U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q
[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2012

[   ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from          to            .

Commission file number:  000-14209
 
FIRSTBANK CORPORATION
(Exact name of registrant as specified in its charter)
 
Michigan   38-2633910
(State of Incorporation)
 
(I.R.S. Employer Identification No.)
     
311 Woodworth Avenue
   
Alma, Michigan
  48801
(Address of principal executive offices)   (Zip Code)
 
Registrant’s telephone number, including area code:  (989) 463-3131

Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.     Yes   X       No___

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes   X       No___

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ___  Accelerated filer ___ Non-accelerated filer ­­­___ Smaller reporting company _X__
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes            No X  

Common stock outstanding at July 31, 2012: 7,946,081 shares.
 
 
 

 
 
INDEX      
       
PART I.
FINANCIAL INFORMATION
   
       
Item 1.
Financial Statements (UNAUDITED)
Page 3
       
Item 2.
Management's Discussion and Analysis of Financial Condition  and Results of Operations
Page 23
       
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
Page 29
       
Item 4.
Controls and Procedures
 
Page 29
       
       
PART II.
OTHER INFORMATION
   
       
Item 5.
Other Information
 
Page 30
       
Item 6.
Exhibits
 
Page 30
       
       
SIGNATURES
   
Page 31
 
 
2

 
 
FIRSTBANK CORPORATION
              CONSOLIDATED BALANCE SHEETS
           AS OF JUNE 30, 2012 AND DECEMBER 31, 2011
(Dollars in thousands)
UNAUDITED  
                                                                                                                                                                                
   
June 30,
2012
   
December 31,
2011
 
ASSETS
           
Cash and due from banks
  $ 29,340     $ 40,151  
Short term investments
    61,832       35,665  
Total Cash and cash equivalents
    91,172       75,816  
                 
FDIC insured bank time certificates of deposit
    2,927       4,432  
Trading account securities
    7       2  
Securities available for sale
    326,673       342,184  
Federal Home Loan Bank stock
    7,266       7,266  
Loans held for sale
    3,857       349  
Loans, net of allowance for loan losses of $21,522 at June 30, 2012 and $21,019 at December 31, 2011
    966,508       962,890  
Premises and equipment, net
    24,978       25,087  
Goodwill
    35,513       35,513  
Core deposit and other intangibles
    1,177       1,448  
Other real estate owned
    3,741       5,251  
Accrued interest receivable and other assets
    21,919       25,061  
                 
TOTAL ASSETS
  $ 1,485,738     $ 1,485,299  
                 
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
LIABILITIES
               
Deposits:
               
Non-interest bearing accounts
  $ 217,824     $ 214,904  
Interest bearing accounts:
               
Demand
    330,582       340,942  
Savings
    258,607       241,603  
Time
    404,833       423,093  
Total Deposits
    1,211,846       1,220,542  
                 
Securities sold under agreements to repurchase and overnight borrowings
    45,746       46,784  
Federal Home Loan Bank advances
    24,334       19,457  
Subordinated Debentures
    36,084       36,084  
Accrued interest and other liabilities
    22,585       7,055  
Total Liabilities
    1,340,595       1,329,922  
                 
                 
SHAREHOLDERS’ EQUITY
               
Preferred stock; no par value, 300,000 shares authorized, 17,000 issued
    16,901       32,792  
Common stock; 20,000,000 shares authorized, 7,945,647 shares issued and outstanding ( 7,892,486 at December 31, 2011 )
    117,087       115,734  
Retained earnings
    7,397       3,955  
Accumulated other comprehensive income
    3,758       2,896  
Total Shareholders’ Equity
    145,143       155,377  
                 
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
  $ 1,485,738     $ 1,485,299  

See notes to consolidated financial statements.
 
 
3

 
 
FIRSTBANK CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
JUNE 30, 2012 AND 2011
(Dollars in thousands except per share data)
UNAUDITED
                                                                                           
    Three Months Ended  June 30,  
    2012      2011  
Interest Income:
           
Interest and fees on loans
  $ 14,493     $ 15,571  
Securities
               
Taxable
    1,183       1,319  
Exempt from Federal Income Tax
    290       280  
Short term investments
    54       45  
Total Interest Income
    16,020       17,215  
Interest Expense:
               
Deposits
    1,718       2,945  
FHLB advances and other borrowing
    191       227  
Subordinated Debt
    272       302  
Total Interest Expense
    2,181       3,474  
Net Interest Income
    13,839       13,741  
Provision for loan losses
    2,494       4,256  
Net Interest Income after provision for loan losses
    11,345       9,485  
Non-interest Income:
               
Service charges on deposit accounts
    1,060       1,182  
Gain on sale of mortgage loans
    1,460       413  
Mortgage servicing, net of amortization
    15       76  
Gain/(loss) on trading account securities
    5       2  
Gain/(loss) on securities
    27       (2 )
Other
    462       340  
Total Non-interest Income
    3,029       2,011  
Non-interest Expense:
               
Salaries and employee benefits
    5,468       5,170  
Occupancy and equipment
    1,284       1,284  
FDIC insurance premium
    325       499  
Amortization of intangibles
    126       185  
Outside professional services
    300       318  
Advertising and promotions
    355       380  
Other real estate owned costs
    380       797  
Other
    2,794       2,177  
Total Non-interest Expense
    11,032       10,810  
                 
Income before federal income taxes
    3,342       686  
Federal income taxes
    938       58  
NET INCOME
  $ 2,404     $ 628  
                 
Preferred stock dividends and accretion of discount on preferred stock
    420       420  
NET INCOME AVAILABLE TO COMMON SHAREHOLDERS
  $ 1,984     $ 208  
                 
COMPREHENSIVE INCOME
               
Net Income
  $ 2,404     $ 628  
Change in unrealized gain on securities, net of tax and reclassification effects
    475       1,700  
TOTAL COMPREHENSIVE INCOME
  $ 2,879     $ 2,328  
                 
Basic Earnings Per Share
  $ 0.25     $ 0.03  
Diluted Earnings Per Share
  $ 0.25     $ 0.03  
Dividends Per Share
  $ 0.01     $ 0.01  

See notes to consolidated financial statements.
 
 
4

 
 
FIRSTBANK CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
JUNE 30, 2012 AND 2011
(Dollars in thousands except per share data)
UNAUDITED
                             
    Six Months Ended  June 30,  
    2012      2011  
Interest Income:
           
Interest and fees on loans
  $ 29,061     $ 31,217  
Securities
               
Taxable
    2,404       2,330  
Exempt from Federal Income Tax
    573       573  
Short term investments
    108       84  
Total Interest Income
    32,146       34,204  
Interest Expense:
               
Deposits
    3,610       5,994  
FHLB advances and other borrowing
    382       508  
Subordinated Debt
    548       669  
Total Interest Expense
    4,540       7,171  
Net Interest Income
    27,606       27,033  
Provision for loan losses
    4,988       7,267  
Net Interest Income after provision for loan losses
    22,618       19,766  
Non-interest Income:
               
Service charges on deposit accounts
    2,118       2,274  
Gain on sale of mortgage loans
    3,155       981  
Mortgage servicing, net of amortization
    (79 )     104  
Gain/(loss) on trading account securities
    6       8  
Gain/(loss) on securities
    40       (10 )
Other
    1,003       699  
Total Non-interest Income
    6,243       4,056  
Non-interest Expense:
               
Salaries and employee benefits
    11,138       10,440  
Occupancy and equipment
    2,645       2,708  
FDIC insurance premium
    699       1,042  
Amortization of intangibles
    271       370  
Outside professional services
    603       580  
Advertising and promotions
    719       644  
Other real estate owned costs
    797       1,378  
Other
    5,207       4,410  
Total Non-interest Expense
    22,079       21,572  
                 
Income before federal income taxes
    6,782       2,250  
Federal income taxes
    1,961       407  
NET INCOME
  $ 4,821     $ 1,843  
                 
Preferred stock dividends and accretion of discount on preferred stock
    840       840  
NET INCOME AVAILABLE TO COMMON SHAREHOLDERS
  $ 3,981     $ 1,003  
                 
COMPREHENSIVE INCOME
               
Net Income
  $ 4,821     $ 1,843  
Change in unrealized gain on securities, net of tax and reclassification effects
    862       2,010  
TOTAL COMPREHENSIVE INCOME
  $ 5,683     $ 3,853  
                 
Basic Earnings Per Share
  $ 0.50     $ 0.13  
Diluted Earnings Per Share
  $ 0.50     $ 0.13  
Dividends Per Share
  $ 0.07     $ 0.02  

See notes to consolidated financial statements.
 
 
5

 
 
FIRSTBANK CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
FOR THE PERIODS ENDED DECEMBER 31, 2011 AND JUNE 30, 2012
(In Thousands of Dollars, Except for Share and per Share Data)
 
     
  Common
Stock
     
Preferred
 
     
Retained
Earnings/
 (Accumulated Deficit)
    Accumulated
Other
Comprehensive
Income (Loss)
     Total  
Balances at December 31, 2010
  $ 115,224     $ 32,763     $ 295     $ 146     $ 148,428  
Net income for 2011
                    5,623               5,623  
Cash dividends on common stock - $0.04 per share
                    (313 )             (313 )
Accrued dividends on preferred stock and accretion of discount on preferred stock
            29       (1,679 )             (1,650 )
Amortization of stock warrants
    (29 )             29               0  
Issuance of 11,610 shares of common stock through the dividend reinvestment plan
    62                               62  
Issuance of 34,803 shares of common stock from supplemental shareholder investments
    197                               197  
Issuance of 42,379 shares of common stock
    162                               162  
Stock option and restricted stock expense
    118                               118  
Net change in unrealized gain/(loss) on securities available for sale, net of tax of $1,417
                            2,750       2,750  
Balances at December 31, 2011
  $ 115,734     $ 32,792     $ 3,955     $ 2,896     $ 155,377  
                                         
                                         
Year to date net income June 30, 2012
                    4,821               4,821  
Cash dividends on common stock - $0.07 per share
                    (554 )             (554 )
Accrued dividends on preferred stock and accretion of discount on preferred stock
            15       (840 )             (825 )
Redemption of 16,000 shares of preferred stock
    850       (15,906 )                     (15,056 )
Amortization of stock warrants
    (15 )             15               0  
Issuance of 13,765 shares of common stock through the dividend reinvestment plan
    109                               109  
Issuance of 1,601 shares of common stock from supplemental shareholder investments
    13                               13  
Issuance of 37,795 shares of common stock
    351                               351  
Stock option and restricted stock expense
    45                               45  
Net change in unrealized gain/(loss) on securities available for sale, net of tax of $444
                            862       862  
Balances at June 30, 2012
  $ 117,087     $ 16,901     $ 7,397     $ 3,758     $ 145,143  

See notes to consolidated financial statements.
 
