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FNBH BANCORP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.

August 14, 2014

The Corporation, a Michigan business corporation, is a one bank holding company which owns all of the outstanding capital stock of First National Bank in Howell (the Bank) and all of the outstanding stock of HB Realty Co., Inc. The following is a discussion of the Corporation's regulatory condition, results of operations, for the three and six month periods ended June 30, 2014 and 2013, and the Corporation's financial condition, focusing on its liquidity and capital resources. The level of regulatory enforcement action taken against the Bank by the Office of the Comptroller of the Currency (OCC) escalated from a formal agreement entered in October 2008 to the issuance of a Consent Order in September 2009, which was subsequently revised and reissued as a new Consent Order in October 2013 (the "Consent Order"). Pursuant to the new Consent Order, the Bank continues to be required to maintain total capital equal to 11% of risk weighted assets and Tier 1 capital equal to at least 8.5% of adjusted total assets. Since December 31, 2013, the Bank has satisfied these required minimum ratios due to receipt of capital infusions from the Corporation of $15.4 million in December 2013 and $550,000 in March 2014, using proceeds from the Corporation's completion of a private placement transaction in December 2013 and a rights offering completed in March 2014. However, despite exceeding minimum regulatory capital ratios for a well-capitalized institution at June 30, 2014, the Bank is presently categorized as "adequately capitalized" for purposes of the OCC's Prompt Corrective ("PCA") enforcement powers because the Bank remains subject to the new Consent Order. As a result of this classification, for purposes of PCA, the Bank is subject to a number of additional restrictions. These include, among other things, (1) restrictions on the payment of dividends, capital distributions and management fees, (2) the requirement that the Bank obtain prior written approval of the OCC before paying any bonus or increase in the compensation of any senior executive officer of the Bank, (3) prohibitions on the acceptance of employee benefit plan deposits, (4) restrictions on interest rates paid on deposits, and (5) restrictions on the acceptance, renewal, or roll-over of brokered deposits. The Bank's capital category is determined solely for purposes of applying PCA; the capital category may not constitute an accurate representation of the Bank's overall financial condition or prospects. The Consent Order imposes many other requirements on the Bank in addition to the minimum capital ratios. The Bank must comply with these requirements in order to avoid further regulatory enforcement action. As long as the Bank is subject to the Consent Order, the financial performance of the Corporation will be adversely impacted by elevated FDIC insurance premiums paid by the Bank and ongoing costs incurred to correct deficiencies underlying the requirements

of the Consent Order. The Corporation also remains challenged to a great extent by the economic conditions in Livingston County and the surrounding area. The Corporation has in general experienced a slowing or stagnant economy in Michigan since 2001. In particular, Michigan's current unemployment rate of approximately 7.5%, although improved from highs near 14% during 2009, remains among the worst for all states. Unlike larger banks that are more geographically diversified, we provide banking services to customers primarily in Livingston County. Our loan portfolio, the ability of the borrowers to repay these loans, and the value of the collateral securing these loans is impacted by local economic conditions. The dramatic declines in the housing market in recent years, with falling home prices and elevated levels of foreclosures and unemployment, resulted in and may continue to cause significant write-downs of asset values by us and other financial institutions if borrowers continue to struggle. The continued economic difficulties in Michigan have had and may continue to have many adverse consequences as described below in "Loans". Although improved from 34% at March 31, 2014, our ratio of nonperforming assets to capital plus allowance for loan losses continues to be elevated and approximated 28% at June 30, 2014. As described elsewhere in this Form 10-Q, we have established our allowance for loan losses at a level we currently believe, based on the data available to us, is sufficient to absorb expected losses in our loan portfolio. However, this process involves a very significant degree of judgment, is based on numerous different assumptions that are difficult to make and, by its nature, and is inherently uncertain. Moreover, the performance of our existing loan portfolio is, in many respects, dependent on external factors such as our borrowers' ability to repay their loan obligations and the value of collateral securing those obligations, which in turn depend on macro and micro economic conditions including the pace of economic recovery in southeast Michigan. If our loan portfolio performs worse than we currently expect, we may not have sufficient capital to absorb all of the losses and still maintain the minimum capital levels required under the Consent Order. 22 As fully described in Note 2, "Regulatory Matters and Recovery Initiatives", of the consolidated financial statements included in the 2013 Annual Report within the Corporation's Form 10-K filing, management has undertaken various initiatives to address the current challenges facing the Bank. The successful implementation of the various actions being undertaken by management will be difficult in the current economic environment. Even if such actions are successfully implemented, such strategy or results may not be sufficient to sustain the Bank's capital levels at satisfactory levels, return the Bank to profitability, or otherwise avoid further regulatory enforcement action.



