Management's discussion and analysis of results of operations and financial
condition contains forward-looking statements. Please refer to the discussion
of forward-looking statements at the beginning of this report.
The following section presents additional information to assess our results of operation and financial condition. This section should be read in conjunction with the consolidated financial statements and the supplemental financial data contained elsewhere in this report.
Macatawa Bank Corporationis a Michigancorporation and a registered bank holding company. It wholly-owns Macatawa Bank, Macatawa Statutory Trust Iand Macatawa Statutory Trust II. Macatawa Bankis a Michiganchartered bank with depository accounts insured by the FDIC. The Bank operates twenty-six branch offices and a lending and operational service facility, providing a full range of commercial and consumer banking and trust services in Kent County, Ottawa County, and northern Allegan County, Michigan. Macatawa Statutory Trusts I and II are grantor trusts and have issued $20.0 millioneach of pooled trust preferred securities. These trusts are not consolidated in our Consolidated Financial Statements. For further information regarding consolidation, see the Notes to the Consolidated Financial Statements. At December 31, 2013, we had total assets of $1.52 billion, total loans of $1.04 billion, total deposits of $1.25 billionand shareholders' equity of $132.5 million. We recognized net income of $9.5 millionin 2013 compared to net income of $35.5 millionin 2012. With the reversal of our deferred tax asset valuation allowance at December 31, 2012, our earnings for 2013 reflected tax expense of $4.3 million, while 2012 reflected a tax benefit of $18.6 million. As of December 31, 2013, the Company's and the Bank's regulatory capital ratios were among the highest levels in the Company's history. The Bank was categorized as "well capitalized" at December 31, 2013. On April 12, 2013, the FDICand the Michigan DIFS, the primary banking regulators of the Bank, notified the Bank that the Bank's Memorandum of Understanding ("MOU") with the FDICand DIFS had served its purpose and was released. As a result, the Bank is no longer subject to any regulatory order, memorandum of understanding or other similar regulatory directive or proceeding and has returned to a normal regulatory operating environment. Similiarly, by letter dated August 1, 2013, the Federal Reserve Bank of Chicago("FRB") advised the Company that, based on the overall satisfactory condition of the organization, the FRB poses no objection should the Board of Directors choose to rescind the Board Resolution. Accordingly, the Company's Board of Directors rescinded the Board Resolution as of August 1, 2013. During 2013, the Company improved its capital structure by prepaying and redeeming its $1.7 millionof 11% unsecured subordinated debt, resuming interest payments on its trust preferred securities and completing an exchange of all of the Company's Series A and Series B Preferred Stock to Company common stock and cash, at the election of the holder. Each of these transactions are discussed in detail in Item 7 and in our consolidated financial statements and related notes included in this report. - 27 - -------------------------------------------------------------------------------- Table of Contents Over the past five years, much progress has been made at reducing our nonperforming assets. The following table reflects period end balances of these nonperforming assets as well as total loan delinquencies. December 31, December 31,
2013 2012 2011 2010 2009 Nonperforming loans
$ 12,335 $ 16,003 $ 28,946 $ 75,361 $ 103,885Other repossessed assets 40 6 --- 50 124 Other real estate owned 36,796 51,582 66,438 57,984 37,184
Total nonperforming assets
Total loan delinquencies 30 days or greater past due
$ 5,520 $ 7,887$
Earnings in recent years have been impacted by high costs associated with administration and disposition of nonperforming assets. These costs, including losses on repossessed and foreclosed properties, were
$5.5 million, $10.0 millionand $15.6 millionfor the years ended December 31, 2013, 2012 and 2011, respectively. Going forward, as further reductions in nonperforming assets are accomplished, we expect the costs associated with these assets to continue to decline thereby allowing for improved earnings in future periods. Our earnings in 2013, 2012 and 2011 were favorably impacted by negative provision for loan losses of $4.3 million, $7.1 millionand $4.7 million, respectively. As discussed in detail later in Item 7 of this report under the heading "Allowance for Loan Losses", the large negative provision in 2012 was primarily a result of a large recovery taken in the first quarter of 2012. The negative provision in each period was also impacted by other recoveries from our collection efforts and a continual decline in our historical charge-off levels from prior years. We do not expect a similar level of negative provision for loan losses in 2014. The following table reflects the provision for loan losses for the past five years along with certain metrics that impact the determination of the level of the provision for loan losses. For the year ended December 31, (Dollars in thousands) 2013 2012 2011 2010 2009 Provision for loan losses $ (4,250 ) $ (7,100 ) $ (4,700 ) $ 22,460 $ 74,340Net charge-offs (recoveries) (1,309 ) 802 11,085 29,657 59,942 Net charge-offs to average ) loans (0.13 % 0.08 % 0.99 % 2.18 % 3.54 % Nonperforming loans to total loans 1.18 % 1.52 % 2.70 % 6.19 % 6.88 % Loans transferred to ORE to average loans 0.34 % 0.88 % 3.42 % 3.32 % 1.80 % Performing troubled debt restructurings to average loans 5.61 % 6.24 % 5.15 % 1.91 % 1.62 % The State of Michiganentered into a recession earlier than the rest of the country and has experienced heavy job loss as a result of the concentration the State has related to the automotive industry. Our market areas of Grand Rapidsand Hollandfared better than the state as a whole, but nevertheless the impact of our local economy on our results was profound. The recession and job loss impacted housing values, commercial real estate values and consumer activity. Improvement has been evident during the past three years. The state's unemployment rate at the end of 2013 was 8.8%, no longer the highest in the country and down dramatically from 15.2% in June 2009. The Hollandarea unemployment was 5.8%, and the Grand Rapidsarea unemployment was 5.6% at the end of 2013. Residential housing values and commercial real estate property values decreased significantly during the recession, but have shown signs of stabilization, with some of our newer appraisals tending to reflect values at or above prior year values. It also appears that the housing market in our primary market area has stabilized and is now improving. In the Grand Rapidsmarket during 2013, there were 23% more single family home starts than in 2012. Similarly, in the Holland- Grand Haven/Lakeshore region, there were 32% more single family home starts in 2013 than in 2012. Also, these markets are now also seeing activity in duplex, condominium and apartment starts after years of virtually no activity. - 28 - -------------------------------------------------------------------------------- Table of Contents In recent years, we have continued to diversify our loan portfolio structure by de-emphasizing commercial real estate loans and cautiously increasing volumes of commercial and industrial loans, residential mortgages and other consumer loans. Commercial real estate loans have decreased from $503.0 millionat December 31, 2012to $472.3 millionat December 31, 2013. Consumer loans have increased in 2013, totaling $295.9 millionat December 31, 2013, compared to $289.7 millionat December 31, 2012. With our improved financial condition, successful capital raise in 2011, and retained earnings growth, our focus has shifted from shrinkage in our loan portfolio to stabilizing our loan balances and growing certain portfolios in 2014.
RESULTS OF OPERATIONS
Summary: Net income was
$9.5 million( $13.8 millionon a pretax basis) for 2013, compared to net income of $35.5 million( $16.9 millionon a pretax basis) for 2012 and $5.8 million( $5.8 millionon a pretax basis) for 2011. Earnings (loss) per common share on a diluted basis was $(0.29)for 2013, $1.31for 2012 and $0.26for 2011. Earnings (loss) per share for 2013 was affected by a one-time, non-cash reduction to net income available to common shares of $17.6 millionrepresenting the impact of the preferred stock exchange completed on December 30, 2013. The results for 2012 were significantly impacted by the reversal of an $18.9 millionvaluation allowance on our deferred tax assets ("DTA") as we determined it to be more likely than not that we will be able to utilize the DTA against future taxable income. Also contributing to the higher 2012 income was the collection of a large prepayment fee of $2.8 millionon an individual loan. Earnings in each period were positively impacted by negative provision for loan losses ( $4.3 millionin 2013, $7.1 millionin 2012 and $4.7 millionin 2011). These negative provisions resulted from reduced levels of nonperforming loans, improved asset quality and reduced levels of chargeoffs. The negative provision in 2012 was higher due to the recovery of $4.4 millionon an individual loan previously charged off. These items are discussed more fully below. We continued our improvement in nonperforming asset expenses in 2013. Costs associated with nonperforming assets were $5.5 millionin 2013, compared to $10.0 millionin 2012 and $15.6 millionin 2011. Lost interest from nonperforming assets decreased to approximately $2.4 millionfor 2013, compared to $6.7 millionfor 2012 and $7.5 millionfor 2011. Each of these items are discussed more fully below.