 
6

 
 
FIRSTBANK CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOW
                FOR THE  SIX MONTHS ENDED
               JUNE 30, 2012 AND 2011
                (Dollars in thousands)
                UNAUDITED
 
   
Six months ended June 31,
 
   
2012
   
2011
 
OPERATING ACTIVITIES
           
Net income
  $ 4,821     $ 1,843  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
    4,988       7,267  
Depreciation of premises and equipment
    961       1,064  
Net amortization of security premiums/discounts
    1,913       1,784  
Gain on trading account securities
    (6 )     (8 )
(Gain)/Loss on securities transactions
    (40 )     10  
Amortization and impairment of intangibles
    271       370  
Stock option and stock grant compensation expense
    45       67  
Gain on sale of mortgage loans
    (3,155 )     (981 )
Proceeds from sales of mortgage loans
    96,921       30,104  
Loans originated for sale
    (97,274 )     (28,202 )
Deferred federal income tax expense/(benefit)
    (1,492 )     1,035  
Decrease in accrued interest receivable and other assets
    3,984       1,530  
Increase/(decrease) in accrued interest payable and other liabilities
    15,530       (582 )
NET CASH PROVIDED BY OPERATING ACTIVITIES
    27,467       15,301  
                 
INVESTING ACTIVITIES
               
Proceeds from sale of securities available for sale
    2,745       280  
Proceeds from maturities of CD’s
    1,485       937  
Proceeds from maturities and calls of securities available for sale
    63,841       73,067  
Purchases of securities available for sale
    (51,622 )     (101,970 )
Proceeds from sale of fixed assets
    4       20  
Net (increase)/decrease in portfolio loans
    (9,957 )     14,442  
Proceeds from sale of other real estate owned
    3,068       2,601  
Net purchases of premises and equipment
    (856 )     (1,210 )
NET CASH PROVIDED BY/(USED IN) INVESTING ACTIVITIES
    8,708       (11,833 )
                 
FINANCING ACTIVITIES
               
Net (decrease)/increase in deposits
    (8,696 )     34,537  
(Decrease)/increase in securities sold under agreements to repurchase and other short term borrowings     (1,038     4,976  
Repayment of Federal Home Loan Bank borrowings
    (3,123 )     (19,115 )
Proceeds from Federal Home Loan Bank borrowings
    8,000       0  
Repurchase of preferred stock
    (15,056 )     0  
Cash proceeds from issuance of common stock, net
    473       295  
Cash dividends-preferred stock
    (825 )     (825 )
Cash dividends-common stock
    (554 )     (156 )
NET CASH PROVIDED/(USED IN) BY FINANCING ACTIVITIES
    (20,819 )     19,712  
                 
INCREASE IN CASH AND CASH EQUIVALENTS
    15,356       23,180  
Cash and cash equivalents at beginning of period
    75,816       73,538  
CASH AND CASH EQUIVALENTS AT END OF PERIOD
  $ 91,172     $ 96,718  
                 
Supplemental Disclosure
               
Interest Paid
  $ 4,683     $ 7,405  
Income Taxes Paid
  $ 2,200     $ 975  
Non cash transfers of loans to Other Real Estate Owned
  $ 1,937     $ 3,845  

See notes to consolidated financial statements.
 
 
7

 

FIRSTBANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012
UNAUDITED

NOTE 1- FINANCIAL STATEMENTS

The accompanying unaudited financial information presented is for Firstbank Corporation (“Corporation”) and its wholly owned subsidiaries:  Firstbank - Alma, Firstbank (Mt. Pleasant), Firstbank - West Branch (including its wholly owned subsidiary; 1 st Title, Inc., and its 46% ownership in 1 st Investors Title, LLC, Keystone Community Bank, Firstbank – West Michigan and its wholly owned subsidiary Accord Financial Services, Inc., collectively the “Banks”, FBMI Risk Management Services, Inc., a company that provides insurance coverage to only affiliates of Firstbank Corporation, and Austin Mortgage Company, a company that holds certain performing and non-performing residential mortgage loans originated prior to the acquisition of ICNB Financial Corporation, and beginning in the second quarter of 2009 certain non-performing loans transferred from affiliate banks. All of the subsidiaries listed above are fully owned except 1st Investors Title, LLC, in which we have a 46% minority interest. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six month periods ended June 30, 2012, are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. The balance sheet at December 31, 2011, has been derived from the audited financial statements at that date. For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the year ended December 31, 2011.
 
Effect of Newly Issued but not yet Effective Accounting Standards
In May 2011, the FASB issued ASU 2011.04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (the ASU). The ASU primarily clarifies existing fair value measurement guidance and is intended to align U.S. GAAP and IFRS.  Additionally, the guidance requires several new disclosures.
 
NOTE 2 - INVESTMENTS

The following table presents information about our investment portfolio, showing the gross unrealized gains and losses within each segment of the portfolio. Unrealized gains and losses are included in other comprehensive income. Unrealized losses have been analyzed and determined to be temporary in nature. The unrealized losses are related to changes in the interest rate environment compared with rates at the time the securities were purchased.

 
(Dollars in Thousands)
 
Amortized
Cost
   
Unrealized
  Gains
   
Unrealized
Losses
   
Carrying 
Value
 
June 30, 2012
                       
Securities available for sale
                       
U.S. governmental agency
  $ 117,782     $ 1,347     $ 0     $ 119,129  
States and political subdivisions
    81,060       1,679       (30 )     82,709  
Mortgage backed securities
    65,957       1,735       (1 )     67,691  
Collateralized mortgage obligations
    54,572       933       (18 )     55,487  
Equity and other securities
    1,591       66       0       1,657  
Total securities available for sale
  $ 320,962     $ 5,760     $ (49 )   $ 326,673  
                                 
December 31, 2011
                               
Securities available for sale
                               
U.S. governmental agency
  $ 132,534     $ 1,325     $ (25 )   $ 133,834  
States and political subdivisions
    76,574       1,238       (23 )     77,789  
Mortgage backed securities
    70,059       1,080       (87 )     71,052  
Collateralized mortgage obligations
    57,006       854       (15 )     57,845  
Equity and other securities
    1,606       58       0       1,664  
Total securities available for sale
  $ 337,779     $ 4,555     $ ( 150 )   $ 342,184  
 
 
8

 
 
Securities with unrealized losses at June 30, 2012 and December 31, 2011 not recognized in income are as follows:

(In Thousands of Dollars)
 
Less than 12 Months
   
12 Months or More
   
Total
 
 
Description of Securities
 
Fair
Value
   
Unrealized
  Loss
   
Fair
Value
   
Unrealized
Loss
   
Fair
  Value
   
Unrealized
  Loss
 
June 30, 2012
                                   
US governmental agency
  $ 0     $ 0     $ 0     $ 0     $ 0     $ 0  
States and political subdivisions
    3,902       (25 )     587       (5 )     4,489       (30 )
Mortgage backed securities
    627       (1 )     0       0       627       (1 )
Collateralized mortgage obligations
    2,416       (7 )     3,512       (11 )     5,928       (18 )
Total temporarily impaired
  $ 6,945     $ (33 )   $ 4,099     $ (16 )   $ 11,044     $ (49 )
                                                 
December 31, 2011
                                               
US governmental agencies
  $ 17,974     $ (25 )   $ 0     $ 0     $ 17,974     $ (25 )
States and political subdivisions
    5,987       (23 )     0       0       5,987       (23 )
Mortgage backed securities
    18,091       (87 )     0       0       18,091       (87 )
Collateralized mortgage obligations
    5,703       (11 )     887       ( 4 )     6,590       (15 )
Total temporarily impaired
  $ 47,755     $ ( 146 )   $ 887     $ ( 4 )   $ 48,642     $ ( 150 )

Unrealized losses on securities shown in the previous tables have not been recognized into income because management has the intent and ability to hold these securities for the foreseeable future. The decline in market value is due to changes in interest rates for debt securities and considered normal market fluctuations for equity securities. Management has also reviewed the issuers’ bond ratings, noting they are of high credit quality.

Trading account securities are marked to market with the change in value reported on the income statement. Gains and losses on available for sale securities are recognized if the security is either deemed to be other than temporarily impaired, or the security is sold. The following table shows gross gains and losses on investment securities for the six months ended June 30 of 2012 and 2011.

   
As of June 30,
 
(In Thousands of Dollars)
 
2012
   
2011
 
Trading Account Securities Gains/Losses
  $ 6     $ 8  
                 
Available for Sale Securities
               
Gross realized gains
    40       19  
Gross realized losses
    0       (29 )
Net realized gains (losses)
  $ 40     $ (10 )

The carrying value of securities at June 30, 2012, by stated maturity, is shown below. Actual maturities may differ from stated maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
(In Thousands of Dollars)
 
Carrying
Value
 
Due in one year or less
  $ 29,276  
Due after one year through five years
    152,035  
Due after five years through ten years
    68,406  
Due after ten years
    75,299  
Total debt securities
    325,016  
         
Equity securities
    1,657  
Total securities
  $ 326,673  

At June 30, 2012 and 2011, securities with carrying values approximating $45,746,000 and $46,304,000, respectively, were pledged to secure public trust deposits, securities sold under agreements to repurchase, and for such other purposes as required or permitted by law.

Federal Home Loan Bank stock is carried at cost, which approximates fair value.
 
 
9

 
 
NOTE 3 - LOANS

The following information provides a description of how loan grades are determined for our Commercial and Industrial and Commercial Real Estate Segments. In general, for Commercial and Industrial, and Commercial Real Estate Segments, the probability of loss increases with each rate change from the Grade 1 Excellent down through the Grade 9 Doubtful classes. For Consumer and Residential Mortgage segments, the probability of loss increases as loans move down from current to greater than 60 days past due, nonaccrual.

Grade 1 Excellent – Characteristics of loans in this category include: the loan is generally secured by cash or readily marketable securities; the borrower provides annual audited financials with interim financials reviewed quarterly; the loan has no delinquencies over ten days in the past year; the company’s management is considered to have a high degree of integrity; management of the company has over 15 years of experience; lines of credit have not and are not expected to be utilized; financial statements demonstrate consistently strong profits; and the company has little competition and excellent growth prospects.

Grade 2 Quality – Characteristics of loans in this category include: high net worth borrowers with excellent cash flow and a high degree of liquidity; the borrower generally has annual audited financial statements; there has been one or fewer delinquencies over ten days in the past year; the company’s management is considered to have a high degree of integrity; the company’s management has over ten years of experience; lines of credit have had nominal use over the preceding 12 months; financial statements demonstrate consistent profitability; and the company is in an excellent competitive position.

Grade 3 Good – Loans in this category are very strong, but may lack some of the net worth and/or cash flow characteristics of the previous rating. Characteristics of loans in this category include: annual reviewed financial statements and compiled quarterly financial statements, there has only been one or fewer delinquencies over 15 days in the past year, the company’s management has solid integrity, the company’s management is capable and has over five years of experience, lines of credit have regular usage with no balance in the last 60 days, financial statements demonstrate consistent but nominal profits, and the company has good a solid market share.

Grade 4 Acceptable – Characteristics of loans in this category include: annual compiled financial statements with quarterly information available or CPA prepared tax returns, there are only two or fewer delinquencies over 15 days of which only one is over 30 days in the past year, the company’s management has average business experience of over three years, lines of credit have regular use but have no current balance or a significant reduction in balance in the last 30 days, the company has been profitable in two of the preceding three years, and the company is competitive in its market and is maintaining its market share.

