Mackinac Financial Corp.
Annual Report 2012

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2012 A n n uA l R e p o Rt Table of Contents To Our Shareholders ..............................................................................................................................1 Five-Year Overview...............................................................................................................................6 Regional Review ....................................................................................................................................8 Selected Financial Highlights ..............................................................................................................14 Quarterly Financial Summary ..............................................................................................................15 Report of Independent Registered Public Accounting Firm ................................................................16 Consolidated Balance Sheets ...............................................................................................................17 Consolidated Statements of Operations ...............................................................................................18 Consolidated Statements Comprehensive Income ...............................................................................19 Consolidated Statements of Changes in Shareholders’ Equity ............................................................20 Consolidated Statements of Cash Flows ..............................................................................................21 Notes to Consolidated Financial Statements........................................................................................22 Selected Financial Data........................................................................................................................53 Summary Quarterly Financial Information ..........................................................................................54 Market Information ..............................................................................................................................56 Shareholder Return Performance Graph ..............................................................................................57 Forward-Looking Statements...............................................................................................................58 Management’s Discussion and Analysis of Financial Condition and Results of Operations ................................................................................................60 Directors and Officers ..........................................................................................................................81 ______________________________________________________________________________________ BUSINESS OF THE CORPORATION Mackinac Financial Corporation is a registered bank holding company formed under the Bank Holding Company Act of 1956 with assets in excess of $540 million and whose common stock is traded on the NASDAQ stock market as “MFNC.” The principal subsidiary of the Corporation is mBank. Headquartered in Manistique, Michigan, mBank has 11 branch locations; seven in the Upper Peninsula, three in the Northern Lower Peninsula and one in Oakland County, Michigan. The Company’s banking services include commercial lending and treasury management products and services geared toward small to mid-sized businesses, retail and commercial, title insurance, as well as a full array of personal and business deposit products and consumer loans. FORM 10-K A copy of the Annual Report to the Securities and Exchange Commission on Form 10-K is available without charge by writing the Shareholders’ Relations Department, Mackinac Financial Corporation, 130 South Cedar Street, Manistique, Michigan, 49854. MARKET SUMMARY The Corporation’s common stock is traded on the Nasdaq Capital Market under the symbol MFNC. The Corporation had approximately 1,200 shareholders of record as of March 29, 2013. To Our Shareholders March 29, 2013 Dear Shareholders: We are proud of our 2012 operating results, as discussed in this letter, which provides you with an overview of our performance. We have seen continued progress in reducing nonperforming assets, limiting balance sheet risk, improving our net interest margin and increasing noninterest revenue to build franchise value. We view 2012 as another positive step forward in our mission of enhancing shareholder value. The various charts and graphs following this letter track the performance of the company through the last five years in terms of key shareholder metrics and operating performance levels. During this period of highly challenging economic times for banks across the country and especially in the State of Michigan, the Corporation increased its common stock book value from $7.75 per share at December 31, 2005 to $11.05 at 2012 year end, an increase of $3.30 per share, or 43%. During this five year period, we also significantly increased total assets, loans, and core deposits which provide the foundation for future organic growth. This organic growth, along with future initiatives, including possible accretive acquisitions, will add shareholder value. At the end of 2012, the Corporation and the Bank had strong equity positions. The Corporation had a Tier 1 ratio of 11.98% and total risk based capital of 14.93%. The Bank’s Tier 1 capital ratio stood at 9.63% with a total risk based capital ratio of 12.21%. Listed below are some key performance highlights and events that shaped 2012. Capital Offering (cid:2) Consummation of a common stock rights offering and the investment by Steinhardt Capital Investors, LLLP with the issuance of 2.140 million shares for net proceeds of $11.500 million. Dividend Declaration (cid:2) In December, the Corporation announced its first quarterly dividend since the recapitalization at $.04 per share. Strong Loan Production (cid:2) We continued to experience loan demand with approximately $214 million of new loan production split between commercial related credits accounting for $103 million, and consumer/mortgage loans totaling $111 million. Our total outstanding loans increased by $47.931 million after reductions for loan sales, (SBA/USDA and secondary market) amortization and payoffs. Most importantly, we continue to be successful in producing well priced high quality loans in the Upper Peninsula with 2012 loan production of $134 million. In 2012, we began to see resurgence in loan opportunities in Northern Lower Michigan with production of $38 million and also Southeast Michigan with production of $42 million. (cid:2) Balance sheet growth equated to $47.9 million for 2012, an 11.9% increase in loans outstanding from 2011 year- end. Growth in Noninterest Income (cid:2) In 2012 we continued to be a state leader in the origination of sound SBA and USDA guaranteed loans with total gain on sales of $1.176 million in 2012 compared to $1.500 million during 2011. Sold guaranteed loans totaled $12 million in 2012 compared to $19 million in 2011. 