Net Interest Income: Net interest income totaled
The decrease in net interest income during 2013 compared to 2012 was largely due to the collection of a one-time prepayment fee of
$2.8 millionrelated to prepayment on a commercial loan in the third quarter of 2012. Our net interest income as a percentage of average interest-earning assets (i.e. "net interest margin" or "margin") decreased by 44 basis points compared to 2012. The prepayment fee contributed 21 basis points to the margin in 2012. As is customary in the banking industry, interest income on tax-exempt securities is adjusted in the computation of the yield on tax-exempt securities and net interest margin using a 35% tax rate to report these items on a fully taxable equivalent basis. Average interest earning assets increased slightly from $1.35 billionin 2012 to $1.36 billionin 2013. The increase in net interest income during 2012 compared to 2011 was due primarily to the collection of a one-time prepayment fee of $2.8 millionrelated to prepayment on a commercial loan in the third quarter of 2012. Partially offsetting this was the impact of a $41.6 milliondecrease in average earning assets as a result of our focus on reducing credit exposure within certain segments of our loan portfolio and liquidity improvement. Our net interest margin increased by 20 basis points compared to 2011. The prepayment fee contributed 21 basis points to the margin in 2012. Average interest earning assets decreased from $1.39 billionin 2011 to $1.35 billionin 2012. The yield on earning assets decreased 63 basis points from 4.21% for 2012 to 3.58% for 2013, and decreased 11 basis points to 4.21% for 2012 from 4.32% for 2011. The decreases were due to decreases in the yield on our commercial, residential and consumer loan portfolios, which repriced in the generally lower rate environment during 2012 and 2013. Our margin was negatively impacted by our decision to hold significant balances in liquid and short-term investments in the past three years. Going forward, as we deploy these balances into higher yielding assets within the investment securities and loan portfolios, we expect our net interest margin to be positively impacted. - 29 - -------------------------------------------------------------------------------- Table of Contents Our net interest margin for 2013 benefitted from a 23 basis point decrease in our cost of funds from 0.92% for 2012 to 0.69% for 2013. Average interest bearing liabilities decreased from $1.06 billionin 2012 to $1.05 billionin 2013. Our net interest margin for 2012 benefitted from a 34 basis point decrease in our cost of funds from 1.26% for 2011 to 0.92% for 2012. Average interest bearing liabilities decreased from $1.15 billionin 2011 to $1.06 billionin 2012. Decreases in the rates paid on our deposit accounts in response to declining market rates and the rollover of time deposits and other borrowings at lower rates within the current rate environment caused the reduction in our cost of funds for each period. Margin continued to be dampened by the impact of our elevated levels of nonperforming assets, including other real estate owned and nonaccrual loans. However, as we work to further reduce these levels, our margin is expected to benefit. The estimated negative impact of these nonperforming assets on net interest margin decreased from 54 basis points in 2011 to 37 basis points in 2012 and 18 basis points in 2013. We are encouraged by the slight increase in average earning assets in 2013 and expect these balances to continue to increase in 2014, which should positively affect net interest income. - 30 - -------------------------------------------------------------------------------- Table of Contents The following table shows an analysis of net interest margin for the years ended December 31, 2013, 2012 and 2011. For the years ended December 31, 2013 2012 2011 Interest Average Interest Average Interest Average Average Earned Yield Average Earned Yield Average Earned Yield Balance or paid or cost Balance or paid or cost Balance or paid or cost (Dollars in thousands) Assets Taxable securities $ 108,079 $ 1,7981.67 % $ 79,379 $ 1,5441.94 % $ 25,452 $ 4971.95 % Tax-exempt securities (1) 33,930 742 3.44 % 13,769 330 4.03 % 1,235 38 5.24 % Loans (2) 1,034,775 45,201 4.32 % 1,049,501 54,549 5.14 % 1,123,295 59,334 5.23 % Federal Home Loan Bank stock 11,236 393 3.45 % 11,236 351 3.08 % 11,539 294 2.51 % Federal funds sold and other short-term investments 167,833 486 0.29 % 197,423 502 0.25 % 231,417 616 0.26 % Total interest earning assets (1) 1,355,853 48,620 3.58 % 1,351,308 57,276 4.21 % 1,392,938 60,779 4.32 % Noninterest earning assets: Cash and due from banks 24,033 23,042 23,011 Other 129,954 124,510 115,552 Total assets $ 1,509,840 $ 1,498,860 $ 1,531,501Liabilities Deposits: Interest bearing demand $ 272,689369 0.13 % $ 225,250346 0.15 % $ 185,591424 0.23 % Savings and money market accounts 472,920 1,999 0.43 % 420,553 2,003 0.48 % 369,758 2,063 0.56 % Time deposits 171,657 1,625 0.94 % 254,796 3,372 1.32 % 371,870 6,786 1.83 % Borrowings: Other borrowed funds 90,580 1,781 1.94 % 121,300 2,374 1.92 % 175,063 3,609 2.03 % Long-term debt 41,238 1,450 3.47 % 41,238 1,537 3.67 % 41,238 1,413 3.38 % Subordinated debt 1,013 113 11.10 % 1,650 182 11.00 % 1,839 185 10.05 % Total interest bearing liabilities 1,050,097 7,337 0.69 % 1,064,787 9,814 0.92 % 1,145,359 14,480 1.26 % Noninterest bearing liabilities: Noninterest bearing demand accounts 317,332 323,368 296,926 Other noninterest bearing liabilities 8,070 7,507 6,934 Shareholders' equity 134,341 103,198 82,282 Total liabilities and shareholders' equity $ 1,509,840 $ 1,498,860 $ 1,531,501Net interest income $ 41,283 $ 47,462 $ 46,299Net interest spread (1) 2.89 % 3.29 % 3.06 % Net interest margin (1) 3.05 % 3.49 % 3.29 % Ratio of average interest earning assets to average interest bearing liabilities 129.12 % 126.91 % 121.62 %
(1) Yields are presented on a tax equivalent basis using a 35% tax rate.
(2) Loan fees of
included in interest income. Includes average nonaccrual loans of
and 2011. - 31 - -------------------------------------------------------------------------------- Table of Contents The following table presents the dollar amount of changes in net interest income due to changes in volume and rate. For the years ended
December 31, 2013vs 2012 2012 vs 2011 Increase (Decrease) Due to Increase (Decrease) Due to
Volume Rate Total Volume Rate Total (Dollars in thousands) Interest income Taxable securities
$ 501 $ (247 ) $ 254 $ 1,049 $ (2 ) $ 1,047Tax-exempt securities 473 (61 ) 412 311 (19 ) 292 Loans (756 ) (8,592 ) (9,348 ) (3,848 ) (937 ) (4,785 ) Federal Home Loan Bank stock --- 42 42 (8 ) 65 57 Federal funds sold and other short-term investments (80 ) 64 (16 )
(87 ) (27 ) (114 ) Total interest income 138 (8,794 ) (8,656 ) (2,583 ) (920 ) (3,503 )
Interest expense Interest bearing demand
$ 67(44 ) $ 23 $ 79(157 ) $ (78 )Savings and money market accounts 235 (239 ) (4 ) 263 (323 ) (60 ) Time deposits (933 ) (814 ) (1,747 ) (1,822 ) (1,592 ) (3,414 ) Other borrowed funds (604 ) 11 (593 ) (1,060 ) (175 ) (1,235 ) Long-term debt --- (87 ) (87 ) --- 124 124 Subordinated debt (37 ) (32 ) (69 ) (7 ) 4 (3 ) Total interest expense (1,272 ) (1,205 ) (2,477 )
(2,547 ) (2,119 ) (4,666 ) Net interest income
Provision for Loan Losses: The provision for loan losses for 2013 was a negative
$4.3 millioncompared to a negative $7.1 millionfor 2012 and a negative $4.7 millionfor 2011. The negative provisions in each period were the result of continued significant declines in the level of net charge-offs, reduction in the balances and required reserves on nonperforming loans and stabilizing real estate values on problem credits. The provision for loan losses for 2012 was affected by a $4.4 millionrecovery on a previously charged-off loan in the first quarter of 2012. Net charge-offs were $58.0 millionin 2009, $29.7 millionin 2010, $11.1 millionin 2011, and $802,000in 2012 and a net recovery of $1.3 millionin 2013. The lower level of net charge-offs was a result of a slowing in the rate of declines in real estate values, success at reducing our levels of nonperforming loans and positive results from our aggressive collection recovery efforts. We have experienced a decline in the pace of commercial loans migrating to a worse loan grade, which receive higher allocations in our loan loss reserve. In addition to experiencing fewer downgrades of credits, we continue to see an increase in the quality of some credits resulting in an improved loan grade. Over the past two years, we have experienced improvements in our weighted average loan grade. Our weighted average commercial loan grade was 3.88 at December 31, 2013reflecting improvement compared to 4.01 at December 31, 2012and 4.19 at December 31, 2011. We believe efforts that began in late 2009 and in early 2010 to improve loan administration and loan risk management practices have had a significant impact, ultimately allowing for the reduction in the level of the allowance for loan losses since then. The amounts of loan loss provision in each period were the result of establishing our allowance for loan losses at levels believed necessary based upon our methodology for determining the adequacy of the allowance. The sustained lower level of quarterly net charge-offs over the past three years has had a significant effect on the historical loss component of our methodology. More information about our allowance for loan losses and our methodology for establishing its level may be found in this Item 7 of the report under the heading "Allowance for Loan Losses" below and in Item 8 of this report in Note 3 of the Consolidated Financial Statements. - 32 - -------------------------------------------------------------------------------- Table of Contents Noninterest Income: Noninterest income totaled $16.1 millionin 2013, compared to $15.6 millionin 2012 and $14.9 millionin 2011. The components of noninterest income are shown in the table below (in thousands): 2013 2012
Service charges and fees on deposit accounts
$ 3,963 $ 3,323 $ 3,692Net gains on mortgage loans 2,554 2,882 1,728 Trust fees 2,413 2,389 2,543 Gain as sales of securities 120 73 --- ATM and debit card fees 4,325 4,130 3,963 Bank owned life insurance ("BOLI") income 713 847 942 Investment services fees 943 771 796 Other income 1,110 1,213 1,228 Total noninterest income $ 16,141 $ 15,628 $ 14,892Revenue from deposit services was $4.0 millionin 2013, compared to $3.3 millionin 2012 and $3.7 millionin 2011. The increase from 2012 to 2013 was due primarily to increased levels of returned check fees from changes to the overdraft privilege feature of our checking accounts implemented in late 2012. The decrease from 2011 to 2012 was related primarily to decreases in fees driven from account balances, as our average deposit balances were lower in 2012 than in 2011. Net gains on mortgage loans included gains on the sale of real estate mortgage loans in the secondary market. We sell the majority of the fixed-rate mortgage loans we originate. We do not retain the servicing rights for the loans we sell. A summary of gain on sales of loans and related loan volume was as follows (in thousands): For the Year Ended December 31, 2013 2012 2011 Gain on sales of loans $ 2,554 $ 2,882 $ 1,728
