, 2006 2005 2005 ------------- ------------ ------------- Commercial, financial and agricultural loans $1,431 $1,492 $1,716 One to four family residential real estate loans 29 17 80 Consumer loans -- -- -- Unallocated and general reserves 3,856 4,599 4,793 ------ ------ ------ Totals $5,316 $6,108 $6,589 ====== ====== ====== The following ratios assist management in the determination of the Corporation's credit quality (dollars in thousands): Nine Months Twelve Months Nine Months Ended Ended Ended September 30, December 31, September 30, 2006 2005 2005 ------------- ------------- ------------- Allowance to total loans, at period end 1.82% 2.55% 3.02% Average loans outstanding for the periods indicated $271,351 $207,928 $202,381 Net charge-offs to average outstanding loans .07% .41% .19% Nonperforming loans to gross loans, at period end .71% .05% 1.79% 16. MACKINAC FINANCIAL CORPORATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Total nonperforming loans increased $1.951 million since December 31, 2005. The 2006 increase resulted primarily from the nonaccrual status of one commercial credit with a current principal balance of $1.693 million. Late in 2005, the Bank sold $2.1 million of nonperforming assets, which included $1.000 million of nonperforming loans. Management continues to address market issues impacting its loan customer base. In conjunction with the Corporation's senior lending staff and the bank regulatory examinations, management reviews the Corporation's loans, related collateral evaluations, and the overall lending process. The Corporation also utilizes a loan review consultant 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 has engaged this same consultant for loan review during 2006. As part of the process of resolving problem credits, the Corporation may acquire ownership of collateral which secured such credits. The Corporation carries this collateral in other real estate, which is grouped with other assets on the condensed consolidated balance sheet. The following table represents the activity in other real estate for the periods indicated (dollars in thousands): Nine Months Nine Months Ended Year Ended Ended September 30, December 31, September 30, 2006 2005 2005 ------------- ------------- ------------- Balance at beginning of period $ 945 $ 1,730 $1,730 Other real estate transferred from loans 23 274 556 Other real estate sold/written down (942) (1,059) (338) ----- ------- ------ Balance at end of period $ 26 $ 945 $1,948 ===== ======= ====== During the first nine months of 2006, the Corporation received real estate in lieu of loan payments of $23,000. 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. Any additional reduction in the fair value results in a write-down of other real estate. Write-downs on other real estate may be recorded based on subsequent evaluations of current realizable fair values. DEPOSITS The Corporation had an increase in deposits in the first nine months of 2006. Total deposits increased by $60.862 million, or 26.2%, in the first nine months of 2006. This growth in deposits included $41.508 million of non-core deposits, mostly brokered certificates of deposit. The Corporation continues to evaluate its deposit products and pricing alternatives in an effort to fund loan growth as economically as possible. 17. MACKINAC FINANCIAL CORPORATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) The following table represents detail of deposits at the end of the periods indicated (dollars in thousands): September 30, December 31, September 30, 2006 2005 2005 ------------- ------------ ------------- Demand deposit accounts $ 22,826 $ 19,684 $ 19,690 NOW and money market 73,797 64,566 61,093 Savings and IRAs 22,576 22,555 23,670 Certificates of Deposit <$100,000 76,575 67,725 57,850 -------- -------- -------- Total core deposits 195,774 174,530 162,303 -------- -------- -------- Certificates of Deposit >$100,000 20,305 12,335 12,300 Internet CDs <$100,000 16,727 28,113 33,461 Internet CDs >$100,000 4,898 7,698 5,204 Brokered Deposits 55,790 9,956 -- -------- -------- -------- Total non-core deposits 97,720 58,102 50,965 -------- -------- -------- Total deposits $293,494 $232,632 $213,268 ======== ======== ======== BORROWINGS In the second quarter of 2006 the Corporation established a $6 million line of credit with a correspondent bank. This line of credit will be utilized by the Corporation to provide infusions of capital to the Bank. As of September 30, 2006, the outstanding balance on this line was $1.959 million. In the first quarter of 2005 the Corporation prepaid $48.555 million of the FHLB borrowings in order to reduce interest rate risk and to better match earning assets and funding sources. The remaining FHLB borrowings carry both fixed and variable interest rates and mature in 2010 and 2011. The $15 million of fixed rate FHLB borrowings 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 other assets. Management may increase FHLB borrowings in the future as a source for funding future loan production. In the first quarter of 2005, the Bank borrowed $2 million in Canadian dollars from a correspondent bank in order to reduce the risk of an asset sensitive foreign exchange position. This term loan was repaid in 2005. SHAREHOLDERS' EQUITY Total shareholders' equity increased $1.638 million from December 31, 2005 to September 30, 2006. The increase is comprised