In response to these regulatory actions, difficult market conditions and significant losses incurred from 2007 through 2011, we have taken steps or initiated action plans to restore and maintain our capital levels, improve our operations and return to profitability, with the primary objective of fully satisfying all requirements of the Consent Order in as timely a manner as possible.

There can be no assurance that management's efforts will improve the Bank's financial condition. Further deterioration of the Bank's capital position is possible. The current economic environment in southeast Michigan and local real estate market conditions will continue to impose challenges on the Bank. It is against this backdrop that we discuss our financial condition and results of operations for the three and six months ended June 30, 2014 compared to the same periods in 2013. Earnings Three months ended June 30, Six months ended June 30, 2014 2013 2014 2013 (dollars in thousands, except per share amounts) Net income $ 106 $



215 $ 155$ 2,705 Basic and diluted net income per share $ 0.00$ 0.47$ 0.01$ 5.91

Net income for the three months ended June 30, 2014 decreased $109,000 compared to the same period last year. In each of the second quarters of 2014 and 2013, the Bank recorded no provision for loan losses. Net interest income increased by $150,000 from the second quarter of 2013 to the second quarter of 2014. This favorable variance was offset by a decrease in noninterest income of $55,000 and an increase in noninterest expense of $350,000. Net income for the six months ended June 30, 2014 decreased by $2.6 million compared to the same period last year primarily due to $2.3 million of negative provision expense recognized in the first quarter of 2013. For the six months ended June 30, 2014, net interest income decreased by $76,000, noninterest income decreased by $182,000, and noninterest expense increased by $141,000. Net Interest Income Three months ended June 30, Six months ended June 30, 2014 2013 2014 2013 (dollars in



thousands)

Interest and dividend income $ 2,670$ 2,574

$ 5,163$ 5,320 Interest expense 177 231 385 466 Net Interest Income $ 2,493$ 2,343$ 4,778$ 4,854 23 Interest Yields and Costs The following shows the daily average balances for major categories of interest earning assets and interest bearing liabilities, interest earned (on a taxable equivalent basis) or paid, and the effective rate or yield as follows: Three months ended June 30, 2014 2013 Average Yield/ Average Yield/ Balance Interest Rate Balance Interest Rate (in thousands) Assets: Interest earning assets: Short term investments $ 198$ 0.1 0.23 % $

197 $ 0.1 0.23 % Securities: Taxable 112,196 451.2 1.61 % 81,243 262.3 1.29 % Tax-exempt (1) 1,023 15.3 5.99 % 1,033 15.4 5.97 % Commercial loans (2)(3) 134,293 1,973.4 5.81 % 142,777 2,022.2 5.60 % Consumer loans (2)(3) 15,903 176.0 4.44 % 15,002 176.3 4.71 % Mortgage loans (2)(3) 11,598 91.6 3.16 % 12,891 108.5 3.37 % Total earning assets and total interest income 275,211 $ 2,707.6 3.90 % 253,143 $ 2,584.8 4.05 % Cash and due from banks 34,519



39,032

All other assets 10,649



11,896

Allowance for loan losses (9,462 )