Real estate mortgage loans originated for sale
116,757 135,929 87,709 Net gain on the sale of mortgage loans as a percent of real estate mortgage loans sold ("Loan sale margin") 2.19 % 2.12 % 1.97 % As demonstrated in the table above, we realized significant volumes of activity the past few years, peaking in 2012. Mortgage rates increased in the second half of 2013, reducing the residential mortgage volume and thus reducing gains on mortgage loans in the latter half of 2013. This income was up significantly during 2012 as a result of our renewed focus on residential mortgage volume and the addition of experienced mortgage professionals during 2011, and the low interest rate environment that existed throughout 2011 and 2012. During 2013, we saw a shift in our mortgage production from refinance activity to purchase activity. We expect this trend to continue in 2014. Trust service revenue increased
$24,000in 2013 after having decreased $154,000in 2012. This increase is due to improvements in general market conditions and our improved financial condition. Our financial performance in previous years and the existence of our previous regulatory orders likely impacted how we were perceived in the marketplace, resulting in challenges to retain trust customers and maintain levels of trust revenue. We believe that our improved financial performance in the past several years and the termination of our previous regulatory orders are having a positive impact on our trust service revenue. ATM and debit card processing income increased $195,000in 2013 to $4.3 million, following an increase of $167,000in 2012 over 2011. These increases reflected a continued increase in usage from current customers and overall growth in the number of debit and ATM card customers. Promotional efforts to increase volume in these low cost transaction alternatives continued to be successful. Our recent rollout of our uChoose Rewards program is expected to have a positive impact on this income in 2014. Recent regulatory changes implementing price controls over what financial institutions can charge for these services may impact the level of such income we recognize in 2014. - 33 - -------------------------------------------------------------------------------- Table of Contents We sold securities in 2013 resulting in net gains of $120,000. In 2012, we sold securities resulting in net gains of $73,000. We did not sell any investment securities during 2011, and therefore had no gains on sale of securities during the year. The sales in 2012 and 2013 were made due to downgrades of the individual investments sold. We continually review our securities portfolio and will dispose of securities that pose higher than desired credit or market risk. Other categories of noninterest income totaled $2.8 millionin 2013, $2.8 millionin 2012 and $3.0 millionin 2011. Investment service fees were up $172,000in 2013 due to our focus on these services and improvement in the stock market performance. Earnings from bank owned life insurance decreased $134,000from 2012 as the underlying investments performed better in 2012 than in 2013. This followed a reduction in bank owned life insurance earnings of $95,000from 2011 to 2012, again due to the performance of the underlying investments. ORE rental income was $304,000in 2013, compared to $684,000in 2012 and $549,000in 2011. The fluctuations are due to the relative average other real estate owned balances during each period. Noninterest Expense: Noninterest expense was $47.9 millionin 2013, $53.3 millionin 2012 and $60.1 millionin 2011. The steady decline in our noninterest expense areas reflects our active management of controllable costs to offset the high level of nonperforming assets costs. These costs have decreased dramatically during the periods presented as well. The components of noninterest expense are shown in the table below (in thousands): 2013 2012 2011 Salaries and benefits $ 23,012 $ 22,986 $ 22,217Occupancy of premises 3,756 3,815 3,949 Furniture and equipment 3,224 3,259 3,318 Legal and professional 680 664 971 Marketing and promotion 870 929 834 Data processing 1,351 1,268 1,284 FDIC assessment 1,458 2,196 3,472 ATM and debit card processing 1,300 1,222
Bond and D&O insurance 740 909
FHLB Advance prepayment penalty --- 322
Administration and disposition of problem assets 5,524 9,960
15,601 Outside services 1,606 1,407 1,540 Other noninterest expense 4,334 4,346 4,158 Total noninterest expense
$ 47,855 $ 53,283 $ 60,062Salaries and benefit expense were the highest component of noninterest expense and was $23.0 millionin 2013 and 2012, and $22.2 millionin 2011. The increases in 2013 and 2012 were primarily due to salary and wage cost of living increases and commissions paid for mortgage origination activity, partially offset by reduced medical insurance costs driven by lower claims experience in 2013. Also impacting salary and benefit expense in 2013 was the reinstatement of our 401(k) plan matching contribution, effective January 1, 2013. Costs associated with nonperforming assets remain elevated, but have decreased significantly each of the past three years, totaling $5.5 millionin 2013 compared to $10.0 millionin 2012 and $15.6 millionin 2011. These costs included legal costs, repossessed and foreclosed property administration expense and losses on repossessed and foreclosed properties. Repossessed and foreclosed property administration expense included survey and appraisal, property maintenance and management and other disposition and carrying costs. Losses on repossessed and foreclosed properties included both net losses on the sale of properties and unrealized losses from value declines for outstanding properties.
These costs are itemized in the following table (in thousands):
Legal and professional - nonperforming assets
$ 2,389Repossessed and foreclosed property administration 2,817 3,516
Losses on repossessed and foreclosed properties 1,825 5,295
$ 5,524 $ 9,960 $ 15,601- 34 -
-------------------------------------------------------------------------------- Table of Contents As problems loans move through the collection process, the costs associated with nonperforming assets have remained elevated, yet have decreased significantly during each of the past three years. During 2013, we added only
$3.5 millionin other real estate and sold $16.5 million, allowing for a meaningful reduction in our year end balance. This compares to 2012, when we added $9.2 millionin other real estate and sold $18.7 millionand 2011 when we added $38.4 millionin other real estate and sold $21.5 million. Looking forward to 2014, we expect this trend to continue and should see meaningful reductions in the balances of other real estate owned and the related nonperforming asset carry costs. Legal and professional fees totaled $680,000in 2013, $664,000in 2012 and $971,000in 2011. These expenses have been unusually high in recent years as a result of legal fees associated with consultation related to our previous regulatory orders we had been under and our implementation of additional corporate governance procedures, including more consultation with corporate legal counsel. We anticipate reductions in legal and professional expenses in 2014. FDICassessments decreased to $1.5 millionin 2013 compared to $2.2 millionin 2012 and $3.5 millionin 2011 primarily due to the termination of our previous regulatory orders and resulting change in our assessment category and our reduced level of deposits. Further discussion regarding the determination of FDICassessments for the Bank may be found in Item 1 of this report under the heading "Supervision and Regulation." Insurance costs for bond and directors and officers ("D&O") insurance decreased significantly from $1.5 millionin 2011 to $909,000in 2012 and $740,000in 2013. The reductions experienced in 2012 and 2013 were a result of the improvement in our regulatory status and financial condition, which demonstrated to the insurance carriers lower risk and resulted in a reduction in premiums charged. Occupancy expense declined $59,000in 2013 following decreases of $134,000in 2012 and $107,000in 2011. Furniture and equipment expense was down $35,000in 2013 after decreases of $59,000in 2012 and $236,000in 2011. These expenses were down due to our continued efforts to reduce facility costs. Marketing expenses decreased $59,000in 2013 and increased $95,000in 2012. The increase in 2012 was due to some significant marketing campaigns as we shifted our focus to growth in our market areas. We incurred a $322,000prepayment fee in 2012 associated with the early payoff of $20 millionin FHLB advances. Other noninterest expenses not discussed above were $5.9 millionin 2013, compared to $5.8 millionin 2012 and $5.7 millionin 2011. The increase in 2013 was primarily due to increases in outside services and donations, partially offset by decreases in electronic banking services. Enhancements to our personal online banking delivery channel contributed to an increase in electronic banking expense of $238,000in 2012. These increases were largely offset by other declines in 2012 within these expense areas that were the direct result of our continued initiatives to reduce controllable costs. In addition to eliminating or outsourcing certain backroom functions, these initiatives included restructuring third party contracts, acceleration of electronic delivery for certain customers and trimming controllable costs. Federal Income Tax Expense (Benefit): We recorded federal income tax expense of $4.3 millionin 2013, a federal income tax benefit of $18.6 millionin 2012 and no federal income tax expense or benefit in 2011. From June 30, 2009to December 31, 2012, we had concluded that a full valuation allowance needed to be maintained for all of our net deferred tax assets based primarily on our net operating losses in 2008 and 2009 and the continued challenging environment confronting banks that could negatively impact future operating results. With the termination of our previous regulatory orders, cumulative earnings in the most recent three year period and projections showing future taxable income at December 31, 2012, we concluded that the valuation allowance was no longer required and the $18.9 millionvaluation allowance was reversed at that time. Our effective tax rate for 2013 was 31%.