Loans graded as one through four are considered as Pass loans and are shown as one class of loans in our credit quality table.

Grade 5 Watch - This rating is used for loans which have shown some sign of weakness, but have not degraded to the point of requiring an impairment review. Characteristics of loans in this rating include: annual management prepared financial statements; delinquencies not exceeding three times over 30 days or one time over 60 days in the past year; weakening financial statements but profitable in two of the last three years; and a declining market share in a competitive market. These loans merit monitoring by management to assure that if circumstances deteriorate further actions are taken to protect the bank’s position.

Grade 6 Special Mention - This rating is used for loans which are included on a watch list and have degraded to a point where additional supervision is required; however, the bank remains confident in the full collection of all principal and interest. These loans are reviewed for impairment on a quarterly basis. Characteristics of loans in this rating may include: repeat delinquency; longer term negative trends in financial results; continuing deterioration of cash flows; concerns regarding the liquidity of guarantors; and other negative business trends.

Grade 7 Substandard - This rating is for loans for which a lender is actively working with the borrower to resolve issues and the full repayment of the loan is questionable. The loan is inadequately protected by current sound worth of the borrower, paying capacity of the guarantor, or pledged collateral. Loans in this grade have well defined weaknesses that jeopardize the full collectability of the loan and a distinct possibility of loss exits.  These loans are reviewed for impairment on a quarterly basis. Characteristics of loans in this rating may include: persistent delinquency; poor financial results of the business; negative cash flow; and the ability of guarantor(s) to provide support for the loan is questionable.
 
 
10

 
 
Grade 8 Impaired Nonaccrual - This rating is for loans which are considered impaired and classified as nonaccrual. Loans in this grade have all the weaknesses of those classified as substandard grade 7 above, with the added characteristic that, based upon currently known facts, the weaknesses make collection of all principal and interest due according to contractual terms unlikely. These loans are reviewed for impairment on a quarterly basis. Loans in this grade may be assigned an allocated reserve in the loan loss allowance analysis if a determination is made that the future cash flows or the value of the collateral do not support the current carrying value of the loan.

Grade 9 Doubtful Nonaccrual- This rating is for loans which are considered impaired and are classified as nonaccrual. Loans in this grade have all the weaknesses of those classified as impaired nonaccrual grade 8 above, with the added characteristic that the weaknesses make full collection through payment or liquidation of the collateral, based on currently known facts, highly questionable or improbable. These loans are reviewed for impairment on a quarterly basis. Loans in this grade may be assigned an allocated reserve in the loan loss allowance analysis if a determination is made that the future cash flows or the value of the collateral do not support the current carrying value of the loan.

Restructured Loans
Impaired Restructured and Accruing - Loans where the borrower is experiencing financial difficulty and the bank has granted a concession to the borrower. A concession may be: a reduction in the contractual interest rate below current market rates for loans of similar quality, a lengthening of the accrual time frame beyond normal market terms, a forgiveness of a portion of the outstanding principal, or acceptance of collateral in lieu of payment for a portion of the loan balance. If the loan is in accrual status at the time of the restructuring, the borrower has the ability to make the payments under the restructured terms, and the restructuring does not forgive principal, the loan remains on an accrual status under the new terms. However, if there is a forgiveness of debt or partial charge off, the loan will generally be graded as impaired nonaccrual (Grade 8) with any accrued interest reversed against interest income. If a loan is in nonaccrual status at the time of a restructuring, it will remain in nonaccrual status (Grade 8) at the time of restructuring. All non-accruing restructured loans remain in nonaccrual status until the borrower has demonstrated the ability to make the payments under the restructured terms by making a minimum of six months of payments. If the borrower makes the six months of payments without becoming past due 30 days or more, the loan may be returned to accrual status. The determination of the need for an allowance for loan loss adjustment is based on a factor relating to historical losses multiplied by the balance of the loan for residential mortgages, or a collateral impairment review for commercial loans, and a net present value adjustment relating to a change in interest rate and other terms, if applicable.

Impaired Restructured and Accruing loans are graded seven or better based on the above definitions. If  a restructured loan is graded as eight or nine, it is reported as Impaired Nonaccrual or Doubtful Nonaccrual, respectively.

For commercial loans graded eight and nine and consumer and residential mortgage loans reported in nonaccrual, interest income is generally not recognized until the loan improves and is returned to accrual status. In some cases, if the loan is well secured and the borrower’s ability to support the loan payments has improved, such as in the case of a restructured nonaccrual loan, interest income may be recognized on a cash basis while the loan is in nonaccrual status.

For Consumer and Residential Mortgage Loan Segments, loans are classified by risk based on current delinquency and nonaccrual status. These segments of loans will contain a separate class for restructured loans, if they exist.

The following credit quality indicators provide a system for distribution of our loan portfolio in a manner consistent with the previously described loan grading system and for use in the determination of our loan loss allowance. This presentation differs somewhat by loan category from classification of loans presented elsewhere in our regulatory reports and within this report. These variations primarily relate to how real estate loans are analyzed internally to determine the adequacy of the loan loss allowance, versus how we are required to report real estate loans for regulatory purposes.
 
 
11

 
 
Credit Quality Indicators:

Loans at period end were as follows:
     
(In Thousands of Dollars)
 
June 30,
2012
   
December 31,
2011
 
Commercial & Industrial
           
Pass loans
  $ 135,250     $ 122,812  
Watch loans
    13,824       19,542  
Special mention loans
    6,226       7,878  
Substandard loans
    2,587       2,928  
Impaired restructured and accruing loans
    3,058       3,562  
Impaired nonaccrual loans
    1,452       1,771  
Doubtful nonaccrual loans
    0       0  
Total Commercial & Industrial
    162,397       158,493  
                 
Commercial Real Estate
               
Pass loans
  $ 374,765     $ 373,320  
Watch loans
    57,624       56,571  
Special mention loans
    19,922       21,155  
Substandard loans
    7,044       5,686  
Impaired restructured and accruing loans
    10,985       10,652  
Impaired nonaccrual loans
    10,490       15,336  
Doubtful nonaccrual loans
    695       0  
Total Commercial Real Estate
    481,525       482,720  
                 
First lien residential mortgage loans
               
Performing loans
  $ 202,711     $ 199,117  
Loans > 60 days past due
    1,511       2,203  
Impaired restructured and accruing loans
    4,836       4,425  
Nonaccrual loans
    4,674       5,374  
Total First lien residential mortgage loans
    213,732       211,119  
                 
Junior lien residential mortgage loans
               
Performing loans
  $ 61,780     $ 66,169  
Loans > 60 days past due
    116       328  
Impaired restructured and accruing loans
    224       278  
Nonaccrual loans
    227       278  
Total Junior lien residential mortgage loans
    62,347       67,053  
                 
Consumer Loans
               
Performing loans
  $ 67,400     $ 64,075  
Loans > 60 days past due
    113       239  
Impaired restructured and accruing loans
    176       0  
Nonaccrual loans
    340       210  
Total Consumer Loans
    68,029       64,524  
                 
Total Loans
  $ 988,030     $ 983,909  

Allowance for Loan Losses

The allowance for loan losses is determined based on management’s estimate of probable losses incurred within the loan portfolio as of the balance sheet date. We determine the amount of the allowance for loan losses based on periodic evaluation of the loan portfolios and other relevant factors. This evaluation is inherently subjective and requires material estimates, which are subject to change. Factors that are considered in the evaluation of individual, and pools of loans, include: historical loss experience; likelihood of default; liquidation value of a loan’s underlying collateral; timing and amounts of expected future cash flows; and our exposure to loss in the event of default. We further estimate the impact of qualitative factors that may cause future losses to differ from historical experience. Such factors include: changes in credit quality, macro economic impacts on our customers, and changes in underwriting standards.

Our historical loss experience is determined based on actual losses incurred over the previous twelve quarters. We utilize a method of averaging these losses whereby we place a heavier emphasis on more recent experience. Our model provides a 50% weighting on the most recent four quarters, 30% weighting on the middle four quarters, and 20% weighting on the oldest four quarters.
 
 
12

 

The loan portfolio is segmented into five loan types: commercial and industrial loans; commercial real estate loans; consumer loans; residential mortgages – first liens; and residential mortgage – junior liens. These segments are further grouped by credit quality classifications.

The segments comprising commercial and industrial loans and commercial real estate loans are classified based on the loan grading system described above. We group loans rated as one through four together into one class of Pass loans. Commercial and industrial and commercial real estate loans graded as Pass and Watch are assigned a unique pooled loss rate based on historical losses incurred over the prior three years as described above. We adjust the calculated historical loss rate up or down based on current developments, that in management’s judgment are not reflected in the historical losses of the company. The current outstanding balance for each of these classes of loans is then multiplied by the adjusted historical loss rate to determine the amount of allowance for loan losses to reserve on that pool of loans.

Loans graded special mention use a shorter 12 month loss history to determine the loss rate. Losses over the preceding 12 month period are divided by the average balance outstanding of substandard and impaired loans to determine a historical loss rate. That calculated historical loss rate is multiplied by a probability factor to determine a loss rate to be applied to this class of loans. The probability factor is determined from an analysis of the migration of special mention loans to more severe risk classes over the preceding 12 month period.

Loans graded as substandard use the shorter 12 month loss history to determine the loss rate. Losses over the preceding 12 month period are divided by the average balance outstanding of substandard and impaired loans to determine a historical loss rate. The calculated historical loss rate, without adjustment for migration, is then multiplied times the outstanding balance of substandard loans to determine the amount of allowance for loan losses to provide for this class of loans.

Loans graded as impaired nonaccrual, impaired doubtful, and impaired restructured and accruing are individually analyzed for loan losses. An allocated reserve is established within the allowance for loan losses for the difference between the carrying value of the loan and its determined collectable value. To determine the collectable value of the loan, the present value of expected cash flows, the collateral value, or some combination of the two is used. The allocated reserve is established as the difference between the carrying value of the loan and the collectable value.

For consumer and residential loan segments, loans that are current, or less than 60 days past due are assigned a unique historical loss rate as described above for commercial Pass and Watch loans. For loans that are more than 60 days past due including nonaccrual loans, a loss rate is determined based on charge offs within the last 12 months, divided by the sum of the average balance of loans 60 days or more past due and nonaccrual loans. These loss rates are multiplied by the outstanding balances in each unique loan segment at the end of the reporting period to determine the amount of allowance for loan loss.

For restructured loans where the bank has granted a rate concession, an additional amount is added to the loan loss reserve that represents the difference in the present value of the cash flows between the original terms and the new terms of the modified loan, using the original interest rate of the loan as a discount rate. Any change in the present value of the loan due to passage of time is reflected as an adjustment to provision for loan loss expense.

After each of the steps outlined above is completed, the results are aggregated and compared with the existing balance of the allowance for loan losses. If the aggregation is greater than the balance, the allowance for loan losses is increased through a charge to earnings on the provision for loan losses line. If the resulting aggregation is below the current balance of the allowance for loan losses, management will determine, based upon the number, potential impact, and uncertainty of the estimates contained within the process whether the unallocated reserve is excessive. If in management’s judgment the unallocated reserve exceeds a level deemed prudent given the inherent uncertainty of these issues, a reversal of the provision for loan losses may be recorded.
 