(9,620 ) Total assets $ 310,917$ 294,451 Liabilities and Shareholders' Equity: Interest bearing deposits: NOW $ 30,745$ 1.9 0.02 % $ 30,927$ 1.6 0.02 % Savings 46,862 2.3 0.02 % 43,069 2.2 0.02 % MMDA 40,758 24.4 0.24 % 39,115 40.4 0.41 % Time deposits 75,237 148.2 0.79 % 81,165 186.8 0.92 % Total interest bearing liabilities and total interest expense 193,602 176.8 0.37 % 194,276 231.0 0.48 % Noninterest bearing deposits 87,593 87,483 All other liabilities 1,533 2,487 Shareholders' equity 28,189 10,205 Total liabilities and shareholders' equity $ 310,917$ 294,451 Interest spread 3.53 % 3.57 % Net interest income-FTE $ 2,530.8$ 2,353.8 Net interest margin 3.65 % 3.68 %



(1) Average yields in the above table have been adjusted to a tax-equivalent

basis using a 34% tax rate and exclude the effect of any unrealized market

value adjustments included in other comprehensive income recorded under ASC

Topic 320, Investments - Debt and Equity Securities.

(2) For purposes of the computation above, average non-accruing loans of $9.3

million and $10.2 million for the three months ended June 30, 2014 and 2013

are included in the average daily balance.

(3) Interest on loans includes origination fees totaling $28,000 and $36,000 for

the three months ended June 30, 2014 and 2013. 24 Six months ended June 30, 2014 2013 Average Yield/ Average Yield/ Balance Interest Rate Balance Interest Rate (in thousands) Assets: Interest earning assets: Short term investments $ 198$ 0.2 0.23 % $

197 $ 0.2 0.23 % Securities: Taxable 102,093 831.4 1.63 % 82,599 531.9 1.28 % Tax-exempt (1) 1,028 30.8 5.99 % 1,033 30.9 5.97 % Commercial loans (2)(3) 135,068 3,792.6 5.58 % 145,707 4,206.9 5.74 % Consumer loans (2)(3) 15,984 359.1 4.53 % 14,722 351.4 4.81 % Mortgage loans (2)(3) 11,718 196.2 3.35 % 13,102 220.6 3.37 % Total earning assets and total interest income 266,089 $ 5,210.3 3.90 % 257,360 $ 5,341.9 4.13 % Cash and due from banks 45,624



35,998

All other assets 9,926



12,314

Allowance for loan losses (9,351 ) (10,663 ) Total assets $ 312,288$ 295,009 Liabilities and Shareholders' Equity: Interest bearing deposits: NOW $ 30,717$ 4.0 0.03 % $ 30,749$ 3.3 0.02 % Savings 45,972 4.6 0.02 % 42,196 4.3 0.02 % MMDA 40,787 62.9 0.31 % 39,826 84.2 0.43 % Time deposits 76,637 313.1 0.82 % 81,506 374.1 0.93 % Total interest bearing liabilities and total interest expense 194,113 384.6 0.40 % 194,277 465.9 0.48 % Noninterest bearing deposits 89,390 89,487 All other liabilities 1,716 2,282 Shareholders' equity 27,069 8,963 Total liabilities and shareholders' equity $ 312,288$ 295,009 Interest spread 3.50 % 3.65 % Net interest income-FTE $ 4,825.7$ 4,876.0 Net interest margin 3.61 % 3.77 %



(1) Average yields in the above table have been adjusted to a tax-equivalent

basis using a 34% tax rate and exclude the effect of any unrealized market

value adjustments included in other comprehensive income recorded under ASC

Topic 320, Investments - Debt and Equity Securities.

(2) For purposes of the computation above, average non-accruing loans of $10.4

million and $11.0 million for the six months ended June 30, 2014 and 2013 are

included in the average daily balance.

(3) Interest on loans includes origination fees totaling $52,000 and $58,000 for

the six months ended June 30, 2014 and 2013.