Summary: Due to the continuing soft economic conditions, we have been focused on improving our loan portfolio, reducing exposure in higher loan concentration types, building our investment portfolio, and improving our financial condition through diversification of credit risk, improved capital ratios, and reduced reliance on non-core funding. We have experienced positive results in each of these areas over the past three years. Total assets were
$1.517 billionat December 31, 2013, a decrease of $43.3 millionfrom $1.561 billionat December 31, 2012. This change reflected increases of $16.2 millionin securities available for sale and $25.0 millionof interest-bearing time deposits in other financial institutions, offset by declines of $10.0 millionin our loan portfolio and $69.5 millionin cash and cash equivalents. Total deposits decreased by $36.5 million, other borrowed funds were down by $1.8 millionat December 31, 2013compared to December 31, 2012and long-term debt decreased by $1.7 millionas we prepaid and redeemed our subordinated debt in 2013. - 35 - -------------------------------------------------------------------------------- Table of Contents In the second half of 2013, we discontinued the deferral and resumed regular payment of quarterly interest payments on our trust preferred securities and paid all accrued and unpaid interest that had been previously deferred became due and payable upon the discontinuance of the deferral. For Macatawa Statutory Trust I, a total of $3.0 million, representing all of the deferred and current interest payment due was distributed on September 30, 2013. For Macatawa Statutory Trust II, a total of $2.7 million, representing all of the deferred and current interest payment due was distributed on October 7, 2013. Total shareholders' equity increased by $2.0 millionfrom December 31, 2012to December 31, 2013. Shareholders' equity was increased by $9.5 millionof net income in 2013, partially offset by the $4.7 millioncash payment made to holders of Series A and Series B Preferred Stock as part of the exchange completed on December 30, 2013. The exchange is discussed further in this section under the heading "Capital Resources". Shareholders' equity was also reduced by $2.9 millionin 2013 as a result of an other comprehensive income swing due to the effect of interest rate movement on the fair value of our available for sale securities portfolio. As of December 31, 2013, the Bank was categorized as "well capitalized" under applicable regulatory guidelines. Cash and Cash Equivalents: Our cash and cash equivalents, which include federal funds sold and short-term investments, were $156.9 millionat December 31, 2013compared to $226.4 millionat December 31, 2012. The $69.5 milliondecrease was partially due to investing $25.0 millionof these funds in interest-bearing time deposits with other financial institutions as discussed below. We expect our balances of short term investments to remain elevated until loan demand materially increases and more attractive investment opportunities emerge. Interest-bearing Time Deposits with Other Financial Institutions: We opened two time deposit accounts with our primary correspondent bank in the first quarter of 2013, each in equal amounts totaling $25.0 million. One of these deposits matures 12 months after issuance and the other 18 months after issuance, and both provide a higher interest rate than federal funds sold or other short-term investments. Securities: Securities available for sale were $139.7 millionat December 31, 2013compared to $123.5 millionat December 31, 2012. We began rebuilding our investment portfolio during the second quarter of 2011 after selling the entire portfolio in the second quarter of 2010. The balance at December 31, 2013primarily consisted of U.S. agency securities, agency mortgage backed securities and various municipal investments. Our held to maturity portfolio increased from $4.3 millionat December 31, 2012to $19.2 millionat December 31, 2013. Our held to maturity portfolio is comprised of state and municipal bonds. We expect to continue to reinvest excess liquidity and selectively rebuild our investment portfolio. Portfolio Loans and Asset Quality: Total portfolio loans declined by $10.0 millionto $1.04 billionat December 31, 2013compared to $1.05 billionat December 31, 2012. During 2013, our commercial portfolio decreased by $16.2 million, while our residential and consumer portfolios increased by $6.0 millionand $226,000, respectively. We saw a comparable level of volume of residential mortgage loans originated for sale in the first nine months of 2013 compared to the same period in 2012, but this did slow in the fourth quarter of 2013 due to the rise in mortgage rates in the latter part of 2013. Residential mortgage loans originated for sale were $108.0 millionin 2013 compared to $140.2 millionin 2012. Our commercial loan portfolio balances declined in recent years reflecting the continuing weak economic conditions in West Michiganand our interest in improving the quality of our loan portfolio through reducing our exposure to these generally higher credit risk assets. We have focused our efforts on reducing our exposure to residential land development loans, diversifying our commercial loan portfolio and improving asset quality. We believe our loan portfolio has stabilized. During the fourth quarter of 2012, we achieved growth in our commercial loan portfolio for the first time since the fourth quarter of 2008. While this portfolio decreased during the first two quarters of 2013, growth returned in the third quarter when the portfolio increased by $12.7 millionand the fourth quarter of 2013 when the portfolio increased by $11.3 million. We plan to continue measured, high quality loan portfolio growth in 2014. Commercial and commercial real estate loans remained our largest loan segment and accounted for approximately 72% of the total loan portfolio at December 31, 2013and 73% at December 31, 2012. Residential mortgage and consumer loans comprised approximately 28% of total loans at December 31, 2013and 27% at December 31, 2012. - 36 - -------------------------------------------------------------------------------- Table of Contents A further breakdown of the composition of the loan portfolio is shown in the table below (in thousands): December 31, Percent of
2013 Total Loans 2012 Total Loans Commercial real estate: (1) Residential developed
$ 18,1301.8 % $ 26,0902.5 % Unsecured to residential developers 7,315 0.7 5,547 0.5 Vacant and unimproved 42,988 4.1 56,525 5.3 Commercial development 2,434 0.2 1,799 0.2 Residential improved 76,294 7.3 75,813 7.2 Commercial improved 247,195 23.7 255,738 24.4 Manufacturing and industrial 77,984 7.5 81,447 7.7 Total commercial real estate 472,340 45.3 502,959 47.8 Commercial and industrial 274,099 26.3 % 259,700 24.7 % Total commercial 746,439 71.6 762,659 72.5 Consumer Residential mortgage 188,648 18.1 182,625 17.3 Unsecured 1,337 0.1 1,683 0.2 Home equity 95,961 9.2 92,764 8.8 Other secured 9,992 1.0 12,617 1.2 Total consumer 295,938 28.4 289,689 27.5 Total loans $ 1,042,377100.0 % $ 1,052,348100.0 %
(1) Includes both owner occupied and non-owner occupied commercial real estate.