 
13

 
 
Allowance for credit losses for the three and six months ended June 30 were:

(In Thousands of Dollars)
                                         
 
Three months ending
June 30, 2012
 
Commercial
and Industrial
   
Commercial
Real Estate
   
First Lien Residential Mortgages
   
Junior Lien Residential Mortgages
   
Consumer
Loans
   
 
Unallocated
   
 
Total
 
Allowance for Credit Losses:
                                         
Beginning balance
  $ 2,369     $ 11,767     $ 5,563     $ 532     $ 945     $ 44     $ 21,220  
Provision for loan losses
    317       720       581       100       (66 )     842       2,494  
Loans charged off
    (297 )     (1,308 )     (572 )     (109 )     (136 )     0       (2,422 )
Recoveries
    15       36       71       0       108       0       230  
Ending balance
  $ 2,404     $ 11,215     $ 5,643     $ 523     $ 851     $ 886     $ 21,522  
                                                         
Three months ending
June 30, 2011
                                                       
Allowance for Credit Losses:
                                                       
Beginning balance
  $ 2,762     $ 12,637     $ 4,022     $ 548     $ 1,078     $ 300     $ 21,347  
Provision for loan losses
    89       1,792       1,917       (212 )     394       276       4,256  
Loans charged off
    (129 )     (2,872 )     (1,303 )     218       (336 )     0       (4,422 )
Recoveries
    10       39       36       0       61        0       146  
Ending balance
  $ 2,732     $ 11,596     $ 4,672     $ 554     $ 1,197     $ 576     $ 21,327  
                                                         
                                                         
 
 
 
Six months ending
June 30, 2012
 
Commercial
  and Industrial
   
Commercial
  Real Estate
   
First Lien Residential Mortgages
   
Junior Lien Residential Mortgages
   
Consumer
  Loans
   
 
Unallocated
   
 
Total
 
Allowance for Credit Losses:
                                         
Beginning balance
  $ 2,485     $ 11,534     $ 5,393     $ 505     $ 931     $ 171     $ 21,019  
Provision for loan losses
    320       2,246       1,288       321       98       715       4,988  
Loans charged off
    (426 )     (2,649 )     (1,155 )     (303 )     (384 )     0       (4,917 )
Recoveries
    25       84       117       0       206       0       432  
Ending balance
  $ 2,404     $ 11,215     $ 5,643     $ 523     $ 851     $ 886     $ 21,522  
                                                         
Six months ending
June 30, 2011
                                                       
Allowance for Credit Losses:
                                                       
Beginning balance
  $ 3,024     $ 12,375     $ 3,960     $ 774     $ 1,162     $ 136     $ 21,431  
Provision for loan losses
    475       3,605       2,436       (107 )     418       440       7,267  
Loans charged off
    (889 )     (4,427 )     (1,764 )     (113 )     (518 )     0       (7,710 )
Recoveries
    122       43       40       0       134        0       339  
Ending balance
  $ 2,732     $ 11,596     $ 4,672     $ 554     $ 1,197     $ 576     $ 21,327  
                                                         
 
 
14

 
 
R ecorded investment in financing receivables at period end were:
 
(In Thousands of Dollars)               First Lien        Junior Lien                    
June 30, 2012
 
Commercial and Industrial
   
Commercial Real Estate
   
Residential Mortgages
   
Residential Mortgages
   
Consumer Loans
   
 
Unallocated
   
 
Total
 
Ending balance: individually evaluated for impairment
  $ 169     $ 2,963     $ 0     $ 0     $ 0     $ 0     $ 3,132  
                                                         
Ending balance: collectively evaluated for impairment
  $ 2,235     $ 8,252     $ 5,643     $ 523     $ 851     $ 886     $ 18,390  
                                                         
Financing Receivables:
                                                       
Ending balance
  $ 162,397     $ 481,525     $ 213,732     $ 62,347     $ 68,029     $ 0     $ 988,030  
                                                         
Ending balance: individually evaluated for impairment
  $ 4,510     $ 22,170     $ 0     $ 0     $ 0     $ 0     $ 26,680  
                                                         
Ending balance: collectively evaluated for impairment
  $ 157,887     $ 459,355     $ 213,732     $ 62,347     $ 68,029     $ 0     $ 961,350  
                                                         
June 30, 2011
                                                       
Ending balance: individually evaluated for impairment
  $ 659     $ 3,318     $ 0     $ 0     $ 0     $ 0     $ 3,977  
                                                         
Ending balance: collectively evaluated for impairment
  $ 2,073     $ 8,278     $ 4,672     $ 554     $ 1,197     $ 576     $ 17,370  
                                                         
Financing Receivables:
                                                       
Ending balance
  $ 163,010     $ 491,893     $ 201,675     $ 72,807     $ 76,577     $ 0     $ 1,005,962  
                                                         
Ending balance: individually evaluated for impairment
  $ 1,129     $ 7,128     $ 0     $ 0     $ 0     $ 0     $ 8,257  
                                                         
Ending balance: collectively evaluated for impairment
  $ 161,881     $ 484,765     $ 201,675     $ 72,807     $ 76,577     $ 0     $ 997,705  

Age Analysis of Past Due Loans excluding nonaccrual loans:
 
(In thousands of dollars)
 
 
 
At June 30, 2012
 
 
30-59 Days
Past Due
   
 
 
60-89 Days
  Past Due
   
 
90 Days or
More Past Due
   
 
 
Total
Past Due
   
 
 
 
Current
   
 
Total
 Financing Receivables
   
Recorded Investment >
 90 days and accruing
 
Commercial and Industrial
  $ 622     $ 223     $ 8     $ 853     $ 160,092     $ 162,397     $ 8  
Commercial Real Estate
    562       437       177       1,176       469,164       481,525       177  
Residential Mortgages 1 st Liens
    698       1,154       356       2,208       206,850       213,732       365  
Residential Mortgages Junior Liens
    192       100       17       309       61,811       62,347       17  
Consumer
    469       113       0       582       67,107       68,029       0  
Total
  $ 2,543     $ 2,027     $ 558     $ 5,128     $ 965,024     $ 988,030     $ 567  
 
At December 31, 2011
                                                       
Commercial and Industrial
  $ 1,039     $ 94     $ 0     $ 1,133     $ 155,589     $ 158,493     $ 0  
Commercial Real Estate
    4,313       500       0       4,813       462,571       482,720       0  
Residential Mortgage 1st Liens
    973       1,875       328       3,176       202,847       211,119       336  
Residential Mortgage Junior Liens
    561       255       73       889       65,886       67,053       73  
Consumer
    848       221       18       1,087       63,227       64,524       18  
Total
  $ 7,734     $ 2,945     $ 419     $ 11,098     $ 950,120     $ 983,909     $ 427  

Note: Recorded investment includeds principle outstandanding plus deferred fees and accrued interest.
 
 
15

 

Impaired loans were as follows:

(In Thousands of Dollars)
         
June 30, 2012
 
Recorded
Investment
   
Unpaid
Principal
Balance
   
Related
Allowance
 
Period end loans with no allocated allowance for loan losses
                 
Commercial and Industrial
  $ 3,659     $ 3,658       0  
Commercial Real Estate
    8,314       8,312       0  
Residential Mortgages 1 st Liens
    9,510       9,510       0  
Residential Mortgages Junior Liens
    450       450       0  
Consumer
    516       516       0  
Total
  $ 22,449     $ 22,446     $ 0  
                         
Period end loans with allocated allowance for loan losses
                       
Commercial and Industrial
  $ 439     $ 618     $ 180  
Commercial Real Estate
    11,134       14,084       2,952  
Residential Mortgages 1 st Liens
    0       0       0  
Residential Mortgages Junior Liens
    0       0       0  
Consumer
    0       0       0  
Total
  $ 11,573     $ 14,702     $ 3,132  
                         
Total
                       
Commercial and Industrial
  $ 4,098     $ 4,276     $ 180  
Commercial Real Estate
    19,448       22,396       2,952  
Residential Mortgages 1 st Liens
    9,510       9,510       0  
Residential Mortgages Junior Liens
    450       450       0  
Consumer
    516       516       0  
Total
  $ 34,022     $ 37,148     $ 3,132  
                         
December 31, 2011
                       
Period end loans with no allocated allowance for loan losses
                       
Commercial and Industrial
  $ 4,358     $ 5,846       0  
Commercial Real Estate
    11,940       16,987       0  
Residential Mortgages 1 st Liens
    10,079       11,120       0  
Residential Mortgages Junior Liens
    278       331       0  
Consumer
    210       249       0  
Total
  $ 26,865     $ 34,533     $ 0  
                         
Period end loans with allocated allowance for loan losses
                       
Commercial and Industrial
  $ 720     $ 998     $ 253  
Commercial Real Estate
    10,423       15,225       3,622  
Residential Mortgages 1 st Liens
    0       0       0  
Residential Mortgages Junior Liens
    0       0       0  
Consumer
    0       0       0  
Total
  $ 11,143     $ 16,223     $ 3,875  
                         
Total
                       
Commercial and Industrial
  $ 5,078     $ 6,844     $ 253  
Commercial Real Estate
    22,363       32,212       3,622  
Residential Mortgages 1 st Liens
    10,079       11,120       0  
Residential Mortgages Junior Liens
    278       331       0  
Consumer
    210       249       0  
Total
  $ 38,008     $ 50,756     $ 3,875  

Note: Recorded investment includes principle outstanding plus deferred fee and accrued interest, net of related allowance for loan losses.
 