Interest Earning Asset/Interest Income

On a tax equivalent basis, interest income increased $123,000 (4.8%) in the second quarter of 2014 compared to the second quarter of 2013. The increase was due to an increase in average earning assets of $22.1 million (8.7%) partially offset by a decrease in the yield on average earning assets of 15 basis points. The average balance of securities increased $30.9 million (37.6%) in the second quarter of 2014 compared to the same period in 2013. The increase was due to the investment security purchases made during the first and second quarters of 2014, as explained below. The yield on average security balances increased 30 basis points in the second quarter of 2014 compared to the second quarter of 2013 due to higher yields on new securities purchased in 2014. Loan average balances decreased $8.9 million (5.2%) in the second quarter of 2014 compared to the same period last year and average loan yield increased 13 basis points. The largest decline in terms of average balances was commercial loans, the majority of our portfolio, which decreased $8.5 million (5.9%) in the second quarter of 2014 compared to the second quarter of 2013. Commercial loan yield increased 21 basis points compared to the same prior year period primarily due to the timing and amount of interest income recognized on payoffs of existing and former nonaccrual loans. Commercial loans have continued to decrease due to receipt of scheduled payments, payoffs received from borrowers, payoffs from borrowers' refinancing with other financial institutions and limited new loan originations. The renewal of maturing loans and origination of new loans in the current lower rate environment will continue to exert downward pressure on our average loan portfolio yields. For the first six months of the year, on a tax equivalent basis, interest income decreased $132,000 (2.5%) compared to the same period of 2013. The decrease was due to a decrease in the yield on average earning assets of 24 basis points partially offset by an increase in average earning assets of $8.7 million (3.4%). The average balance of securities increased $19.5 million (23.3%) in the first six months of 2014 compared to 2013. The increase was due to $60 million of investment security purchases made in 2014 funded by excess on-balance sheet liquidity resulting from the December 2013 private placement transaction and run-off in the existing investment and loan portfolios. The yield on average security balances increased 32 basis points for the first six months of 2014 compared to 2013 due to higher yields on the 2014 security purchases. 25 Loan average balances decreased $10.8 million (6.2%) in the first six months of 2014 compared to 2013. The largest decline in terms of average balances was commercial loans, the majority of our portfolio, which decreased $10.6 million (7.3%) compared to 2013. Commercial loan yield decreased 16 basis points compared to the same prior year period primarily due to a decrease in interest income recognized on payoffs of nonaccrual loans. Commercial loans have continued to decrease due to receipt of scheduled payments, payoffs received from borrowers, payoffs from borrowers' refinancing with other financial institutions and limited new loan originations. The renewal of maturing loans and origination of new loans in the current lower rate environment will continue to exert downward pressure on our average loan portfolio yields.



Interest Bearing Liabilities/Interest Expense

Interest expense on deposits for the second quarter of 2014 decreased $54,000 (23.5%) compared to the second quarter of 2013. This was the result of lower interest rates paid on deposits of 11 basis points combined with lower average balances of $674,000 (0.3%). Interest expense on deposits for the first six months of 2014 decreased $81,000 (17.5%) compared to 2013. This was a result of lower interest rates paid on deposits of 8 basis points combined with lower average deposit balances of $164,000 (0.1%). Specifically, the effective rate paid on average MMDA deposits decreased 12 basis points to curb deposit growth given the Bank's current excess liquidity position and $1.1 million of brokered deposits which bore interest at 3.50% were repaid in February 2014.