of net income of $1.378 million, contributed capital of $.234 million in recognition of stock option expense and a $.026 million increase in the market value of securities. The Board of Directors does not anticipate declaring any dividends in the near future. The declaration of dividends is contingent on a variety of factors including regulatory and state statutes, and the Corporation's return to profitability. RESULTS OF OPERATIONS NET INTEREST INCOME Net interest income before provision for loan losses for the quarter ended September 30, 2006, increased by $1.466 million, or 20.65%, compared to the same period one year ago. This increase in net interest income was a result of the combination of increased average balances and increased rates. The Corporation benefited from prime rate increases in the first nine months of 2006 due to the amount of assets that repriced with each increase. This benefit related to a net asset sensitive position has been declining in recent periods as the Corporation initiated steps as a part of its ALCO Committee to reduce interest rate risk in the event of a future decline in interest rates. More discussion is included relative to repricing and asset sensitivity under the caption "Interest Rate Risk" elsewhere in this report. 18. MACKINAC FINANCIAL CORPORATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) The following tables present the amount of interest income from average interest-earning assets and the yields earned on those assets, as well as the interest expense on average interest-bearing obligations and the rates paid on those obligations. All average balances are daily average balances. THREE MONTHS ENDED ---------------------------------------------------------------------------------------------- AVERAGE BALANCES 2006-2005 ------------------------------ AVERAGE RATES INTEREST ----------------------------------- September 30, September 30, September 30, Income/ Rate/ ------------------ Increase/ ------------- ------------- Expense Volume Rate Volume (dollars in thousands) 2006 2005 (Decrease) 2006 2005 2006 2005 Variance Variance Variance Variance -------- -------- ---------- ---- ---- ------ ------ -------- -------- -------- -------- Loans (1,2) $289,210 $209,785 $79,425 7.99% 7.13% $5,824 $3,769 $2,055 $1,427 $ 456 172 Taxable securities 33,482 32,087 1,395 3.61 3.49 305 282 23 12 10 1 Nontaxable securities 354 3,613 (3,259) 5.60 4.61 5 42 (37) (38) 9 (8) Federal funds sold 18,142 12,062 6,080 5.07 3.39 232 103 129 52 51 26 Other interest-earning assets 7,099 4,855 2,244 2.01 5.97 36 74 (38) 34 (49) (23) -------- -------- ------- ---- ---- ------ ------ ------ ------ ----- ---- Total earning assets 348,287 262,402 85,885 7.29 6.46 6,402 4,270 $2,132 1,487 477 168 -------- -------- ------- Reserve for loan losses (5,384) (6,632) 1,248 Cash and due from banks 5,354 5,958 (604) Intangible assets 252 -- 252 Other assets 14,123 18,778 (4,655) -------- -------- ------- Total assets $362,632 $280,506 $82,126 ======== ======== ======= NOW and money market deposits $ 71,232 $ 57,534 $13,698 3.40 2.09 610 302 308 72 191 45 Savings deposits 14,198 17,489 (3,291) 1.59 1.36 57 60 (3) (11) 10 (2) Time deposits 187,504 114,945 72,559 4.83 3.37 2,284 976 1,308 616 424 268 Borrowings 36,454 36,436 18 5.44 4.62 500 425 75 0 75 0 -------- -------- ------- ---- ---- ------ ------ ------ ------ ----- ---- Total interest-bearing liabilities 309,388 226,404 82,984 4.43 3.09 3,451 1,763 1,688 677 700 311 -------- -------- ------- Demand deposits 23,674 21,229 2,445 Other liabilities 1,529 4,761 (3,232) Shareholders' equity 28,041 28,112 (71) -------- -------- ------- Total liabilities and shareholders' equity $362,632 $280,506 $82,126 ======== ======== ======= Rate spread 2.87% 3.37% ---- ---- ------ ------ ------ ------ ----- ---- Net interest margin/revenue 3.36 3.79% $2,951 $2,507 $ 444 $ 810 $(223) $(143) ==== ==== ====== ====== ====== ====== ===== ==== (1) For purposes of these computations, nonaccruing loans are included in the daily average loan amounts outstanding. (2) Interest income on loans includes loan fees. NINE MONTHS ENDED ------------------------------------------------------------------------------------------------ AVERAGE BALANCES 2006-2005 ------------------------------ AVERAGE RATES INTEREST ----------------------------------- September 30, September 30, September 30, Income/ Rate/ ------------------ Increase/ ------------- --------------- Expense Volume Rate Volume (dollars in thousands) 2006 2005 (Decrease) 2006 2005 2006 2005 Variance Variance Variance Variance -------- -------- ---------- ---- ---- ------- ------- -------- -------- -------- -------- Loans (1,2) $271,351 $202,381 $68,970 7.83% 6.94% $15,891 $10,501 $5,390 $3,579 $1,351 $ 460 Taxable securities 31,949 43,304 ( 11,355) 3.57 3.64 852 1,178 (326) (309) (23) 6 Nontaxable securities 2,104 3,674 (1,570) 5.53 4.59 87 126 (39) (54) 26 (11) Federal funds sold 12,467 11,905 562 4.92 2.86 459 254 205 12 184 9 Other interest-earning assets 6,208 6,789 (581) 3.73 4.24 173 216 (43) (18) (27) 2 -------- -------- ------- ---- ---- ------- ------- ------ ------ ------ ----- Total earning assets 324,079 268,053 56,026 7.20 6.12 17,462 12,275 5,187 3,210 1,511 466 -------- -------- ------- Reserve for loan losses (5,618) (6,773) 1,155 Cash and due from banks 5,880 5,392 488 Intangible assets 285 362 (77) Other assets 17,020 