 
16

 
 
Average recorded investment and income recognized on impaired loans were as follows:

   
Three months ended
June 30, 2012
   
Three months ended
June 30, 2011
 
(In Thousands of Dollars)
 
Average
Recorded Investment
   
Interest Income Recognized
   
Average
Recorded Investment
   
Interest Income Recognized
 
Period end loans with no allocated allowance for loan losses
                       
Commercial and Industrial
  $ 3,582     $ 62       972     $ 0  
Commercial Real Estate
    9,854       217       11,716       11  
Residential Mortgages 1 st Liens
    9,762       116       8,868       15  
Residential Mortgages Junior Liens
    530       4       451       0  
Consumer
    501       5       190       2  
Total
  $ 24,229     $ 404     $ 22,196     $ 28  
                                 
Period end loans with allocated allowance for loan losses
                               
Commercial and Industrial
  $ 348     $ 0     $ 836     $ 0  
Commercial Real Estate
    10,662       40       8,623       0  
Residential Mortgages 1 st Liens
    0       0       0       0  
Residential Mortgages Junior Liens
    0       0       0       0  
Consumer
    0       0       0       0  
Total
  $ 11,010     $ 40     $ 9,459     $ 0  
                                 
Total
                               
Commercial and Industrial
  $ 3,930     $ 62     $ 1,808     $ 0  
Commercial Real Estate
    20,516       257       20,339       11  
Residential Mortgages 1 st Liens
    9,762       116       8,868       15  
Residential Mortgages Junior Liens
    530       4       451       0  
Consumer
    501       5       190       2  
Total
  $ 35,239     $ 444     $ 31,655     $ 28  
 
 
   
Six months ended
June 30, 2012
   
Six months ended
June 30, 2011
 
Period end loans with no allocated allowance for loan losses
                       
Commercial and Industrial
  $ 3,840     $ 146       807     $ 2  
Commercial Real Estate
    10,549       535       11,191       208  
Residential Mortgages 1 st Liens
    9,868       239       9,034       21  
Residential Mortgages Junior Liens
    446       7       486       130  
Consumer
    404       13       171       2  
Total
  $ 25,107     $ 940     $ 21,688     $ 363  
                                 
Period end loans with allocated allowance for loan losses
                               
Commercial and Industrial
  $ 556     $ 1     $ 788     $ 0  
Commercial Real Estate
    11,790       91       8,990       5  
Residential Mortgages 1 st Liens
    0       0       0       0  
Residential Mortgages Junior Liens
    0       0       0       0  
Consumer
    0       0       0       0  
Total
  $ 12,346     $ 92     $ 9,778     $ 5  
                                 
Total
                               
Commercial and Industrial
  $ 4,397     $ 147     $ 1,595     $ 2  
Commercial Real Estate
    22,339       626       20,181       213  
Residential Mortgages 1 st Liens
    9,868       239       9,034       21  
Residential Mortgages Junior Liens
    446       7       486       130  
Consumer
    404       13       171       2  
Total
  $ 37,453     $ 1.032     $ 31,466     $ 368  
 
 
17

 
Loan Modifications as of the period ending:

(In thousands of dollars)
 
Troubled Debt Restructurings
   
Troubled Debt Restructurings
that Subsequently Defaulted
 
   
 
Number of
contracts
   
Pre-modification
 outstanding
recorded
  investment
   
Post-modification outstanding
recorded
investment
   
 
Number of
contracts
   
 
Recorded
  investment
 
Quarter to date
                             
June 30, 2012
                             
Commercial and industrial
    1     $ 21     $ 19       -     $ -  
Commercial real estate
    -       -       -       1       96  
Residential 1 st liens
    6       425       422       -       -  
Residential junior liens
    -       -       -       -       -  
Consumer
    -       -       -       -       -  
Total
    7     $ 446     $ 441       1     $ 96  
                                         
June 30, 2011
                                       
Commercial and industrial
    1     $ 1,495     $ 1,495       -     $ -  
Commercial real estate
    11       4,161       3,624       1       82  
Residential 1 st liens
    2       268       272       5       556  
Residential junior liens
    -       -       -       -       -  
Consumer
    -       -       -       -       -  
Total
    14     $ 5,924     $ 5,391       6     $ 638  
                                         
Year to date
                                       
June 30, 2012
                                       
Commercial and industrial
    6     $ 808     $ 801       5     $ 1,143  
Commercial real estate
    8       1,985       1,983       4       401  
Residential 1 st liens
    10       802       799       -       -  
Residential junior liens
    2       103       103       -       -  
Consumer
    2       107       107       -       -  
Total
    28     $ 3,805     $ 3,793       9     $ 1,544  
                                         
June 30, 2011
                                       
Commercial and industrial
    3     $ 1,591     $ 1,594       1     $ 150  
Commercial real estate
    15       4,514       3,978       2       1,078  
Residential 1 st liens
    5       598       623       7       808  
Residential junior liens
    -       -       -       -       -  
Consumer
    -       -       -       -       -  
Total
    23     $ 6,703     $ 6,195       10     $ 2,036  


Financing Receivables on Nonaccrual Status were as follows:

(In Thousands of Dollars)
 
June 30,
2012
   
December 31,
2011
 
Nonaccrual loans at period end
           
Commercial and Industrial
  $ 1,452     $ 1,771  
Commercial Real Estate
    11,185       15,336  
Residential Mortgages 1 st Liens
    4,674       5,374  
Residential Mortgages Junior Liens
    227       278  
Consumer
    340       210  
Total nonaccrual loans
  $ 17,878     $ 22,969  


NOTE 4 – SHAREHOLDERS’ EQUITY

We are subject to various regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums.  At June 30, 2012 and year end 2011 we exceeded all requirements to be classified as well as capitalized.

On January 30, 2009 we issued 33,000 shares of Series A, no par value $1,000 liquidation preference, fixed rate cumulative perpetual preferred stock (Preferred Stock) and warrants to purchase 578,947 shares of our common stock at an exercise price of $8.55 per share (Warrants), to the U.S. Department of Treasury in return for $33 million under the Capital Purchase Program (CPP). Of the proceeds, $32.7 million was allocated to the Preferred Stock and $0.3 million was allocated to the Warrants based on the relative fair value of each. The discount on the Preferred Stock is being accreted using an effective yield method over ten years. The Preferred Stock and Warrants qualify as Tier 1 capital.
 
 
18

 

The Preferred Stock pays cumulative quarterly cash dividends at a rate of 5% per year on the $1,000 liquidation preference through February 15, 2014 and at a rate of 9% per year thereafter. We accrue dividends based on the rates, liquidation preference and time since last quarterly dividend payment. All accrued and unpaid dividends on the Preferred Stock must be declared and the payment set aside for the benefit of the holders of Preferred Stock before any dividend may be declared on our common stock.

Holders of shares of the Preferred Stock have no right to exchange or convert such shares into any other security of Firstbank Corporation and have no right to require the redemption or repurchase of the Preferred Stock. The Preferred Stock does not have a sinking fund. The Preferred Stock is non-voting, other than class voting rights on certain matters that could adversely affect the Preferred Stock.

On June 28, 2012 the U.S. Department of Treasury sold all of the shares of our Preferred Stock in a modified Dutch auction process. During the auction, we successfully bid on and retired 16,000 of the 33,000 outstanding shares of our Preferred Stock at a price of $941.01 per share, or $15.1 million aggregate price. As a result of the retirement of these shares, 17,000 shares remain outstanding and carry the same terms under which they were originally issued.

The Warrants were immediately exercisable for 578,947 shares of our common stock at an exercise price of $8.55 per common share. The Warrants were transferrable and could be exercised at any time on or before January 30, 2019. Subsequent to the end of the quarter, we negotiated a repurchase of all of the outstanding warrants with the U.S. Treasury at a price of $1,946,670. The repurchase of these warrants occurred in July 2012 and  reduced equity by the amount of the purchase price.


NOTE 5 – FAIR VALUE

Carrying amount and estimated fair values of financial instruments were as follows:

June 30, 2012
(In Thousands of Dollars)
 
Carrying
Amount
   
Estimated
Fair Value
   
Quoted
Prices in
Active
 Markets
(Level 1)
   
Significant
Other
Observable
 Inputs
(Level 2)
   
Significant
 Unobservable
Inputs
(Level 3)
 
Financial Assets:
                             
Cash and cash equivalents
  $ 91,172     $ 91,172     $ 91,172     $ -     $ -  
FDIC insured bank certificates of deposit
    2,927       2,927       2,927       -       -  
Trading account securities
    7       7       7       -       -  
Securities available for sale
    326,673       326,673       100       310,863       15,710  
Federal Home Loan Bank stock
    7,266       7,266       -       -       7,266  
Loans held for sale
    3,857       3,857       -       3,857       -  
Loans, net
    966,508       955,516       -       -       955,516  
Accrued interest receivable
    4,377       4,377       4,377       -       -  
                                         
Financial Liabilities:
                                       
Non-interest bearing deposits
    (217,824 )     (217,824 )     (217,824 )     -       -  
Interest bearing deposits
    (994,022 )     (994,040 )     -       -       (994,040 )
Securities sold under agreements to repurchase and overnight borrowings
    (45,746 )     (45,746 )     -       (45,746 )     -  
Federal Home Loan Bank advances
    (24,334 )     (26,120 )     -       -       (26,120 )
Accrued interest payable
    (613 )     (613 )     (613 )     -       -  
Subordinated debentures
    (36,084 )     (44,274 )     -       -       (44,274 )
 
 
19

 
 
December 31, 2011
 
Carrying
Amount
   
Estimated
Fair Value
 
Financial Assets:
           
Cash and cash equivalents
  $ 75,816     $ 75,816  
FDIC insured bank certificates of deposit
    4,432       4,432  
Trading account securities
    2       2  
Securities available for sale
    342,184       342,184  
Federal Home Loan Bank stock
    7,266       7,266  
Loans held for sale
    349       349  
Loans, net
    962,890       944,756  
Accrued interest receivable
    4,531       4,531  
                 
Financial Liabilities:
               
Non-interest bearing deposits
    (214,904 )     (214,904 )
Interest bearing deposits
    (1,005,638 )     (1,000,580 )
Securities sold under agreements to repurchase and overnight borrowings
    (46,784 )     (46,784 )
Federal Home Loan Bank advances
    (19,457 )     (21,359 )
Accrued interest payable
    (762 )     (762 )
Subordinated debentures
    (36,084 )     (36,488 )
 
The methods and assumptions used to estimate fair value are described as follows: The carrying amount is the estimated fair value for cash and cash equivalents, short term borrowings, Federal Home Loan Bank stock, accrued interest receivable and payable, demand deposits, short term debt, and variable rate loans or deposits that re-price frequently and fully. Security fair values are based on market prices or dealer quotes, and if no such information is available, on the rate and term of the security and information about the issuer. For fixed rate loans and variable rate loans, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk based on historical losses on similar loan pools. For deposits with infrequent re-pricing or re-pricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life of the product.

Fair values for impaired loans are estimated using discounted cash flow analysis or underlying collateral values for the specific loans in the portfolio and assumes the bank will resolve them through orderly liquidation. Fair value of loans held for sale is based on market quotes. Fair value of debt is based on current rates for similar financing. The fair value of off-balance sheet items is based on the current fees or cost that would be charged to enter into or terminate such arrangements. The fair value of off-balance sheet items was not material to the consolidated financial statements at June 30, 2012 and December 31, 2011.

The following tables present information about our assets measured at fair value on a recurring basis at June 30, 2012, and valuation techniques used by us to determine those fair values.

Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability. Level 3 Securities include local Municipal Securities where market pricing is not available, trust preferred securities issued by banks, and other miscellaneous investments.
 