Commercial real estate loans accounted for approximately 45% of the total loan portfolio at
December 31, 2013and consisted primarily of loans to business owners and developers of owner and non-owner occupied commercial properties and loans to developers of single and multi-family residential properties. In the table above, we show our commercial real estate portfolio by loans secured by residential and commercial real estate, and by stage of development. Improved loans are generally secured by properties that are under construction or completed and placed in use. Development loans are secured by properties that are in the process of development or fully developed. Vacant and unimproved loans are secured by raw land for which development has not yet begun and agricultural land. Total commercial real estate loans declined $30.6 millionsince December 31, 2012. Our commercial and industrial loan portfolio increased by $14.4 millionto $274.1 millionat December 31, 2013and represented 26% of our commercial portfolio. Our consumer residential mortgage loan portfolio, which also includes residential construction loans made to individual homeowners, comprised approximately 18% of portfolio loans at December 31, 2013and 17% at December 31, 2012as we continue to execute our strategy to diversify our credit risk from commercial real estate. We expect to continue to retain in our loan portfolio certain types of residential mortgage loans (primarily high quality, low loan to value loans) in an effort to continue to diversify our credit risk and deploy our excess liquidity. A large portion of our residential mortgage loan production continues to be sold on the secondary market with servicing released. We saw a decrease in the volume of residential mortgage loans originated for sale during 2013 compared to 2012 as discussed above, however the decrease began in the third quarter of 2013 as interest rates increased beginning late in the second quarter of 2013. We expect this trend to continue in 2014. We have not yet had to repurchase any residential mortgage loans sold to historical purchasers; however, due to market conditions many banks are being required to repurchase loans resulting from actual or alleged failure to strictly conform to the investor's purchase criteria. Our portfolio of other consumer loans includes loans secured by personal property and home equity fixed term and line of credit loans. Consumer loans increased by $226,000to $107.3 millionat December 31, 2013from $107.1 millionat December 31, 2012due to an increase in home equity loans. Consumer loans comprised approximately 10% of our portfolio loans at both December 31, 2013and December 31, 2012. - 37 - -------------------------------------------------------------------------------- Table of Contents The following table shows our loan origination activity for portfolio loans during 2013, broken out by loan type and also shows average originated loan size (dollars in thousands): Portfolio Percent of Average Originations Total Loan Size 2013 Originations 2013 Commercial real estate: Residential developed $ 5,4401.1 % $ 302Unsecured to residential developers --- --- --- Vacant and unimproved 10,273 2.1 367 Commercial development --- --- --- Residential improved 53,741 10.8 221 Commercial improved 67,748 13.5 560 Manufacturing and industrial 18,662 3.7 622 Total commercial real estate 155,864 31.2 354 Commercial and industrial 237,425 47.5 % 43 Total commercial 393,289 78.7 67 Consumer Residential mortgage 61,381 12.3 211 Unsecured 591 0.1 20 Home equity 41,404 8.3 68 Other secured 2,971 0.6 12 Total consumer 106,347 21.3 90 Total loans $ 499,636100.0 % $ 70Our loan portfolio is reviewed regularly by our senior management, our loan officers, and an internal loan review team that is independent of our loan originators and credit administration. An administrative loan committee consisting of senior management and seasoned lending and collections personnel meets monthly to manage our internal watch list and proactively manage high risk loans. When reasonable doubt exists concerning collectability of interest or principal of one of our loans, the loan is placed in nonaccrual status. Any interest previously accrued but not collected is reversed and charged against current earnings. Nonperforming assets are comprised of nonperforming loans, foreclosed assets and repossessed assets. At December 31, 2013, nonperforming assets totaled $49.2 millioncompared to $67.6 millionat December 31, 2012. Additions to other real estate owned in 2013 were just $3.5 million, compared to $9.2 millionin 2012. Based on the loans currently in their redemption period, we expect there to be fewer additions to other real estate owned in 2014 than there were in 2013. Proceeds from sales of foreclosed properties were $16.5 millionin 2013 resulting in a net gain of $1.1 million. Proceeds from sales of foreclosed properties were $18.7 millionin 2012, resulting in a small net realized loss on sale of $59,000. We expect the level of sales of foreclosed properties in 2014 to be similar to the levels experienced in 2013. Nonperforming loans include loans on nonaccrual status and loans delinquent more than 90 days but still accruing. As of December 31, 2013, nonperforming loans totaled $12.3 million, or 1.18% of total portfolio loans, compared to $16.0 million, or 1.52% of total portfolio loans, at December 31, 2012. Loans for development or sale of 1-4 family residential properties comprised approximately $2.6 million, or 21.0% of total nonperforming loans, at December 31, 2013compared to $3.2 million, or 19.7% of total nonperforming loans, at December 31, 2012. The remaining balance of nonperforming loans at December 31, 2013consisted of $3.1 millionof commercial real estate loans secured by various types of non-residential real estate, $5.6 millionof commercial and industrial loans, and $1.0 millionof consumer and residential mortgage loans. - 38 - -------------------------------------------------------------------------------- Table of Contents Foreclosed and repossessed assets include assets acquired in settlement of loans. Foreclosed assets totaled $36.8 millionat December 31, 2013and $51.6 millionat December 31, 2012. Of this balance at December 31, 2013, there were 80 commercial real estate properties totaling approximately $34.8 million. The remaining balance was comprised of 21 residential properties totaling approximately $2.0 million. Four commercial real estate properties comprised $15.6 million, or 43%, of total other real estate owned at December 31, 2013. All properties acquired through or in lieu of foreclosure are initially transferred at their fair value less estimated costs to sell and then evaluated monthly for impairment after transfer using a lower of cost or market approach. Updated property valuations are obtained at least annually on all foreclosed assets. At December 31, 2013, our foreclosed asset portfolio had a weighted average age held in portfolio of 3.18 years. Below is a breakout of our foreclosed asset portfolio at December 31, 2013by property type and the percentages the property has been written down since taken into our possession and the combined writedown percentage, including losses taken when the property was loan collateral (dollars in thousands): Combined Carrying Writedown Value at Foreclosed (Loan and December 31, Asset Foreclosed Foreclosed Asset Property Type 2013 Writedown Asset) Single Family $ 1,4584.11 % 32.96 % Residential Lot 559 32.36 49.59 Multi-Family --- --- --- Vacant Land 5,607 35.13 50.21 Residential Development 12,393 39.06 74.03 Commercial Office 1,753 32.15 54.42 Commercial Industrial 85 47.96 67.19 Commercial Improved 14,941 22.73 37.82 $ 36,79631.11 % 59.12 % The following table shows the composition and amount of our nonperforming assets (dollars in thousands): December 31, December 31, 2013 2012 Nonaccrual loans $ 12,182 $ 15,385Loans 90 days past due and still accruing 153
Total nonperforming loans (NPLs) 12,335 16,003 Foreclosed assets 36,796 51,582 Repossessed assets 40 6 Total nonperforming assets (NPAs) 49,171
Accruing restructured loans (ARLs) (1) 57,790 65,024 Total NPAs and ARLs
$ 106,961 $ 132,615NPLs to total loans 1.18 % 1.52 % NPAs to total assets 3.24 % 4.33 %
(1) Comprised of approximately
been restructured at
being accrued on these loans under their restructured terms as they are less
than 90 days past due. - 39 -
-------------------------------------------------------------------------------- Table of Contents Allowance for loan losses: Determining the appropriate level of the allowance for loan losses is highly subjective. Timely identification of risk rating changes within the commercial loan portfolio is key to our process of establishing an appropriate allowance balance. The internal risk rating system is discussed below. The allowance for loan losses at
December 31, 2013was $20.8 million, a decrease of $2.9 million, compared to $23.7 millionat December 31, 2012. The balance of the allowance for loan losses was 2.00% of total portfolio loans at December 31, 2013compared to 2.26% of total portfolio loans at December 31, 2012. While this ratio decreased slightly, the allowance for loan losses to nonperforming loan coverage ratio continued to increase, from 148.34% at December 31, 2012to 168.61% at December 31, 2013.
The following is a summary of our portfolio loan balances and changes in the allowance for loan losses and related ratios:
December 31 (Dollars in thousands) 2013 2012 2011 Portfolio loans: Average daily balance of loans for the year
$ 1,030,766 $ 1,041,833 $ 1,120,857Amount of loans outstanding at end of period 1,042,377 1,052,348 1,070,975 Allowance for loan losses: Balance at beginning of year 23,739 31,641 47,426 Provision for loan losses (4,250 ) (7,100 ) (4,700 ) Loans charged-off: Real estate - construction (55 ) (1,455 ) (3,014 ) Real estate - mortgage (1,010 ) (1,751 ) (7,967 ) Commercial and industrial (317 ) (1,245 ) (2,935 ) Total Commercial (1,382 ) (4,451 ) (13,916 ) Residential mortgage (433 ) (2,257 ) (1,559 ) Consumer (389 ) (788 ) (976 ) (2,204 ) (7,496 ) (16,451 ) Recoveries: Real estate - construction 1,568 5,521 2,541 Real estate - mortgage 573 319 802 Commercial and industrial 1,134 547 1,727 Total Commercial 3,275 6,387 5,070 Residential mortgage 65 142 39 Consumer 173 165 257 3,513 6,694 5,366 Net (charge-offs) recoveries 1,309 (802 ) (11,085 ) Balance at end of year $ 20,798 $ 23,739 $ 31,641Ratios: Net charge-offs to average loans outstanding (0.13 )% 0.08 % 0.99 % Allowance for loan losses to loans outstanding at 2.00 % 2.26 % 2.95 % year-end Allowance for loan losses tononperforming loans at 168.61 % 148.34 % 109.31 % year-end - 40 -
-------------------------------------------------------------------------------- Table of Contents The continued reduction in net charge-offs over the last several years has had a significant effect on the historical loss component of our allowance for loan losses computation as have the improvements in our credit quality metrics. The table below shows the changes in these metrics over the past five years: (in millions) 2013 2012 2011 2010 2009 Commercial loans