Liquidity and Funds Management

Liquidity is managed to ensure stable, reliable and cost-effective sources of funds to satisfy demand for credit, deposit withdrawals and investment opportunities. Liquidity risk is the risk of the Corporation being unable to meet current and future financial obligations in a timely manner. To manage liquidity risk the Corporation relies primarily on a large, stable core deposit base, excess on-balance sheet cash positions and a readily marketable available for sale investment portfolio. Additionally, the Corporation has access to certain wholesale funding sources (as discussed below) to manage unexpected liquidity needs. The Corporation identifies, measures and monitors its liquidity profile. The profile is evaluated daily, weekly and monthly by analyzing the composition of all funding sources, reviewing projected liquidity commitments by future month and identifying sources and uses of funds. A contingency funding plan is also prepared that details the potential erosion of funds in the event of a systemic financial market crisis or different levels of institution-specific stress. In addition, the overall management of the Corporation's liquidity position is integrated into retail deposit pricing policies to ensure a stable core deposit base. Asset liquidity for financial institutions typically consists of cash and cash equivalents, certificates of deposits and investment securities available for sale. These categories totaled $157.5 million at June 30, 2014 or about 49.3% of total assets. This compares to $145.7 million or about 46.7% of total assets at December 31, 2013. Liquidity is important for financial institutions because of their need to meet loan funding commitments and depositor withdrawal requests. Liquidity can vary significantly on a daily basis based on customer activity. The core deposit base is the primary source of the Corporation's liquidity. Management monitors rates at other financial institutions in the area to ascertain that its rates are competitive in the market. Management also attempts to offer a wide variety of products to meet the needs of its customers. The make-up of the Bank's "Large Certificates", which are generally considered to be more volatile and sensitive to changes in rates, consists principally of local depositors known to the Bank. The Bank had Large Certificates totaling approximately $27.6 million at June 30, 2014 and $29.1 million at December 31, 2013. The Bank paid off its (non-core) $1.1 million brokered deposit in February 2014. Due to the Bank's classification as "adequately capitalized" for PCA purposes, it may not renew or issue additional brokered deposits without prior approval of the Federal Deposit Insurance Corporation ("FDIC"). See the "Capital" section of this Management's Discussion and Analysis for further details.



Of the Corporation's available liquidity at June 30, 2014 noted above, investment securities with a fair value of approximately $55.7 million were pledged primarily for borrowing availability on a line of credit from the Federal Home Loan Bank of Indianapolis and to secure public deposits, or for other purposes as required or permitted by law.

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

The Corporation's liquidity could be adversely affected by both direct and indirect circumstances. An example of a direct event would be restrictions imposed by regulators due to factors such as deterioration in asset quality, a large charge to earnings, a decline in profitability or other financial measures. Examples of indirect events unrelated to the Corporation that could have an effect on the Corporation's access to liquidity would be terrorism or war, natural disasters, political events, or the default or bankruptcy of a major corporation, mutual fund or hedge fund. Similarly, market speculation or rumors about the Corporation or the banking industry in general may adversely affect the cost and availability of normal funding sources. The Corporation maintains a liquidity contingency plan that outlines the process for addressing a potential liquidity crisis. The plan provides for an evaluation of funding sources under various market conditions. It also assigns specific roles and responsibilities for effectively managing liquidity though a problem period. It is Bank management's intention to handle unexpected liquidity needs through its cash and cash equivalents, FHLBI borrowings, or Federal Reserve discount borrowings. At June 30, 2014, the Bank had a $24.9 million line of credit available at the FHLBI for which the Bank has pledged investment securities and certain commercial and consumer loans secured by residential real estate as collateral. The Bank also had a $3.7 million line of credit available at the Federal Reserve for which the Bank has pledged certain commercial loans as collateral. At June 30, 2014, the Bank had no borrowings outstanding against these lines of credit. In addition, during the quarter ended June 30, 2014, the Bank had no short-term borrowings on these lines of credit for liquidity needs or other purposes. Although the Bank has established these lines of credit, because of its regulatory status, any borrowing requests are subject to review (i.e., for purpose and repayment ability) and approval by the FHLBI and Federal Reserve, respectively. Consequently, full borrowing availability under these existing lines may be restricted at the respective lender's discretion and terms may be limited or restricted. However, in the event the Bank would need additional funding and be unable to access either line of credit facility, management could act to remove the pledge of investment securities presently securing a portion of the FHLBI line of credit, thereby allowing such securities to be liquidated to provide further liquidity. If necessary, the Bank could also satisfy unexpected liquidity needs through liquidation of unpledged securities.



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