 
20

 

Assets Measured at Fair Value on a Recurring Basis

 
 
 
 
(Dollars in Thousands)
 
Quoted Prices in
Active Markets
 for Identical
Assets
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
   
 
 
 
Total
 
June 30, 2012
                       
Securities available for sale
                       
U.S. governmental agency bonds
  $ 0     $ 119,129     $ 0     $ 119,129  
Mortgage backed securities
    0       67,691       0       67,691  
Collateralized mortgage obligations
    0       55,487       0       55,487  
States and political subdivisions
    0       68,556       14,153       82,709  
Equity and other Securities
    100       0       1,557       1,657  
Total Securities available for sale
  $ 100     $ 310,863     $ 15,710     $ 326,673  
                                 
Trading equity securities
  $ 7     $ 0     $ 0     $ 7  
                                 
December 31, 2011
                               
Securities available for sale
                               
U.S. governmental agency bonds
  $ 0     $ 133,834     $ 0     $ 133,834  
Mortgage backed securities
    0       71,052       0       71,052  
Collateralized mortgage obligations
    0       57,845       0       57,845  
States and political subdivisions
    0       62,447       15,342       77,789  
Equity and other Securities
    92       0       1,572       1,664  
Total Securities available for sale
  $ 92     $ 325,179     $ 16,914     $ 342,184  
                                 
Trading equity securities
  $ 2     $ 0     $ 0     $ 2  

Changes in Level 3 Assets Measured at Fair Value on a Recurring Basis

(Dollars in Thousands)
 
2012
   
20111
 
Balance at beginning of year
  $ 16,914     $ 10,833  
Total realized and unrealized gains/(losses) included in income
    0       0  
Total unrealized gains/(losses) included in other comprehensive income
    0       (26 )
Purchases of securities
    2,652       3,360  
Sales of securities
    0       0  
Calls and maturities
    (4,076 )     (4,470 )
Net transfers in/(out) of Level 3
    220       500  
Balance at June 30 of each year
  $ 15,710     $ 10,197  

Both observable and unobservable inputs may be used to determine the fair value of positions classified as Level 3 assets. As a result, the unrealized gains and losses for these assets presented in the tables above may include changes in fair value that were attributable to both observable and unobservable inputs.

Available for sale investments securities categorized as Level 3 assets primarily consist of bonds issued by local municipalities and other like assets. We carry local municipal securities at historical cost, which approximates fair value, unless economic conditions for the municipality changes to a degree requiring a valuation adjustment. We also have assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets consist of impaired loans and other real estate owned. We have estimated the fair value of impaired loans using Level 3 inputs, specifically valuation of loans based on either a discounted cash flow projection, or a discount to the appraised value of the collateral underlying the loan. We use discounted appraised values or broker’s price opinions to determine the fair value other real estate owned.
 
 
21

 
 
Assets Measured at Fair Value on a Nonrecurring Basis

 
 
 
 
 
(Dollars in Thousands)
 
 
 
 
 Balance at
  June 30,
   
Quoted Prices
 in Active
Markets for
Identical
Assets
(Level 1)
   
Significant
Other
Observable
Inputs
(Level 2)
   
 
Significant
Unobservable
Inputs
(Level 3)
   
 
Total Losses for
 the six month
 period ended
  June 30,
 
2012
                             
Impaired loans
  $ 37,149       0       0     $ 37,149     $ (1,857 )
Other Real Estate Owned
  $ 3,741       0       0     $ 3,741     $ (390 )
                                         
2011
                                       
Impaired loans
  $ 38,194       0       0     $ 38,194     $ (3,138 )
Other Real Estate Owned
  $ 8,469       0       0     $ 8,469     $ (829 )

Impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. We estimate the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals). Other Real Estate Owned is valued based on either a recent appraisal for the property or a brokers' price opinion of the value of the property, which are discounted for expected costs to dispose of the property. The $1,857,000 loss on impaired loans indicated in the table above, for the six month period ended June 30, 2012, and the $3,138,000 for the six months ended June 30, 2011, were charged to the allowance for loan losses, while the $390,000 and the $829,000 losses, for the six months ended June 30 of 2012 and 2011, in other real estate owned were charged to earnings through other non-interest expense on the income statement.

NOTE 6 – BASIC AND DILUTED EARNINGS PER SHARE

(Dollars in Thousands Except per Share Data)
 
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Earnings per share
                       
Net income
  $ 2,404     $ 628     $ 4,821     $ 1,843  
Preferred stock dividends and accretion of discount
    420       420       840       840  
Income available to common shareholders
  $ 1,984     $ 208     $ 3,981     $ 1,003  
Weighted average common shares outstanding
    7,928,000       7,833,000       7,912,000       7,820,000  
                                 
Basic Earnings per Share
  $ 0.25     $ 0.03     $ 0.50     $ 0.13  
                                 
Earnings per share assuming dilution
                               
Net income
  $ 2,404     $ 628     $ 4,821     $ 1,843  
Preferred stock dividends and accretion of discount
    420       420       840       840  
Income available to common shareholders
  $ 1,984     $ 208     $ 3,981     $ 1,003  
Weighted average common shares outstanding
    7,928,000       7,833,000       7,912,000       7,820,000  
Add dilutive effect of assumed exercises of options
    67,000       2,000       15,000       2,000  
Weighted average common and dilutive potential common shares outstanding
    7,995,000       7,835,000       7,927,000       7,822,000  
                                 
Diluted Earnings per Share
  $ 0.25     $ 0.03     $ 0.50     $ 0.13  

Stock options and stock warrants for 255,182 shares for the three months and 872,079 for the six months of 2012, were not considered in computing diluted earnings per share because they were anti-dilutive. Stock options and warrants for 1,033,518 shares for the three and six month periods of 2011, were not considered in computing diluted earnings per share because they were anti-dilutive.
 
 
22

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

The consolidated financial information presented is for Firstbank Corporation (“Corporation”) and its wholly owned subsidiaries; Firstbank - Alma, Firstbank (Mt. Pleasant), Firstbank - West Branch (including 1 st Title, Inc. and its 46% holdings in 1 ST Investors Title, LLC), Keystone Community Bank, Firstbank – West Michigan (collectively the “Banks”), FBMI Risk Management Services, Inc., and Austin Mortgage Company.

Highlights

During the second quarter, we repurchased 16,000 shares of the 33,000 outstanding shares of our preferred stock. In the last week of June, the U.S. Treasury included the preferred stock of our company in one of a series of Dutch auctions which they are conducting in an effort to exit the Capital Purchase Program (CPP).  The shares sold in the auction at a price of $941.01 per share (liquidation preference value $1,000) netting the U.S. Treasury $31,053,330. In July, we negotiated a repurchase of the 578,947 outstanding warrants, which were issued to the U.S. Treasury at the time of their investment in our preferred shares, for a price of $1,946,670. In total, between the sale of the preferred shares and the sale of the warrants, investors and Firstbank Corporation paid $33 million to the U.S. Treasury, the same amount of the U.S. Treasury’s original investment in our company. The repurchase of the 16,000 preferred shares is reflected in our results of operations in the second quarter, and the repurchase of the warrants will be reflected in our results during the third quarter as a reduction in common equity. The repurchase of preferred shares and warrants will affect total equity by the amounts of the purchase price and will reduce dividends on preferred stock going forward. As a result, income available to common shareholders will be increased by the amount of the reduced dividend on preferred stock in future periods.
   
Financial Condition

Total assets at June 30, 2012 were virtually unchanged from year end 2011 at $1.486 billion, increasing by $439,000. While the overall asset balance is flat, we have seen some improvement in the loan portfolio as loan balances increased $4.1 million before allowance for loan losses and cash and cash equivalents increased $15.4 million. Securities available for sale decreased $15.5 million as we allowed maturing securities to run off during the second quarter.

The allowance for loan losses remained relatively stable during the first half of the year at $21.5 million, up $503,000 from year end. The allowance to ending loans ratio was 2.18%, compared with 2.14% at year end 2011 and 2.12% at June 30, 2011. Our problem assets categories improved during the quarter as nonaccrual loans declined $5.1 million from year end and $2.3 million from June 30 a year ago. Restructured loans which are in conformance with their new terms were $362,000 higher compared with year end, and increased $1.3 million from June 30, 2011. Loans 90 days or more past due increased $139,000 from year end, but were $1.2 million below  year ago levels. Other Real Estate Owned decreased $1.5 million from the end of the year to $3.7 million, and was down $4.7 million from last year’s second quarter. We are pleased with the progress we have made in the problem loan area so far this year, but expect that problem loans will remain elevated, relative to our historical standards, in the near term.

Despite the current elevated levels of these categories of loans, our overall asset quality compares favorably to many of our competitor banks in Michigan. We continue to be diligent in review of our loan portfolios for problem loans and believe that early detection of troubled credits is critical to our ability to minimize or avoid losses. We maintain the allowance for loan losses at a level considered adequate to cover losses within the loan portfolio. The allowance balance is established after considering past loan loss experience, current economic conditions, composition of the loan portfolio, delinquencies, and other relevant factors.
 
 
23

 

Following is a comparison of loan balances for the quarter and prior year end.

 
     
(In Thousands of Dollars)
 
June 30,
2012
   
December 31,
2011
 
Commercial
  $ 160,106     $ 156,551  
Mortgage Loans on Real Estate:
               
Residential
    339,663       340,060  
Commercial
    365,801       365,029  
Construction
    56,599       60,280  
Consumer
    65,861       61,989  
Subtotal
    988,030       983,909  
Less:
               
Allowance for loan losses
    ( 21,522 )     (21,019 )
Loans, net
  $ 966,508     $ 962,890  

Residential mortgages decreased $397,000, or 0.1%, from year end 2011 as pay downs of loans and refinanced loans sold in the secondary market exceeded our ability to generate replacement balances. Real estate construction loans also decreased $3.7 million, or 6.1%, during the first six months of 2012. Commercial and commercial real estate loans were $4.3 million, or 0.8%, higher at June 30 when compared with year end 2011 as loan demand from qualified borrowers was able to outpace principal pay downs. Consumer loans increased $3.9 million, or 6.2% from year end. While these numbers do not show strong growth, it is the first time in many quarters that we have been able to generate any increases in loan balances.

Net charge-offs of loans were $4.5 million in the first half of 2012, compared with $7.4 million in the first half of 2011. For the second quarter of 2012 net charge offs were $2.2 million compared with $2.3 million in the first quarter of 2012 and $4.3 million in the second quarter of 2011. The ratio of net charge-offs of loans (annualized) to average loans was 0.89% in the second three months of 2012 compared to 0.94% in the first quarter and 1.45% in the second quarter of 2011 .

Total deposits decreased $8.7 million, or 0.7% when compared with year end 2011 balances. In this low interest rate environment, our customers have been willing to trade a small step up in yield for liquidity, resulting in a decline in time balances even as other deposit categories continue to grow. Within the deposit base, interest bearing demand account balances decreased $10 million, or 3.0%, savings balances increased $17 million, or 7.0%, and time balances decreased $18 million, or 4.3%. Within time balances, wholesale CDs were $363,000 higher than year end, while core market CDs were down $18.6 million. Given our current low levels of loan demand, time deposits are being allowed to mature without replacement, or being renewed at lower rates. Non-interest bearing demand account balances were $2.9 million, or 1.4% higher than year end.

For the six month period ended June 30, 2012, Federal Home Loan Bank advances were up $4.9 million, or 25.1% from year end, primarily to take advantage of some favorable longer term rates and to manage the matching of the duration of our assets and liabilities. Securities sold under agreements to repurchase and overnight borrowings were $1.0 million, or 2.2% lower due to normal fluctuations in customer cash flows.  Accrued interest and other liabilities increased $15.5 million compared with year end primarily due to the funds set aside for the July 3 payment for preferred stock redeemed in the treasury auction on June 27.