$ 746.4 $ 762.7 $ 795.3 $ 933.9 $ 1,172.6Nonperforming loans 12.3 16.0 28.9 75.4 103.9 Other real estate owned and repo assets 36.8 51.6 66.4 58.0 37.3 Total nonperforming assets 49.2 67.6 95.4 133.4 141.2 Net charge-offs (recoveries) (1.3 ) 0.8 11.1 29.7 58.0 Total delinquencies 5.5 7.9 13.1 55.7 118.6 Nonperforming loans have continually declined since the first quarter of 2010 to $12.3 millionat December 31, 2013. As discussed earlier, we have had net loan recoveries in several quarters over the last year and a half and for the full year 2013. Perhaps even more importantly, our total delinquencies have decreased each year since 2009, to just $5.5 millionat December 31, 2013. These factors all provide for a reduction in our allowance for loan losses, and thus impacts our provision for loan losses. The provision for loan losses was a negative $4.3 millionfor 2013 compared to a negative $7.1 millionfor 2012 and a negative $4.7 millionfor 2011. The negative provision in each period was partially due to a smaller level of nonperforming loans as they continue to stabilize at a more reasonable level. We had net recoveries in 2013 totaling $1.3 million. For 2012, we had net charge-offs of $802,000, compared to net charge-offs of $11.1 millionin 2011. At December 31, 2013, we have had net recoveries in three of the last five quarters. The ratio of net charge-offs (recoveries) to average loans was -0.13% for 2013, compared to 0.08% for 2013 and 0.99% for 2011. We are encouraged by the reduced level of charge-offs over the past four years. We do, however, recognize that future charge-offs and resulting provisions for loan losses are expected to be impacted by the timing and extent of changes in the overall economy and the real estate markets. We believe we have seen some stabilization in economic conditions and real estate markets. However, we expect it to take additional time for sustained improvement in the economy and real estate markets in order for us to reduce our nonperforming and impaired loans to acceptable levels. Our allowance for loan losses is maintained at a level believed appropriate based upon our assessment of the probable estimated losses inherent in the loan portfolio. Our methodology for measuring the appropriate level of allowance and related provision for loan losses relies on several key elements, which include specific allowances for loans considered impaired, general allowance for commercial loans not considered impaired based upon applying our loan rating system, and general allocations based on historical trends for homogeneous loan groups with similar risk characteristics. Impaired loans declined $14.4 millionto $68.9 millionat December 31, 2013compared to $83.3 millionat December 31, 2012. The specific allowance for impaired loans decreased $2.2 millionto $3.9 million, or 5.6% of total impaired loans, at December 31, 2013compared to $6.1 million, or 7.3% of total impaired loans, at December 31, 2012. The overall balance of impaired loans remained elevated due to an accounting rule (ASU 2011-02) adopted in 2011 that requires us to identify classified loans that renew at existing contractual rates as troubled debt restructurings ("TDRs") if the contractual rate is less than market rates for similar loans at the time of renewal. As TDRs are also considered impaired, this increased our impaired loan balance for each period presented as most of our classified loans renewed in this time period. Specific allowances are established on individually impaired credits where we believe it is probable that a loss may be incurred. Specific allowances are determined based on discounting estimated cash flows over the life of the loan or based on the fair value of collateral supporting the loan. For commercial real estate loans, generally appraisals are used to estimate the fair value of the collateral and determine the appropriate specific allowance. Estimated selling costs are also considered in the estimate. When it becomes apparent that liquidation of the collateral is the only source of repayment, the collateral shortfall is charged off rather than carried as a specific allowance. The general allowance (referred to as "formula allowance") allocated to commercial loans that were not considered to be impaired was based upon the internal risk grade of such loans. We use a loan rating method based upon an eight point system. Loans are stratified between real estate secured and non real estate secured. The real estate secured portfolio is further stratified by the type of real estate. Each stratified portfolio is assigned a loss allocation factor. Generally, a worse grade assigned to a loan category results in a greater allocation percentage. Changes in risk grade of loans affect the amount of the allowance allocation. - 41 - -------------------------------------------------------------------------------- Table of Contents The determination of our loss factors is based upon our actual loss history by loan grade and adjusted for significant factors that, in management's judgment, affect the collectability of the portfolio as of the analysis date. We use a rolling 18 month (6 quarter) actual net charge-off history as the base for our computation for commercial loans. The 18 month period ended December 31, 2013reflected a sizeable decrease in net charge-off experience. We addressed this volatility in the qualitative factor considerations applied in our allowance computation. Adjustments to the qualitative factors also involved consideration of different loss periods for the Bank, including 12, 24, 36 and 48 month periods. Considering the change in our qualitative factors and changes in our commercial loan portfolio balances, the general commercial loan allowance decreased $471,000to $14.2 millionat December 31, 2013compared to $14.7 millionat December 31, 2012. This resulted in a general reserve percentage allocated at December 31, 2013of 2.03% of commercial loans, a decrease from 2.12% at December 31, 2012. The qualitative component of our allowance allocated to commercial loans was $13.9 millionat December 31, 2013(up from $13.8 millionat December 31, 2012) to maintain the allowance balances despite the reduction in the historical loss rate. Groups of homogeneous loans, such as residential real estate and open- and closed-end consumer loans, receive allowance allocations based on loan type. A rolling 12 month (4 quarter) historical loss experience period was applied to residential mortgage and consumer loan portfolios. As with commercial loans that are not considered impaired, the determination of the allowance allocation percentage is based principally on our historical loss experience. These allocations are adjusted for consideration of general economic and business conditions, credit quality and delinquency trends, collateral values, and recent loss experience for these similar pools of loans. The homogeneous loan allowance was $2.8 millionat December 31, 2013compared to $3.0 millionat December 31, 2012. The decrease was related to improvements in delinquencies in both residential mortgage and consumer loan portfolios. As noted above, the formula allowance allocated to commercial loans that are not considered to be impaired is calculated by applying historical loss factors to outstanding loans based on the internal risk rating of such loans. We use a loan rating method based upon an eight point system. Loans rated a 4 or better are considered of acceptable risk. Loans rated a 5 exhibit above-normal risk to the Company and warrant a greater level of attention by management. These loans are subject to on-going review and assessment by our Administrative Loan Committee. Loans rated a 6 or worse are considered substandard, doubtful or loss, exhibit a greater relative risk of loss to the Company based upon the rating and warrant an active workout plan administered by our Special Asset Group, as discussed above. Loans are assigned a loss allocation factor for each loan class based principally on the loss history for each risk rating within each loan category. Commercial real estate loans are stratified and grouped by the type of real estate securing such loans for determining the loan classification category. For 2009 and the first three quarters of 2010, the loss history was based upon the latest 12 month period, as this was considered most representative within the then current economic cycle. However, given the significant improvement in our charge-off history over the 12 month periods in late 2010, we determined that an 18 month (6 quarter) historical period was more appropriate for the fourth quarter 2010 as heavy charge-off months would have rolled off the 12 month period, and would have resulted in a substantially smaller overall allowance balance. Until overall levels of nonperforming loans decline over a sustained period, we believe such a reduction in the allowance balance would be premature. We have continued to use the 18 month historical period in 2011, 2012 and 2013. The historical loss allocation factor used is adjusted for consideration of significant qualitative factors that affect the collectability of the portfolio as of the analysis date. The worse the risk rating assigned to a loan category, the greater the loss allocation factor that is applied. The qualitative factors assessed and used to adjust historical loss experience reflect our assessment of the impact of economic trends, delinquency and other problem loan trends, trends in valuations supporting underlying collateral, changes in loan portfolio concentrations and changes in internal credit administration practices have on probable losses inherent in our loan portfolio. Qualitative adjustments are inherently subjective and there can be no assurance that these adjustments have properly identified probable losses in our loan portfolio. More information regarding the subjectivity involved in determining the estimate of the allowance for loan losses may be found in this Item 7 of the report under the heading "Critical Accounting Policies and Estimates." - 42 - -------------------------------------------------------------------------------- Table of Contents The following table shows the allocation of the allowance for loan losses by portfolio type at the dates indicated. December 31, (Dollars in thousands) 2013 2012 % of Each % of Each Allowance Category to Allowance Category to Amount Total Loans Amount Total Loans Commercial and commercial real estate $ 17,09572 % $ 19,95273 % Residential mortgage 2,368 18 2,544 17 Consumer 1,335 10 1,243 10 Total $ 20,798100 % $ 23,739100 %
The components of the allowance for loan losses were as follows:
December 31, (Dollars in thousands) 2013 2012 Balance of Allowance Balance of Allowance Loans Amount Loans Amount Commercial and commercial real estate: Impaired with allowance recorded
$ 42,434 $ 2,989 $ 45,245 $ 5,338Impaired with no allowance recorded 12,006 --- 23,976 ---
Loss allocation factor on non-impaired loans 691,999 14,106
746,439 17,095 762,659 19,952 Residential mortgage and consumer: Reserves on troubled debt restructurings 14,483 881 14,086 716 Loss allocation factor 281,455 2,822 275,603 3,071 Total
$ 1,042,377 $ 20,798 $ 1,052,348 $ 23,739With the exception of certain TDRs, impaired commercial loans at December 31, 2013were classified as substandard or worse per our internal risk rating system. The $14.5 millionof residential mortgage troubled debt restructurings were associated with programs approved by the U.S. government during 2009 to minimize the number of consumer foreclosures. These loans involved the restructuring of terms on consumer mortgages to allow customers to mitigate foreclosure by meeting a lower loan payment requirement based upon their current cash flow. We have been active at utilizing these programs and working with our customers to reduce the risk of foreclosure. Additional information regarding impaired loans at December 31, 2013and 2012 may be found in Item 8 of this report in Note 3 to the Consolidated Financial Statements. The decrease in the level of the allowance for 2013 was due to decreases in net charge-offs from commercial loans, shrinkage in the overall loan portfolio during 2013, a reduction in the level of impaired loans and nonperforming loans, a reduction in specific reserves on these impaired loans, and improvement in the loan grades, which provides a lower allocation. Our weighted average loan grade improved from 4.38 at December 31, 2010to 4.19 at December 31, 2011, 4.01 at December 31, 2012and 3.88 at December 31, 2013. The decrease of $2.9 millionin reserves on commercial loans was due to a $624,000decrease in the loss allocation factor on non-impaired loans, and a $2.3 milliondecrease in specific reserves on impaired loans. The decrease in the losses incurred during this period, and a general improvement in the credit quality and overall risk ratings of commercial loans were the primary reasons for this decrease.