17,944 (924) -------- -------- ------- Total assets $341,646 $284,978 $56,668 ======== ======== ======= NOW and money market deposits $ 69,718 $ 54,537 $15,181 3.13 1.78 1,633 725 908 202 552 154 Savings deposits 14,721 18,054 (3,333) 1.39 1.19 153 161 (8) (30) 27 (5) Time deposits 168,979 115,854 53,125 4.55 3.21 5,754 2,780 2,974 1,275 1,165 534 Borrowings 36,827 42,038 (5,211) 4.92 4.80 1,355 1,509 (154) (187) 38 (5) -------- -------- ------- ---- ---- ------- ------- ------ ------ ------ ----- Total interest-bearing liabilities 290,245 230,483 59,762 4.10 3.00 8,895 5,175 3,720 1,260 1,782 678 -------- -------- ------- Demand deposits 21,053 20,598 455 Other liabilities 2,908 4,679 (1,771) Shareholders' equity 27,440 29,218 (1,778) -------- -------- ------- Total liabilities and shareholders' equity $341,646 $284,978 $56,668 ======== ======== ======= Rate spread 3.11% 3.12% ---- ---- ------- ------- ------ ------ ------ ----- Net interest margin/revenue 3.53% 3.54% $ 8,567 $ 7,100 $1,467 $1,950 $ (271) $(212) ==== ==== ======= ======= ====== ====== ====== ===== (1) For purposes of these computations, nonaccruing loans are included in the daily average loan amounts outstanding. (2) Interest income on loans includes loan fees. PROVISION FOR LOAN LOSSES The Corporation records a provision for loan losses at a level it believes is necessary to maintain the allowance at an adequate level after considering factors such as loan charge-offs and recoveries, changes in the mix of loans in the portfolio, loan growth, and other economic factors. In recognition of the improved credit quality, the Corporation reduced its loan loss reserve by $600,000 in the first quarter of 2006. There was no provision for loan losses in the second or third quarter of 2006. Management continues to monitor the loan portfolio for changes which may impact the required allowance for loan losses. A provision for loan losses may be required for future periods if credit quality should deteriorate or loan growth is such that the general reserve is no longer deemed adequate. 19. MACKINAC FINANCIAL CORPORATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) OTHER INCOME Other income decreased by $.102 million for the nine months ended September 30, 2006, compared to the nine months ended September 30, 2005. The Corporation recorded a $.098 million net security gain in the second quarter of 2005. Service fees decreased $.105 million in the first nine months of 2006, while loan and lease fees increased $.047 million, gains on sales of loans increased $.112 million, and other noninterest income decreased $.059 million. The decline in service fees is primarily due to the introduction of new "no fee" deposit products in an attempt to stimulate growth in transactional account deposits. In the third quarter of 2006, the Corporation recognized $.066 million of revenue due to mortgage loans produced and sold in the secondary market. Other noninterest income was positively impacted in the first nine months of 2006 from a gain due to foreign currency transactions which amounted to $.035 million. Management does not expect noninterest income to grow significantly in the near future, but is currently exploring several noninterest income expansion opportunities. The following table details noninterest income for the three and nine months ended September 30, 2006 and 2005 (dollars in thousands): Three Months Ended Nine Months Ended September 30, % Increase September 30, % Increase ------------------ (Decrease) ----------------- (Decrease) 2006 2005 2006-2005 2006 2005 2006-2005 ---- ---- ---------- ---- ---- ---------- Service fees $133 $137 (2.9) $365 $470 (22.3) Loan and lease fees 23 5 360.0 58 11 427.3 Net gains on sale of loans 66 17 288.2 149 37 302.7 Other 19 96 (80.2) 135 194 (30.4) ---- ---- ----- ---- ---- ----- Subtotal 241 255 (5.5) 707 712 (0.7) ---- ---- ----- ---- ---- ----- Net securities gains (1) (1) 100.0 (1) 96 100.0 ---- ---- ----- ---- ---- ----- Total other income $240 $254 (5.5) $706 $808 (12.6) ==== ==== ===== ==== ==== ===== OTHER EXPENSES Other expenses decreased $5.225 million for the nine months ended September 30, 2006, compared to the same period in 2005. The prepayment penalty on FHLB borrowings incurred by the Corporation in the first quarter of 2005 amounted to $4.320 million and was the primary reason for the decrease. Salaries, commissions, and related benefits decreased modestly, during the first nine months of 2006, compared to the first nine months of 2005. The Corporation adopted SFAS No. 123 ("Share Based Payments") in 2006 which requires certain compensation related to the issuance of stock options. The 2006 expense amounted to $234,000 which is included in salaries and benefits. The $.214 million decrease in data processing costs is the result of a full systems conversion which occurred in the fourth quarter of 2005. The increase of $.195 million in occupancy was due primarily to the opening of a new full service branch office in January of 2006. The $.390 million decrease in loan and deposit expense is due in large part to the reduction in FDIC insurance premiums, which amounted to $.299 million in the first nine months of 2005, compared to $.076 million in 2006, a reduction of $.223 million. This reduction in premium was due to the improved capital position of the Bank which resulted in the removal of the Cease and Desist Order in the first quarter of 2005. In the first nine months of 2006, the Corporation incurred approximately $400,000 in legal costs to pursue legal action against the Corporation's former accountants. The remaining expected cost on pursuit of this lawsuit is estimated at $250,000. Management continually reviews all areas of noninterest expense for cost reduction opportunities that will not negatively impact service quality and employee morale. 