Total shareholders’ equity decreased $10.2 million from the previous year end primarily due to the repurchase and retirement of preferred stock. Net income of $4,821,000 and common stock issuances of $473,000 increased shareholders’ equity, while common and preferred stock dividends of $1.4 million and the redemption of 16,000 shares of our preferred stock decreased shareholders’ equity. Accumulated other comprehensive income increased $862,000 from year end. Common stock issuance was primarily related to shares issued through supplemental investment plans and dividend reinvestment. Book value per share of shareholders’ common equity was $16.14 at June 30, 2012, increasing from $15.53 at December 31, 2011. Tangible shareholders common equity per share (total equity less goodwill and other intangible assets) was $11.52 at the end of the second quarter of 2012, increasing from $10.85 at year end 2011. Shareholders’ common equity per share calculations excludes preferred stock of $16.9 million at June 30, 2012 and $32.8 million at December 31, 2011.
 
 
24

 

The following table discloses compliance with current regulatory capital requirements on a consolidated basis:

(Dollars in Thousands)
 
Leverage
   
Tier 1 Capital
   
Total Risk-
Based Capital
 
                   
Capital Balances at June 30, 2012
  $ 140,779     $ 140,779     $ 153,097  
Required Regulatory Capital
    59,492       39,187       78,374  
Capital in Excess of Regulatory Minimums
    81,287       101,592       74,723  
                         
                         
Capital Ratios at June 30, 2012
    9.47 %     14.37 %     15.63 %
Regulatory Capital Ratios – Minimum Requirement
    4.00 %     4.00 %     8.00 %

Our capital remains above regulatory guidelines for the second quarter of 2012. At the end of the second quarter our total risk based capital ratio was 15.63% compared with 16.55% at year end 2011. Tier 1 capital and tier 1 leverage ratios were 14.37% and 9.47% compared with 15.29% and 10.30% at year end 2011. The decrease in all of the capital ratios during the quarter was a result of our repurchase of 16,000 shares of our preferred stock. As of June 30, 2012, all of our affiliate banks continue to exceed the “Well Capitalized” regulatory definition.

  Results of Operations

Three Months Ended June 30, 2012

For the second quarter of 2012, net income was $2,404,000, basic and diluted earnings per share were $0.25, compared with net income of $628,000, and $0.03 basic and diluted per share for the second quarter of 2011, and net income of $2,417,000, $0.25 basic and diluted earnings per share, for the first quarter of 2012. Net income available to common shareholders was $1,984,000 in the current quarter compared with $208,000 in the second quarter of 2011 and $1,997,000 in the first quarter of 2012. We had several onetime events in the second quarter that affected our earnings. Positively affecting earnings for the quarter was the receipt of a non-taxable $178,000 life insurance proceeds from a policy covering a former director of the bank. Negatively affecting earnings in the quarter was a $170,000 non-tax deductible charge for expenses associated with the U.S. Treasury’s auction of our preferred stock, and a $154,000 charge to earnings associated with the closing of one of our two branches in Belding, MI.

Favorably affecting the quarter were mortgage loan sale gains of $1.5 million, increasing $1.0 million from last year’s second quarter, but down $235,000 from this year’s first quarter. The second quarter was once again, heavily impacted by a $2.5 million charge to loan loss provision, as well as $380,000 in expense relating to other real estate owned. The charge to loan loss provision was necessary as we continue to work though loans for which the borrowers have exhausted their sources of repayment, or the value of the supporting collateral declined. These loans were either transferred into nonaccrual status and specific reserves established, or charged down to the estimated value of the collateral that can be recovered on the loan.

Average earning assets increased $26 million, when the second quarter of 2012 is compared to the same quarter a year ago. While overall average earning assets increased from a year ago, a decrease in average net loan balances of $22 million was offset by a $53 million increase in average available for sale securities. Compared with the previous quarter, average earning assets increased $8.6 million, or 0.6%. The yield on earning assets decreased 43 basis points, to 4.67%, for the quarter ended June 30, 2012, compared to 5.10% for the same quarter a year ago, and was six basis points lower when compared with the first quarter of 2012. The cost of funding related liabilities also decreased, falling 39 basis points when comparing this year’s second quarter to the same period a year ago, from 1.02% in 2011, to 0.63% in 2012. Compared with the prior quarter, the cost of funding related liabilities fell by six basis points. The net interest margin decreased three basis points from last year’s second quarter of 4.08% to 4.05% in the current quarter. The net interest margin increased two basis points when compared to the previous quarter. Net interest income increased $98,000 to $13.8 million in the second quarter of 2012 compared with the same period of 2011, as the increase in average earning assets more than offset the lower net interest margin. Unpaid interest on loans which are transferred to nonaccrual status is reversed against interest income in the period when the transfer occurs. During the second quarter of 2012, interest reversals associated with loans moving to nonaccrual status were $42,000 compared with $154,000 in the same quarter a year ago and $72,000 in the first quarter of 2012. Interest expense associated with FHLB advances and subordinated debt decreased $36,000 when the second quarter of 2012 is compared with the same period of 2011, providing for lower cost of funding earning assets.
 
 
25

 

The provision for loan losses decreased $1.8 million when the second quarter of 2012 is compared to the same quarter of 2011. Provision for loan losses was $2.5 million in this year’s second quarter compared with $4.3 million in the second quarter of 2011. The provision for loan losses was unchanged from this year’s first quarter. In the second quarter of the year we charged down $1.6 million of commercial loans, for which we had specific reserves set aside of $0.4 million at the end of the previous year. We also identified loans where the value of the underlying collateral of the loan continued to decline. After a detailed review of these loans, it was determined that some of these loans should be moved to nonaccrual status, while others should be charged off. Following that review, our analysis showed that we needed to provide slightly more for loan losses than our charge offs to cover losses inherent in the portfolio. We perform quantitative and qualitative analysis of factors which impact the allowance for loan losses consistently across our five banking subsidiaries. The process applies risk factors for historical charge-offs and delinquency experience, portfolio segment growth rates, and industry and regional factors and trends as they affect the banks’ portfolios. The consideration of exposures to industries most affected by current risks in the economic and political environment and the review of risks in certain credits that are not considered part of the non-performing loan category contributed to the establishment of the allowance levels at each bank.

Total non-interest income was $3.0 million in the second quarter of 2012, compared with $2.0 million in the second quarter of 2011 and $3.2 million in the first quarter of 2012. Compared with 2011’s second quarter, gains on sale of mortgages were $1.0 million or 254% higher, primarily due to increased mortgage refinancing resulting from the current interest rate environment. Gain on sale of mortgage loans decreased by $235,000, or 13.9% when the second quarter of 2012 is compared to the first quarter of the year. Lower refinance rates and relaxed loan to value ratio criteria in the secondary market lead to increased activity from a year ago. Service charges on deposit accounts were $122,000 lower than the year ago second quarter, but were in line with the first quarter of this year. The higher income a year ago was mainly due to changes in our overdraft policies, and changes in our customers’ management of their accounts, resulting in reduced charges to customers that overdraw their accounts. Other income increased $122,000 over last year’s second quarter but was $79,000 below this year’s first quarter. The increase over the prior year was a result of $178,000 death benefit on a former director’s life insurance, which was partially offset by a decrease of $14,000 in the loss on the sale of other real estate owned, and a $59,000 loss on disposal of fixed assets associated with the write off of leasehold improvements of the branch that was closed during this year’s second quarter. Compared with the first quarter of the year, the previously mentioned death benefit income was offset by a $231,000 detrimental change in other real estate gains and losses, and the loss on disposal of fixed assets mentioned above from the closing of a branch.

Total non-interest expense increased $222,000, or 2.1%, when comparing the three month periods ended June 30, 2012 and 2011 and was primarily due to higher salary and benefits costs and higher other expenses. Partially offsetting these increases were lower amortization of intangibles, FDIC insurance costs, and lower other real estate costs.

Salary and benefits expense was $298,000 higher when compared with the second quarter of last year due primarily to higher variable compensation expense which increased by $269,000 as the company’s performance this year has been better than last year. FDIC insurance premiums were $174,000 lower than a year ago and $49,000 lower than this year’s first quarter. The new method of determining these premiums compared with a year ago has caused the decline in expense compared with a year ago. Other real estate costs comparing the second quarter of the year to last year’s second quarter decreased by $417,000 and were down $37,000 from the first quarter of 2012. Fewer properties held in other real estate owned compared with a year ago and stabilizing property prices have resulted in a reduction of $384,000 in write downs compared with last year’s second quarter. Other expenses increased $617,000 compared with last year and were $381,000 higher than the first quarter of the year. Onetime costs of $170,000 relating to the U.S. Treasury auction of our preferred securities, $95,000 to buyout the lease on the closing of a branch office and the establishment of a $250,000 reserve for losses resulting from the repurchase of mortgages sold in the secondary market were the primary causes of the increase. The reserve for secondary market mortgage repurchases was created due to an increased effort by government sponsored agencies to force back losses to banks that originated the loans in their portfolio.

Federal Income tax expense was $938,000 in the second quarter of 2012, compared with $58,000 in the second quarter last year and $1.0 million in the first quarter of 2012. The change in taxes compared with each of these quarters was primarily driven by changes in pre-tax earnings.

 
26

 
 
Six Months Ended June 30, 2012

For the first half of 2012, net income was $4,821,000,  basic and diluted earnings per share were $0.50, compared with net income of $1,843,000, and $0.13 basic and diluted per share for the first half of 2011. Net income available to common shareholders was $3,981,000 in the 2012’s first half compared with $1,003,000 in the first half of 2011. Favorably affecting this year were mortgage loan sale gains of $3.2 million, increasing $2.2 million from last year’s first half. This year’s first half was once again, heavily impacted by a $5.0 million charge to loan loss provision, as well as $797,000 in expense relating to other real estate owned. The charge to loan loss provision was necessary as we continue to work though loans for which the borrowers have exhausted their sources of repayment, or the value of the supporting collateral declined. These loans were either transferred into nonaccrual status and specific reserves established, or charged down to the estimated value of the collateral that can be recovered on the loan. We had several onetime events in the second quarter that affected our year to date earnings. Positively affecting earnings for the year was the receipt of a non-taxable $178,000 life insurance proceeds from a policy covering a former director of the bank. Negatively affecting earnings in the quarter was $170,000 non-tax deductible charge for expenses associated with the U.S. Treasury’s auction of our preferred stock, and $154,000 charge to earnings associated with the closing of one of our two branches in Belding, MI.