The general allowance for residential real estate and consumer loans was
- 43 - -------------------------------------------------------------------------------- Table of Contents Of the
$20.8 millionallowance at December 31, 2013, 19% related to specific allocations on impaired loans, 68% related to formula allowance on commercial loans and 13% related to general allocations for homogeneous loans. Of the $23.7 millionallowance at December 31, 2012, 25% related to specific allocations on impaired loans, 62% related to formula allowance on commercial loans and 13% related to general allocations for homogeneous loans. Of the $16.9 milliontotal formula based allowance for loan loss allocations at December 31, 2013, $16.4 millionis from general/environmental allocations with $506,000driven from historical experience. Of the $17.7 milliontotal formula based allowance for loan loss allocations at December 31, 2012, $15.2 millionis from general/environmental allocations with $2.5 milliondriven from historical experience.
The above allocations are not intended to imply limitations on usage of the allowance. The entire allowance is available for any loan losses without regard to loan type.
More information regarding steps to address the elevated levels of substandard, impaired and nonperforming loans may be found in this Item 7 of the report under the heading "Loan Portfolio and Asset Quality" above and in Item 8 of this report in Note 3 to the Consolidated Financial Statements. Although we believe our allowance for loan losses has captured the losses that are probable in our portfolio as of
December 31, 2013, there can be no assurance that all losses have been identified or that the allowance is sufficient. The additional efforts by management to accelerate the identification and disposition of problem assets discussed above, and the impact of the lasting economic slowdown, may result in additional losses in 2014.
Premises and Equipment: Premises and equipment totaled
Deposits and Other Borrowings: Total deposits decreased
$36.5 millionto $1.250 billionat December 31, 2013, as compared to $1.286 billionat December 31, 2012. Non-interest checking account balances increased $5.0 millionin 2013. Interest bearing demand account balances increased $8.7 millionand savings and money market account balances decreased $7.3 millionin 2013. We decreased higher costing certificates of deposits by $42.9 millionin 2013. The increase in balances of checking accounts was caused by normal seasonal inflows from municipalities and some shifting between deposit types. We believe our success in maintaining the balances of personal and business checking and savings accounts was primarily attributable to our focus on quality customer service, the desire of customers to deal with a local bank, the convenience of our branch network and the breadth and depth of our product line. Noninterest bearing demand accounts comprised 28% of total deposits at December 31, 2013compared to 26% of total deposits at December 31, 2012. Because of the generally low rates paid on interest bearing account alternatives, many of our business customers chose to keep their balances in these more liquid noninterest bearing demand account types. Interest bearing demand, money market and savings accounts, comprised 60% of total deposits at December 31, 2013and 2012. Time accounts as a percentage of total deposits were 12% at December 31, 2013and 15% at December 31, 2012. Borrowed funds totaled $131.2 millionat December 31, 2013; including $90.0 millionin Federal Home Loan Bankadvances and $41.2 millionin long-term debt associated with trust preferred securities. During the third quarter of 2013, we prepaid and redeemed $1.65 millionin subordinated debt. Borrowed funds totaled $134.7 millionat December 31, 2012; including $91.8 millionof Federal Home Loan Bankadvances, $41.2 millionin long-term debt associated with trust preferred securities and $1.65 millionin subordinated debt. Borrowed funds decreased by $3.5 millionin 2013 as a result of an annual payment on an amortizing Federal Home Loan Bankadvance in the first quarter of 2013 and the prepayment and redemption of subordinated debt in the third quarter of 2013. During the second quarter of 2013, we modified the terms of six of our existing FHLB advances (totaling $60.0 million) having the effect of extending the weighted average maturity for all outstanding advances from 3.22 years to 4.86 years and reducing the weighted average interest rate from 1.95% to 1.94%. As the modifications did not result in the terms being substantially different (as defined in ASC 470-50-40-10), the transaction was accounted for as a modification, not extinguishment of debt. Accordingly, the prepayment fees that were incurred are amortized as an adjustment of the yield over the remaining life of each advance. The Company has outstanding $40.0 millionaggregate liquidation amount of pooled trust preferred securities ("TRUPs") issued through its wholly-owned subsidiary grantor trusts, Macatawa Statutory Trust I (issued $20.0 millionaggregate liquidation amount with floating interest rate of three-month LIBORplus 3.05%) and Macatawa Statutory Trust II (issued $20.0 millionaggregate liquidation amount with a floating interest rate of three-month LIBORplus 2.75%). In December 2009, the Company exercised its right to defer interest payments on the TRUPs for 20 consecutive quarters or until such earlier time as is determined by further action of the Board of Directors. Through June 30, 2013, the Company had deferred interest payments on the TRUPs for 15 quarters. In the second half of 2013, we discontinued the deferral and resumed regular payment of quarterly interest payments on our trust preferred securities and paid all accrued and unpaid interest that had been previously deferred and became due and payable upon the discontinuance of the deferral. For Macatawa Statutory Trust I, a total of $3.0 million, representing all of the deferred and current interest payment due was distributed on September 30, 2013. For Macatawa Statutory TrustII, a total of $2.7 million, representing all of the deferred and current interest payment due was distributed on October 7, 2013. - 44 - -------------------------------------------------------------------------------- Table of Contents In 2009, the Company received proceeds of $1,650,000from the issuance of unsecured subordinated debt in the form of 11% subordinated notes due in 2017. On August 13, 2013, the Company prepaid and redeemed all of the subordinated notes for $1,650,000plus interest accrued through the prepayment date.
Information regarding our off-balance sheet commitments may be found in Item 8 of this report in Note 15 to the Consolidated Financial Statements.
Total shareholders' equity of
$132.5 millionat December 31, 2013increased $2.0 millionfrom $130.5 millionat December 31, 2012. The increase was primarily a result of net income of $9.5 millionearned in 2013, offset in part by payout of $4.7 millionin cash pursuant to the exchange of Series A and Series B Preferred Stock completed on December 30, 2013and unrealized losses of $2.9 millionon securities available for sale during 2013 due to changes in interest rates, particularly in the second half of 2013. Our regulatory capital ratios (on a consolidated basis) improved in 2013 and ended at the highest year-end levels in the Company's history. The Bank was categorized as "well capitalized" at December 31, 2013. The following table shows our regulatory capital ratios (on a consolidated basis) for the past five years. December 31, 2013 2012 2011 2010 2009 Total capital to risk weighted assets 15.7 % 15.0 % 13.2 % 9.7 % 9.2 % Tier 1 capital to average assets 10.6 10.4 8.3 5.8 6.0 On December 30, 2013, we completed the cancellation and exchange (the "Exchange") of each share of issued and outstanding Series A and Series B Preferred Stock for shares of Company stock and, at the election of the holder, cash. Pursuant to the Exchange, we canceled and exchanged each share of Preferred Stock for shares of Company common stock, no par value, in an amount equal to $1,000, the preferred stocks' liquidation preference amount, divided by $5.25plus, at the election of the holder, an amount of cash equal to $142.00, in the case of Series A Preferred Stock, or $182.00, in the case of Series B Preferred Stock, or a number of shares of Company common stock equal to this cash amount divided by $5.25. The one-time cash payments approximated a 5.0% and 4.5% dividend rate for the Series A and Series B, respectively, after considering previous dividends paid. The Exchange resulted in cash payments of $4.4 millionfor the Series A Preferred Stock and $319,000for Series B Preferred Stock. Under the accounting guidance, the cash payments were recorded as a reduction to common stock, rather than retained earnings, as we had a retained deficit at December 30, 2013. In addition to the cash payment discussed above, the Exchange resulted in the issuance of 5,973,519 shares of Company common stock in exchange for the Series A Preferred Stock and 457,159 shares in exchange for the Series B Preferred Stock. The total of the fair value of the new common shares issued and the $4.7 millioncash payment exceeded the fair value of the securities issuable according to the original conversion terms by $17.6 million, which amount is reflected as a reduction of net income available to common shares in the computation of earnings per share for the year ended December 31, 2013. We expect to assess our ability to resume the payment of dividends on our common stock if and when current levels of cash, earnings and capital are at acceptable levels and the prospects are positive for sustained economic growth and improved performance. The declaration and payment of future dividends to common shareholders will be considered by the Board of Directors in its discretion and will depend on a number of factors, including our financial condition and anticipated profitability. All of the $40.0 millionof trust preferred securities outstanding at December 31, 2013qualified as Tier 1 capital. Our regulatory capital ratios have increased each quarter since March 31, 2010through June 30, 2013due to declines in risk weighted assets, positive earnings for each quarter and the stock offering completed in the second quarter of 2011.