20. MACKINAC FINANCIAL CORPORATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) The following table details noninterest expense for the three and nine months ended September 30, 2006 and September 30, 2005 (dollars in thousands): Three Months Ended Nine Months Ended September 30, % Increase September 30, % Increase ------------------ (Decrease) ----------------- (Decrease) 2006 2005 2006-2005% 2006 2005 2006-2005% ------ ------ ---------- ------ ------- ---------- Salaries and employee benefits $1,487 $1,555 (4.4) $4,577 $ 4,665 (1.9) Occupancy 333 275 21.1 943 430 119.3 Furniture and equipment 159 133 19.5 469 748 (37.3) Data processing 176 234 (24.8) 512 726 (29.5) Accounting, legal and consulting fees 341 204 67.2 955 750 27.3 Loan and deposit 78 153 (49.0) 306 696 (56.0) Telephone 55 66 (16.7) 156 203 (23.2) Advertising 70 314 (77.7) 247 696 (64.5) Penalty on prepayment of FHLB borrowings -- -- -- -- 4,320 NM Other 303 345 (12.2) 854 1,010 (15.4) ------ ------ ----- ------ ------- ----- Total other expense $3,002 $3,279 (8.4) $9,019 $14,244 (36.7) ====== ====== ===== ====== ======= ===== FEDERAL INCOME TAXES There was no current tax provision for the first and second quarter of 2006 and 2005. The Corporation recorded a $25,000 federal tax benefit in the second quarter of 2006 due to a refund from a prior year tax return. In the third quarter of 2006, the Corporation recorded a $500,000 deferred tax benefit. This deferred benefit recognized a portion of the NOL carryforward. The Corporation has approximately $35.3 million of NOL carryforward along with various tax credit carryforwards of $2.1 million. The NOL and tax credit carryforward benefit is dependent upon the future profitability of the Corporation. The Corporation will reevaluate these deferred items in future periods to determine whether or not recognition of all or a portion of the benefit is appropriate in accordance with FASB Statement No. 109, "Accounting for Income Taxes." LIQUIDITY During the first nine months of 2006, the Corporation increased cash and cash equivalents by $9.543 million. As shown on the Corporation's condensed consolidated statement of cash flows, liquidity was primarily impacted from growth in loans funded by deposits. In the first nine months of 2006, the Corporation funded loan growth of $52.843 million with deposit growth, the total of which amounted to $60.862 million. The excess deposit growth resulted in an increase in federal funds balances in addition to providing funds for general purposes. It is anticipated that during the remainder of 2006, the Corporation will fund anticipated loan production with a combination of core deposit growth and noncore funding, primarily brokered CD's. The Corporation's parent company is dependent upon its primary operating subsidiary, the Bank, for sources of cash to fund its operating needs. At September 30, 2006, the Corporation's parent had a balance of $.559 million in cash and cash equivalents. The corporation established a $6 million line of credit with a correspondent bank in the second quarter of 2006. The Corporation has borrowed $1.9 million on this line which it infused into the Bank for capital. This line of credit will provide additional resources necessary to provide additional capital infusions to the Bank if needed. The Corporation's liquidity plan for 2006 includes strategies to increase core deposits in the Corporation's local markets. The Corporation continually reviews its existing deposit products and pricing of these products, with a goal of increasing core deposits to reduce the dependency on noncore, out of market, deposits. The Corporation's liquidity plan for 2006 calls for augmenting local deposit growth efforts with brokered CD funding, to the extent necessary. The Corporation also has Bank borrowing lines at correspondent banks to provide additional sources of liquidity. 21. MACKINAC FINANCIAL CORPORATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) CAPITAL AND REGULATORY During the first nine months of 2006, capital increased by $1.638 million, largely due to net income of $1.378 million. This compares to a decrease in tangible capital during the same period in the previous year of $1.280 million, resulting primarily from a net loss of $6.336 million. The increase in 2006 is comprised of net income, contributed capital of $.078 million in recognition of stock option expense, a decrease in intangible assets and increased by a $.258 million change in the market value of securities. The Corporation and the Bank are 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. Although the Corporation and the Bank are well capitalized, the Bank is operating under an informal agreement which requires a minimum Tier 1 Capital ratio of 8%. The following table details sources of capital for the periods indicated (dollars in thousands): September 30, December 31, September 30, 2006 2005 2005 ------------- ------------ ------------- CAPITAL