Average earning assets increased $33 million, when the first half of 2012 is compared to the six month period a year ago. While overall earning assets increased from a year ago, a decrease in average loan balances of $31 million was offset by a $67 million increase in available for sale securities. The yield on earning assets decreased 43 basis points, to 4.70%, for the half ended June 30, 2012, compared to 5.13% for the same half a year ago. The cost of funding related liabilities also decreased, falling 41 basis points when comparing this year’s first half to the same period a year ago, from 1.07% in 2011, to 0.66% in 2012. Since the decrease in the cost of funds relative to earning assets was less than the decrease in the yield on earning assets, the net interest margin declined three basis points from last year’s first half to 4.04% in the current year. Net interest income increased $573,000 to $27.6 million in the first half of 2012 compared with the same period of 2011, as the increase in average earning assets more than offset the lower net interest margin. Unpaid interest on loans which are transferred to nonaccrual status is reversed against interest income in the period when the transfer occurs. During the first half of 2012, interest reversals associated with loans moving to nonaccrual status were $115,000 compared with $253,000 in the same period a year ago. Interest expense associated with FHLB advances and subordinated debt decreased $126,000 when the first half of 2012 is compared with the same period of 2011, providing for lower cost of funding earning assets.

The provision for loan losses decreased $2.3 million when the first half of 2012 is compared to the same six months of 2011. Provision for loan losses was $5.0 million in this year’s first half compared with $7.3 million in the first half of 2011. In the first half of the year we charged down $3.1 million of commercial loans, for which we had specific reserves set aside of $1.4 million at the end of the previous year. We also identified loans where the value of the underlying collateral of the loan continued to decline. After a detailed review of these loans, it was determined that some of these loans should be moved to nonaccrual status, while others should be charged off. Following that review, our analysis showed that we needed to provide slightly more for loan losses than our charge offs to cover losses inherent in the portfolio. We perform quantitative and qualitative analysis of factors which impact the allowance for loan losses consistently across our five banking subsidiaries. The process applies risk factors for historical charge-offs and delinquency experience, portfolio segment growth rates, and industry and regional factors and trends as they affect the banks’ portfolios. The consideration of exposures to industries most affected by current risks in the economic and political environment and the review of risks in certain credits that are not considered part of the non-performing loan category contributed to the establishment of the allowance levels at each bank.

Total non-interest income was $6.2 million in the first half of 2012, compared with $4.1 million in the first half of 2011. Compared with 2011’s first half, gains on sale of mortgages were $2.2 million or 222% higher. Lower refinance rates and relaxed loan to value ratio criteria in the secondary market lead to increased activity. Also effecting non interest income was higher other income, which increased $304,000 compared with last year’s first half primarily due to a favorable swing in the sale of other real estate owned from a loss in the first half of 2011 of $21,000 to a gain in the first half of 2012 of $206,000.

Total non-interest expense increased $507,000, or 2.4%, when comparing the six month periods ended June 30, 2012 and 2011 and was primarily due to higher salary and benefits costs and higher other expenses. Partially offsetting these increases were lower occupancy and equipment, amortization of intangibles, FDIC insurance costs, and other real estate costs.

Salary and benefits expense was $698,000 higher when compared with the first half of last year due to higher variable compensation expense of $281,000, higher base wages of $268,000, and higher employee benefits cost of $149,000. Occupancy and equipment costs decreased $63,000 compared with a year ago. FDIC insurance premiums decrease $343,000 as the new method of calculating the premium by the FDIC benefited the company this year. Amortization of intangibles declined $99,000 from last year as certain intangible became fully amortized, or stepped down in the amortization rate. Advertising and marketing expenses were $75,000 higher in this year’s first half. Other real estate costs decreased from last year’s first half by $581,000 as write downs on properties decreased by $418,000 and expenses associated with maintaining those properties decreased $164,000. Other expenses increased $797,000 compared with a year ago mainly due to onetime costs of $170,000 relating to the U.S. Treasury auction of our preferred securities, $95,000 to buyout the lease on the closing of a branch office and the establishment of a $250,000 reserve for losses resulting from the repurchase of mortgages sold in the secondary market. The reserve for  repurchases of secondary market loans was created due to an increase effort by the government sponsored agencies to force back losses to banks that originated the loans in their portfolio.
 
 
27

 

Federal Income tax expense was $2.0 million in the first half of 2012, compared with $407,000 in the first half of last year. The increase in taxes compared with each of these periods was primarily driven by higher pre-tax earnings.

Liquidity

At June 30, 2012, we have adequate sources of liquidity to meet our needs. Cash and cash equivalent balances were $91 million, an increase of $15 million, or 20%, compared with year end 2011. This increase was primarily the result of a decrease in the investment portfolio of $16 million. Our securities available for sale portfolio now stands at $327 million, providing a source of liquidity should it become necessary.

Our banks maintain access to immediately available funds through federal funds lines at three correspondent banks, the Federal Home Loan Bank of Indianapolis, and the Federal Reserve’s discount window with aggregate available limits of $43 million, $86 million, and $86 million, respectively. Our banks also have access to funds through brokered CD markets for additional funding if needed.

Contractual Obligations, Commitments, Contingent Liabilities, and Off-Balance Sheet Arrangements

The Corporation has various financial obligations, including contractual obligations and commitments that may require future cash payments. Management believes that there have been no material changes in the Corporation’s overall level of these financial obligations since December 31, 2011 and that any changes in the Corporation’s obligations which have occurred are routine for the industry. Further discussion of the nature of each type of obligation is included in Management’s Discussion and Analysis on page 14 and 15 of the Corporation’s Form 10K Annual Report, and is incorporated herein by reference.

Critical Accounting Policies

Certain of the Corporation’s accounting policies are important to the portrayal of the Corporation’s financial condition and results of operations, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain.  Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances.  Facts and circumstances which could affect these judgments include, without limitation, changes in interest rates, in local and national economic conditions, or the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for loan losses, determining the fair value of securities and other financial instruments, the valuation of mortgage servicing rights and other intangibles, determination of purchase accounting adjustments, and estimating state and federal contingent tax liabilities. The Corporation’s significant accounting policies are discussed in detail in Management’s Discussion and Analysis on pages 15 through 17 in the Corporation’s annual report to shareholders for the year ended December 31, 2011.

FORWARD LOOKING STATEMENTS

This report contains forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and about the Corporation itself.  Words such as  “anticipate,”  “believe,”  “determine,” “estimate,”  “expect,”  “forecast,”  “intend,”  “is likely,”  “plan,”  “project,”  “opinion,” variations of such terms, and similar expressions are intended to identify such forward-looking statements.  The presentations and discussions of the provision and allowance for loan losses, and determinations as to the need for other allowances presented in this report are inherently forward-looking statements in that they involve judgments and statements of belief as to the outcome of future events.  These statements are not guarantees of future performance and involve certain risks, uncertainties, and assumptions that are difficult to predict with regard to timing, extent, likelihood, and degree of occurrence.  Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements.  Internal and external factors that may cause such a difference include changes in interest rates and interest rate relationships; demand for products and services; the degree of competition by traditional and non-traditional competitors; changes in banking regulations; changes in tax laws; changes in prices, levies, and assessments; the impact of technological advances; governmental and regulatory policy changes; the outcomes of pending and future litigation and contingencies; trends in customer behavior and customer ability to repay loans; software failure, errors or miscalculations; and the vicissitudes of the national economy.  The Corporation undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events, or otherwise.
 
 
28

 

Item 3.   Quantitative and Qualitative Disclosures about Market Risk

Information under the headings, “Liquidity and Interest Rate Sensitivity” on pages 13 and 14 and “Quantitative and Qualitative Disclosure About Market Risk” on page 17 in the registrant’s annual report to shareholders for the year ended December 31, 2011, is here incorporated by reference.  Firstbank’s annual report is filed as Exhibit 13 to its Form 10-K annual report for its fiscal year ended December 31, 2011.  Also referenced here is information under the heading “Item 1A. Risk Factors” on pages 16 through 19 in the registrant’s Form 10-K annual report for its fiscal year ended December 31, 2011.

We face market risk to the extent that both earnings and the fair values of our financial instruments are affected by changes in volatility, market perceptions of credit risk and interest rates. We manage this risk with static GAP analysis and simulation modeling. We do not believe that there has been a material change in the nature of our primary market risk exposures, including the categories of market risk to which we are exposed and the particular markets that present the primary risk of loss to the Corporation. As of the date of this Form 10-Q quarterly report, we do not know of nor expect there to be any material change in the general nature of our primary market risk exposure in the near term.

The methods by which we manage our primary market risk exposures, as described in the sections of our Form 10-K Annual Report incorporated by reference in response to this item, have not changed materially during the current year. As of the date of this Form 10-Q quarterly report, we do not expect to change those methods in the near term. However, we may change those methods in the future to adapt to changes in circumstances or to implement new techniques.

Our market risk exposure is mainly comprised of our vulnerability to interest rate risk. Prevailing interest rates and interest rate relationships in the future will be primarily determined by market, economic, and geopolitical factors which are outside of our control. All information provided in response to this item consists of forward looking statements. Reference is made to the section captioned “Forward Looking Statements” of this Form 10-Q quarterly report for a discussion of the limitations on our responsibility for such statements.

Item 4.    Controls and Procedures

a)
Evaluation of Disclosure Controls and Procedures

 
On August 9, 2012, the Corporation’s Chief Executive Officer and Chief Financial Officer reported on the Corporation’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e) and 15d-15(e)) to the Audit Committee.  The portion of that report which constitutes their conclusions about the effectiveness of the disclosure controls and procedures based on their evaluation as of June 30, 2012 is as follows:  “Based on our knowledge and the most recent evaluation, we believe the disclosure controls and procedures to be reasonably effective and commercially practical in providing information for management of the Corporation and for fair reporting to the investing public.”

b)
Changes in Internal Controls

During the period covered by this report, there have been no changes in the Corporation’s internal control over financial reporting that have materially affected or are reasonably likely to materially affect the Corporation’s internal control over financial reporting.
 
 
29

 
 
PART II.  OTHER INFORMATION


Item 5.    Other Information

The audit committee of the Board of Directors approved the categories of all non-audit services performed by the registrant’s independent accountants during the period covered by this report.


Item 6.
Exhibits
 
 
Exhibit Description

 
31.1
Certificate of the President and Chief Executive Officer of Firstbank Corporation pursuant to 18 U.S.C. Section 7241, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 
31.2
Certificate of the Executive Vice President and Chief Financial Officer of Firstbank Corporation pursuant to 18 U.S.C. Section 7241, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 
32.1
Certificate of the Chief Executive Officer and the Chief Financial Officer of Firstbank Corporation pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 
101
Interactive Data File
 
 
30

 
 
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
 
 
FIRSTBANK CORPORATION
 
  (Registrant)  
     
     
     
     
Date: August 9, 2012 /s/ Thomas R. Sullivan  
  Thomas R. Sullivan  
  President, Chief Executive Officer  
  (Principal Executive Officer)  
     
     
Date: August 9, 2012  /s/ Samuel G. Stone  
  Samuel G. Stone  
  Executive Vice President, Chief Financial Officer  
  (Principal Accounting Officer)  
 
 
31

 
 
 EXHIBIT INDEX

 
Exhibit Description

31.1
Certificate of the Chief Executive Officer of Firstbank Corporation pursuant to 18 U.S.C. Section 7241, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2
Certificate of the Chief Financial Officer of Firstbank Corporation pursuant to 18 U.S.C. Section 7241, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1
Certificate of the Chief Executive Officer and the Chief Financial Officer of Firstbank Corporation pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
101
Interactive Data File
 
32
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