Capital sources include, but are not limited to, additional private and public common stock offerings, preferred stock offerings and subordinated debt.
- 45 - -------------------------------------------------------------------------------- Table of Contents On
July 3, 2013, the FDIC Board of Directors approved the Regulatory CapitalInterim Final Rule, implementing Basel III. This rule redefines Tier 1 capital as two components (Common Equity Tier 1 and Additional Tier 1), creates a new capital ratio (Common Equity Tier 1 Risk-based Capital Ratio) and implements a capital conservation buffer. It also revises the prompt corrective action thresholds and makes changes to risk weights for certain assets and off-balance-sheet exposures. Banks are required to transition into the new rule beginning on January 1, 2015. Based on our capital levels and balance sheet composition at December 31, 2013, we believe implementation of the new rule will have no material impact on our capital needs.
The Bank was categorized as "well capitalized" at
December 31, 2013and 2012. The following table shows the Bank's regulatory capital ratios for the past five years. December 31, 2013 2012 2011 2010 2009
Average equity to average assets 11.2 % 9.2 % 7.8 % 6.7 %
8.0 % Total risk-based capital 15.4 14.5 12.5 9.7 9.1 Tier 1 risk-based capital 14.2 13.3 11.2 8.4 7.8
Tier 1 capital to average assets 10.5 10.3 8.4 7.1
6.6 LIQUIDITY Liquidity of
Macatawa Bank: The liquidity of a financial institution reflects its ability to manage a variety of sources and uses of funds. Our Consolidated Statements of Cash Flows categorize these sources and uses into operating, investing and financing activities. We primarily focus on developing access to a variety of borrowing sources to supplement our deposit gathering activities and provide funds for our investment and loan portfolios. Our sources of liquidity include our borrowing capacity with the FRB's discount window, the Federal Home Loan Bank, federal funds purchased lines of credit and other secured borrowing sources with our correspondent banks, loan payments by our borrowers, maturity and sales of our securities available for sale, growth of our deposits, federal funds sold and other short-term investments, and the various capital resources discussed above. Liquidity management involves the ability to meet the cash flow requirements of our customers. Our customers may be either borrowers with credit needs or depositors wanting to withdraw funds. Our liquidity management involves periodic monitoring of our assets considered to be liquid and illiquid, and our funding sources considered to be core and non-core and short-term (less than 12 months) and long-term. We have established parameters that monitor, among other items, our level of liquid assets to short-term liabilities, our level of non-core funding reliance and our level of available borrowing capacity. We maintain a diversified wholesale funding structure and actively manage our maturing wholesale sources to reduce the risk to liquidity shortages. We have also developed a contingency funding plan to stress test our liquidity requirements arising from certain events that may trigger liquidity shortages, such as rapid loan growth in excess of normal growth levels or the loss of deposits and other funding sources under extreme circumstances. We have actively pursued initiatives to further strengthen our liquidity position. The Bank reduced its reliance on non-core funding sources, including brokered deposits, and focused on achieving a non-core funding dependency ratio below its peer group average. We have had no brokered deposits on our balance sheet since December 2011. We also reduced other borrowed funds by $56.8 millionin 2012 and by $1.8 millionin 2013. We continue to maintain significant on-balance sheet liquidity. At December 31, 2013, the Bank held $118.2 millionof federal funds sold and other short-term investments and $25.0 millionin time deposits with other financial institutions with maturities of less than 18 months. In addition, the Bank's available borrowing capacity from correspondent banks has been improved and was approximately $186.5 millionas of December 31, 2013.
In the normal course of business, we enter into certain contractual obligations, including obligations which are considered in our overall liquidity management.
- 46 - -------------------------------------------------------------------------------- Table of Contents The table below summarizes our significant contractual obligations at
December 31, 2013. Less than More than (Dollars in thousands) 1 year 1-3 years 3-5 years 5 years Long term debt $ --- $ --- $ --- $ 41,238Time deposit maturities 84,591 55,998 7,636 --- Other borrowed funds 1,884 23,934 54,173 10,000 Total $ 86,475 $ 79,932 $ 61,809 $ 51,238In addition to normal loan funding, we also maintain liquidity to meet customer financing needs through unused lines of credit, unfunded loan commitments and standby letters of credit. The level and fluctuation of these commitments is also considered in our overall liquidity management. At December 31, 2013, we had a total of $313.2 millionin unused lines of credit, $87.5 millionin unfunded loan commitments and $10.8 millionin standby letters of credit. Liquidity of Holding Company: The primary sources of liquidity for the Company are dividends from the Bank, existing cash resources and the various capital resources discussed above. Banking regulations and the laws of the State of Michiganin which our Bank is chartered limit the amount of dividends the Bank may declare and pay to the Company in any calendar year. Under the state law limitations, the Bank is restricted from paying dividends to the Company in excess of retained earnings. From 2010 through the third quarter of 2013, the Company had not received dividends from the Bank, and the Company has suspended payment of dividends on its common and preferred stock. With the release of the Bank's MOU by its regulators effective April 12, 2013, the Bank is no longer required to obtain prior regulatory approval to pay dividends to the Company. In December 2013, the Bank paid a dividend of $5.0 millionto the Company in anticipation of the preferred stock exchange transaction. The Company paid a total of $4.8 million, including transaction expenses, in cash as a result of the preferred stock exchange transaction. At December 31, 2013, the Bank had a retained earnings balance of approximately $9.5 million. The Company continued to suspend payments of cash dividends on its preferred stock during 2010, 2011, 2012 and through the third quarter of 2013. During the period that the Company does not declare and pay cash dividends on its preferred stock, it may not declare and pay cash dividends on its common stock. With the completion of the preferred stock exchange transaction, this restriction on payment of cash dividends on Company common stock has been removed. The Company has the right to defer interest payments for 20 consecutive quarters on its trust preferred securities if necessary for liquidity purposes. During any deferral period, the Company may not declare or pay any dividends on its common stock or preferred stock or make any payment on any outstanding debt obligations that rank equally with or junior to the trust preferred securities. The Company's cash balance at December 31, 2013was $1.9 million. In accordance with the Company's tax allocation agreement with the Bank, in the first quarter of 2014, the Bank will pay the Company approximately $1.3 millionto settle the intercompany tax positions for the 2013 tax year. The Company believes it has sufficient liquidity to meet its cash flow requirements.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES:
To prepare financial statements in conformity with accounting principles generally accepted in
the United States of America, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and future results could differ. The allowance for loan losses, other real estate owned valuation, loss contingencies and income taxes are deemed critical due to the required level of management judgment and the use of estimates, making them particularly subject to change. Our methodology for determining the allowance for loan losses and the related provision for loan losses is described above in the "Allowance for Loan Losses" discussion. This area of accounting requires significant judgment due to the number of factors which can influence the collectability of a loan. Unanticipated changes in these factors could significantly change the level of the allowance for loan losses and the related provision for loan losses. Although, based upon our internal analysis, and in our judgment, we believe that we have provided an adequate allowance for loan losses, there can be no assurance that our analysis has properly identified all of the probable losses in our loan portfolio. As a result, we could record future provisions for loan losses that may be significantly different than the levels that we recorded in 2013. - 47 - -------------------------------------------------------------------------------- Table of Contents Assets acquired through or instead of foreclosure, primarily other real estate owned, are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis. New real estate appraisals are generally obtained at the time of foreclosure and are used to establish fair value. If fair value declines, a valuation allowance is recorded through expense. Estimating the initial and ongoing fair value of these properties involves a number of factors and judgments including holding time, costs to complete, holding costs, discount rate, absorption and other factors. Loss contingencies are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. This, too, is an accounting area that involves significant judgment. Although, based upon our judgment, internal analysis, and consultations with legal counsel we believe that we have properly accounted for loss contingencies, future changes in the status of such contingencies could result in a significant change in the level of contingent liabilities and a related impact to operating earnings. Our accounting for income taxes involves the valuation of deferred tax assets and liabilities primarily associated with differences in the timing of the recognition of revenues and expenses for financial reporting and tax purposes. At December 31, 2013, we had gross deferred tax assets of $18.5 millionand gross deferred tax liabilities of $2.3 millionresulting in a net deferred tax asset of $16.2 million. Accounting standards require that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a "more likely than not" standard. From mid 2009 through the end of 2012, we had maintained a full valuation allowance on our net deferred tax asset. At December 31, 2012, we considered all reasonably available positive and negative evidence and determined that with completing our eleventh consecutive profitable quarter, continued significant improvement in asset quality measures for the third straight year, the termination of our previous regulatory orders and our moving to a cumulative income position in the most recent three year period, that it was "more likely than not" that we will be able to realize our deferred tax assets and, as such, the full $18.9 millionvaluation allowance was reversed as of December 31, 2012. With the positive results in 2013, we concluded at December 31, 2013that no valuation allowance on our net deferred tax asset was required. Changes in tax laws, changes in tax rates, changes in ownership and our future level of earnings can impact the ultimate realization of our net deferred tax asset. - 48 -
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