STRUCTURE Long-term debt $ -- $ -- $ -- Shareholders' equity 28,226 26,588 27,900 -------- -------- -------- Total capitalization $ 28,226 $ 26,588 $ 27,900 -------- -------- -------- Tangible capital $ 27,989 $ 26,258 $ 27,538 -------- -------- -------- INTANGIBLE ASSETS Core deposit premium $ 237 $ 330 $ 362 Other identifiable intangibles -- -- -------- -------- -------- Total intangibles $ 237 $ 330 $ 362 -------- -------- -------- REGULATORY CAPITAL Tier 1 capital: Shareholders' equity $ 28,226 $ 26,588 $ 27,900 Net unrealized (gains) losses on available for sale securities 337 363 78 Less: intangibles (237) (330) (362) -------- -------- -------- Total Tier 1 capital $ 28,326 $ 26,621 $ 27,616 -------- -------- -------- Tier 2 Capital: Allowable reserve for loan losses $ 3,800 $ 3,184 $ 2,912 Qualifying long-term debt -- -- -- -------- -------- -------- Total Tier 2 capital 3,800 3,184 2,912 -------- -------- -------- Total capital $ 32,126 $ 29,805 $ 30,528 ======== ======== ======== Risk-adjusted assets $302,523 $251,796 $229,245 ======== ======== ======== Capital ratios: Tier 1 Capital to average assets 7.81% 9.23% 9.86% Tier 1 Capital to risk weighted assets 9.36% 10.57% 12.05% Total Capital to risk weighted assets 10.62% 11.84% 13.32% Regulatory capital is not the same as shareholders' equity reported in the accompanying condensed consolidated financial statements. Certain assets cannot be considered assets for regulatory purposes, such as acquisition intangibles. 22. MACKINAC FINANCIAL CORPORATION ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued) Presented below is a summary of the capital position in comparison to generally applicable regulatory requirements: Tier 1 Tier 1 Total Capital to Capital to Capital to Average Risk-Weighted Risk-Weighted Assets Assets Assets ---------- ------------- ------------- Regulatory minumum for capital adequacy purposes 4.0% 4.0% 8.0% The Corporation: September 30, 2006 7.81% 9.36% 10.62% December 31, 2005 9.23% 10.57% 11.84% The Bank: September 30, 2006 8.15% 9.86% 11.11% December 31, 2005 8.80% 10.09% 11.35% 23. MACKINAC FINANCIAL CORPORATION ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK INTEREST RATE RISK In general, the Corporation attempts to manage interest rate risk by investing in a variety of assets which afford it an opportunity to reprice assets and increase interest income at a rate equal to or greater than the interest expense associated with repricing liabilities. Interest rate risk is the exposure of the Corporation to adverse movements in interest rates. The Corporation derives its income primarily from the excess of interest collected on its interest-earning assets over the interest paid on its interest-bearing obligations. The rates of interest the Corporation earns on its assets and owes on its obligations generally are established contractually for a period of time. Since market interest rates change over time, the Corporation is exposed to lower profitability if it cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excess levels of interest rate risk could pose a significant threat to the Corporation's earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to the Corporation's safety and soundness. Loans are the most significant earning asset. Management offers commercial and real estate loans priced at interest rates which fluctuate with various indices such as the prime rate or rates paid on various government issued securities. In addition, the Corporation prices the majority of fixed rate loans so it has an opportunity to reprice the loan within 12 to 36 months. The Corporation also has $35.954 million of federal agency securities with an average life of less than one year. The maturity of these investments in the near term will provide opportunities for enhancing portfolio yields. The Corporation also has federal funds sold to correspondent banks, as well as other interest-bearing deposits with correspondent banks. These funds are generally repriced on a daily basis. 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. 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 rate environment affects borrowers and depositors differently. Exposure to interest rate risk is reviewed on a regular basis. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect of interest rate changes on net interest income and to structure the composition of the balance sheet to minimize interest rate risk and at the same time maximize income. Management realizes certain 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 difference between repricing assets and liabilities for a specific period is referred to as the gap. An excess of repricable assets over liabilities is referred to as a positive gap. An excess of repricable liabilities over assets is referred to as a negative gap. The cumulative gap is the summation of the gap for all periods to the end of the period for which the cumulative gap is being measured. Assets and liabilities scheduled to reprice are reported in the following time frames. Those instruments with a variable interest rate tied to an index and considered immediately repricable are reported in the 1- to 90-day time frame. The estimates of principal amortization and prepayments are assigned to the following time frames. 24. MACKINAC FINANCIAL CORPORATION ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (Continued) The following is the Corporation's opportunities at September 30, 2006 (dollars in thousands): 1-90 91 - 365 >1-5 Over 5 Days Days Years Years Total -------- -------- ------- ------- -------- Interest-earning assets: Loans $151,162 $18,217 $43,875 $79,360 292,614 Securities 3,495 22,459 10,000 175 36,129 Other (1) 12,838 -- -- 4,152 16,990 -------- -------- ------- ------- -------- Total interest-earning assets 167,495 40,676 53,875 83,687 345,733 -------- -------- ------- ------- -------- Interest-bearing obligations: NOW, Money Market, and Savings deposits 87,712 -- -- -- 87,712 Time deposits 50,719 60,639 14,953 771 127,082 Brokered CD's 11,742 44,048 -- -- 55,790 Borrowings 21,348 -- -- 16,959 38,307 -------- -------- ------- ------- -------- Total interest-bearing obligations 171,521 104,687 14,953 17,730 308,891 -------- -------- ------- ------- -------- Gap $ (4,026) $(64,011) $38,922 $65,957 $ 36,842 ======== ======== ======= ======= ======== Cumulative gap $ (4,026) $(68,037) $29,115 $36,842 ======== ======== ======= ======= (1) Includes Federal Home Loan Bank Stock The above analysis indicates that at September 30, 2006, the Corporation had a cumulative liability sensitivity gap position of $68.037 million within the one-year time frame. The Corporation's cumulative liability sensitive gap suggests that if market interest rates increase in the next twelve months, the Corporation has the potential to earn less net interest income. Conversely, if market interest rates decreased in the next twelve months, the above GAP position suggests the Corporation's net interest income would increase. At December 31, 2005, the Corporation had a cumulative liability sensitivity gap position of $1.311 million within the one-year time frame. The Corporation's cumulative liability sensitive gap suggested that if market interest rates increased in the next twelve months, the Corporation had the potential to earn less net interest income. Conversely, if market interest rates decreased over a twelve-month period, the December 31, 2005, gap position suggested the Corporation's net interest income would increase. The increase in the gap liability position from December 31, 2005 to September 30, 2006 resulted from the use of short term liabilities to fund loan growth. This was done in order to reduce interest rate risk and better match assets and liabilities. A limitation of the traditional gap analysis is that it does not consider the timing or magnitude of noncontractual repricing or expected prepayments. In addition, the gap analysis treats savings, NOW, and money market accounts as repricing within 90 days, while experience suggests that these categories of deposits are actually comparatively resistant to rate sensitivity. The borrowings in the gap analysis include FHLB advances some of which are fixed-rate advances. These fixed rate 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. In the second quarter of 2006 the FHLB "put" $10 million of the borrowings to the Corporation, which were then converted to variable pricing. Early in July an additional $10 million of FHLB borrowings was converted. The exercise of this conversion feature on the remaining borrowings by the FHLB would impact the repricing dates currently assumed in the analysis. 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. 25. MACKINAC FINANCIAL CORPORATION ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (Continued) Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. The Corporation's interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems, and internal controls are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, the Corporation assesses the existing and potential future effects of changes in interest rates on its financial condition, including capital adequacy, earnings, liquidity, and asset quality. In addition to changes in interest rates, the level of future net interest income is also dependent on a number of variables, including: the growth, composition and levels of loans, deposits, and other earning assets and interest-bearing obligations, and economic and competitive conditions; potential changes in lending, investing, and deposit strategies; customer preferences; and other factors. FOREIGN EXCHANGE RISK In addition to managing interest rate risk, management also actively manages risk associated with foreign exchange. The Corporation provides foreign exchange services, makes loans to, and accepts deposits from, Canadian customers primarily at its banking office in Sault Ste. Marie, Michigan. 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. The Corporation entered into a term loan payable in Canadian dollars during the first quarter of 2005 in order to offset the foreign exchange exposure due to an asset sensitive position. As of September 30, 2006, the Corporation had excess Canadian assets of $.218 million (or $.195 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. OFF-BALANCE-SHEET RISK Derivative financial instruments include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. The Corporation currently does not enter into futures, forwards, swaps or options. However, the Corporation is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the condensed consolidated balance sheets. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower if deemed necessary by the Corporation. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions. Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Corporation until the instrument is exercised. IMPACT OF INFLATION AND CHANGING PRICES The accompanying condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and results of operations in historical dollars, without considering the change in the relative purchasing power of money over time, due to inflation. The impact of inflation is reflected in the increased cost of the Corporation's operations. Nearly all the assets and liabilities of the Corporation are financial, unlike industrial or commercial companies. As a result, the Corporation's performance is directly impacted by changes in interest rates, which are indirectly influenced by inflationary expectations. The Corporation's ability to match the interest sensitivity of its financial assets to the interest sensitivity of its financial liabilities tends to minimize the effect of changes in interest rates on the Corporation's performance. Changes in interest rates do not necessarily move to the same extent as changes in the price of goods and services. 26. MACKINAC FINANCIAL CORPORATION ITEM 4 CONTROLS AND PROCEDURES An evaluation was performed under the supervision of and with the participation of the Corporation's management, including the President and Chief Executive Officer, and the Chief Financial Officer, of the effectiveness of the design and operation of the Corporation's disclosure controls and procedures (as such term is defined in Rules 13-a 15(e) and 15d-15(e) under the Securities Exchange act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. Based on that evaluation, the Corporation's management, including the President and Chief Executive Officer, have concluded that, as of the end of such period, the Corporation's disclosure controls and procedures were effective in timely alerting them to material information relating to the Corporation (including its consolidated subsidiaries) required to be disclosed by the Corporation in the reports that it files or submits under the Exchange Act. There was no change in the Corporation's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Corporation's fiscal quarter ended September 30, 2006, that has materially affected, or is reasonably likely to materially affect, the Corporation's internal control over financial reporting. 27. MACKINAC FINANCIAL CORPORATION PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Corporation and its subsidiaries are subject to routine litigation incidental to the business of banking. In addition, the Corporation or the Bank is subject to an informal agreement with regulatory authorities and the litigation described below. Information regarding the informal agreement 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 that is not routine and incidental to the business of banking is described below. 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 Hendrickson, 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 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, 28. MACKINAC FINANCIAL CORPORATION PART II. OTHER INFORMATION (Continued) 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. 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, consistent 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 opposed the motion to dismiss. In an Order dated September 6, 2005, the Court stayed the proceedings in this case against defendant Littlejohn, in light of her filing for personal bankruptcy under Chapter 7 of the Bankruptcy Code in the U.S. Bankruptcy Court for the Western District of Michigan on August 9, 2005. 29. MACKINAC FINANCIAL CORPORATION PART II. OTHER INFORMATION (Continued) In an Opinion and Order, each dated September 7, 2005, the Court granted the Corporation's motion and dismissed with prejudice (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 Court directed that the case proceed with the claim against defendant Hoffman with respect to his involvement in defendant Ford's December 21, 2001 employment agreement, and with respect to the breach of fiduciary duty claims against defendants Ford and Littlejohn, subject to the stay regarding proceedings against defendant Littlejohn. A Case Management Order was entered by the Court on September 16, 2005. The Court also scheduled a mediation among the parties, the Corporation, and its insurer for November 15, 2005. On October 21, 2005, without the required permission of the Court, the plaintiff filed a Third Amended Complaint which (A) deleted (i) substantive allegations previously asserted against defendants Bittner, Bouschor, Gerou, Lindroth, Madigan, Shunk, Hendrickson, and Tolksdorf, (ii) the claim brought under Section 14 of the Exchange Act, (iii) allegations that the defendants engaged in acts to "artificially inflate the price" of the Corporation's stock, and (iv) the previous allegations quantifying damages to the Corporation at $40 million (instead alleging "million of dollars" in damages), and (B) otherwise appears to have been drafted to comport with the Court's Opinion and Order dated September 7, 2005. The Third Amended Complaint continues to include allegations against defendant Littlejohn, notwithstanding the Court's September 6, 2005 Order staying the case against her because of her personal bankruptcy filing. Before the defendants responded to the Third Amended Complaint, the Court entered an Order on October 31, 2005, striking the Third Amended Complaint because the required permission of the Court was not obtained for its filing. The Court's Order affords plaintiff seven days in which to submit a stipulated order for filing of the Third Amended Complaint, or the filing of a motion to permit its filing. Plaintiff subsequently filed a motion for leave to file a Third Amended Complaint, and the Court has taken the motion under advisement after conducting a hearing on the motion on December 6, 2005. The mediation scheduled by the Court among the parties, the Corporation, and its insurer was held on November 15, 2005. No settlement was reached. A continuation of the mediation has been scheduled for April 26, 2006 by the parties, which are conducting discovery in preparation for the mediation. On November 22, 2005, the U.S. Bankruptcy Court for the Western District of Michigan entered an Order granting the plaintiff's motion to lift the automatic stay under 11 U.S.C. Section 362 and to permit plaintiff to continue the Damon action against defendant Littlejohn, to the extent that plaintiff limits its recovery to insurance proceeds. On December 14, 2005, the Bankruptcy Court entered an order discharging defendant Littlejohn as a debtor in bankruptcy. On March 3, 2006, the Court amended the Case Management Order to extend the discovery and motion cutoff deadlines in the Damon case. Prosecution of this case is the responsibility of the plaintiff and its counsel. The Corporation's role will be to monitor the case and to respond to discovery requests from the parties. Any settlement or judgment ultimately obtained by plaintiff in this action, net of fees and expenses of counsel for plaintiff, will inure to the benefit of the Corporation. If a settlement is not reached as a result of the mediation, the Corporation will incur additional legal fees and expenses in monitoring the plaintiff's prosecution of the case on behalf of the Corporation and in responding to the parties' requests for discovery directed to it. At this time the Corporation cannot accurately estimate the amount of any such future legal fees and expenses. 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 30. MACKINAC FINANCIAL CORPORATION PART II. OTHER INFORMATION (Continued) 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. 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. In an Order dated September 29, 2005, the Court realigned the Corporation as the plaintiff and made the Corporation exclusively responsible for prosecuting all further aspects of the case, including any settlement. In the same Order, the Court stated that the Virginia M. Damon Trust would remain as a nominal plaintiff in the case, entitled to notice. A Case Management Order was entered by the Court on January 27, 2006. A mediation hearing was scheduled by the court for June 2006 and later rescheduled for early August 2006. The Corporation does not expect a resolution of this case as a result of the mediation hearing. 31. MACKINAC FINANCIAL CORPORATION PART II. OTHER INFORMATION (Continued) 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 actions described above. The Corporation does not believe that legal costs associated with the Damon action noted above will be material for 2006. The Corporation incurred and expensed $400,000 of legal costs related to this case in the first nine months of 2006. The Corporation's future costs of this lawsuit are not expected to exceed $250,000, most of which will be expensed in the 2006 fourth quarter. These fourth quarter costs will carry the lawsuit through the trial, if necessary. 32. MACKINAC FINANCIAL CORPORATION PART II. OTHER INFORMATION (Continued) ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: Exhibit 3.1 Articles of Incorporation, as amended, incorporated herein by reference to exhibit 3.1 of the Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 1999. Exhibit 3.2 Amended and Restated Bylaws, incorporated herein by reference to exhibit 3.1 of the Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 2001. Exhibit 31.1 Rule 13a-14(a) Certification of Chief Executive Officer. Exhibit 31.2 Rule 13a-14(a) Certification of Chief Financial Officer. Exhibit 32.1 Section 1350 Certification of Chief Executive Officer. Exhibit 32.2 Section 1350 Certification of Chief Financial Officer. 33. MACKINAC FINANCIAL CORPORATION SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MACKINAC FINANCIAL CORPORATION (Registrant) Date: November 14, 2006 By: /s/ Paul D. Tobias ------------------------------------ PAUL D. TOBIAS, CHAIRMAN (principal executive officer) By: /s/ Ernie R. Krueger ------------------------------------ ERNIE R. KRUEGER, SVP/CHIEF FINANCIAL OFFICER (principal accounting officer) 34. Exhibit Index Exhibit No. Exhibit Description - ----------- ------------------- Exhibit 3.1 Articles of Incorporation, as amended, incorporated herein by reference to exhibit 3.1 of the Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 1999. Exhibit 3.2 Amended and Restated Bylaws, incorporated herein by reference to exhibit 3.1 of the Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 2001. Exhibit 31.1 Rule 13a-14(a) Certification of Chief Executive Officer. Exhibit 31.2 Rule 13a-14(a) Certification of Chief Financial Officer. Exhibit 32.1 Section 1350 Certification of Chief Executive Officer. Exhibit 32.2 Section 1350 Certification of Chief Financial Officer