1 To Our Shareholders (cid:2) We generated higher levels of secondary market income of $1.390 million in 2012 compared to $.700 million in 2011. At 2012 year-end, our mortgage loan servicing portfolio totaled $97 million which provides future refinancing/cross selling opportunities and also provides a stable source of core deposits since many of these clients maintain various transactional accounts. Core Deposit Growth (cid:2) Total deposits of $434.557 million at 2012 year-end increased 7.35% from deposits of $404.789 million at 2011 year-end. The overall increase in deposits for 2012 is comprised of an increase in core deposits of $23.772 million and increased noncore deposits of $5.996 million. The largest increase in core deposits was in non-interest bearing demand deposits. Margin Improvement (cid:2) Net interest income and the net interest margin in 2012 increased to $19.824 million, and 4.17%, compared to $17.929 million, and 4.06%, in 2011. The interest margin increase was largely due to decreased funding costs from 1.33% in 2011 to 1.15% in 2012. Improved Credit Quality (cid:2) We had an overall reduction in nonperforming assets from $11.155 million at the end of 2011 to $7.899 million at the end of 2012 as we continued with our timely and aggressive problem asset remediation plans to strengthen our balance sheet. Our Texas Ratio at 2012 year-end was reduced to 10.25% and is one of the lowest amongst the 15 largest public banks headquartered in Michigan. New Escanaba and Traverse City Locations (cid:2) Opening of our new standalone Escanaba branch banking center relocated from an in-store Menards location in August, and the opening of our new loan production office in Traverse City. Both locations are considered core commerce center hubs in their respective markets. Other events (cid:2) We were pleased to win the “Restructuring Community Impact Award of the Year” from the annual M&A Turnaround Awards Ceremony for our participation in the refinancing and recapitalization of Manistique Papers Incorporated. As we previously discussed in our 2011 Report to Shareholders, this project saved a significant number of jobs in our headquarter market of Manistique, Michigan and created significant goodwill for mBank, accompanied by a positive financial impact. 2012 Earnings Recap In 2012, we reported net income of $6.458 million, or $1.51 per share. This was an increase of $5.006 million, or $1.09 per share from 2011 income of $1.452 million, $.42 per share. The Corporation’s primary asset, its subsidiary bank, mBank, recorded earnings of $7.884 million which was an improvement of $5.228 million from 2011 earnings of $2.656 million. The 2012 results included a $3.0 million deferred tax valuation adjustment. In recent years, we have benefitted from improvements in our core banking platform to including product flexibility and services to our client base. We have also added top quality revenue drivers in key markets in both commercial and mortgage lending, and consolidated several operational areas to provide better efficiencies. The following table illustrates the marked improvement in several key performance areas. Net Interest Margin Efficiency Ratio Credit Quality (Texas Ratio) 2012 2011 2010 4.17% 67.95% 10.25% 4.06% 68.43% 18.56% 3.66% 72.57% 26.66% 2 To Our Shareholders Loan Growth/Production As stated previously, we continue to experience strong loan demand as demonstrated with approximately $214 million in new loan production during 2012, including mortgage loans sold in the secondary market. The table below details the 2012 activity (dollars in thousands): Loan balances as of December 31, 2011 $ 401,246 Total production Secondary market sales SBA loan sales Loans transferred to OREO Loans charged off, net of recoveries Normal amortization/paydowns and payoffs 214,102 (74,142) (11,962) (1,352) (978) (77,737) Loan balances as of December 31, 2012 $ 449,177 Loan production, including secondary market mortgage loans of $74 million, in our three geographical regions is shown below. (dollars in thousands) For the Year Ending December 31, REGION Upper Peninsula Northern Lower Peninsula Southeast Michigan 2012 2011 2010 $ 134,257 37,856 41,989 $ 95,024 48,226 29,327 $ 55,475 10,972 10,646 TOTAL $ 214,102 $ 172,577 $ 77,093 As you will note from the chart, we started in 2012 to see good loan production in all regions from the slowing economy of previous years. We will continue to evaluate growth potential in markets where we can grow loans with good credit quality and acceptable loan pricing enhanced by fee income to maintain and improve our margin. Government Guaranteed Lending Programs # Loans 2012 SBA Amount Premium SBA Loans Originated For the Year Ended December 31, 2011 SBA Amount # Loans Premium # Loans 2010 SBA Amount Premium $ $ $ $ $ $ UP NLP SEM Total 13 2 2 17 8,993 354 2,615 11,962 881 14 281 1,176 12 8 1 21 8,620 9,024 1,326 18,970 776 585 139 1,500 13 8 - 21 8,733 3,838 - 12,571 609 258 - 867 $ $ $ $ $ $ In 2012, the Corporation continued its success as a premier SBA/USDA lender throughout the State of Michigan. As you noted in the chart shown above, the 2012 level of SBA production totaled $11.962 million of loans sold, which generated $1.176 million in fees. Our total for the last three years was $43 million loans sold, with $3.543 million in fees. The Corporation does not sell all the loan guarantees from every credit, only those where acceptable market rates are paid above par that generate an acceptable internal rate of return. We are pleased with our success in this area of lending; first in terms to the benefit of the Corporation, but also for the many local businesses that through these programs are provided the capital to grow and help rebuild the economic base of the State. 3 To Our Shareholders Core Deposit Growth In 2012 core deposits grew by more than $23 million, or 6.82%. Shown below is the mix of our deposits for the three most recent years. DEPOSIT MIX CORE DEPOSITS Transactional accounts: Noninterest bearing NOW, money market, checking Savings Total transactional accounts Certificates of deposit <$100,000 Total core deposits NONCORE DEPOSITS Certificates of deposit >$100,000 Brokered CDs Total noncore deposits 2012 Mix As of December 31, 2011 Mix 2010 Mix 2012/2011 2011/2010 Percent Change $ 67,652 155,465 13,829 236,946 135,550 372,496 24,355 37,706 62,061 15.57 35.78 3.18 54.53 31.19 85.72 5.60 8.68 14.28 % $ 51,273 152,563 14,203 218,039 130,685 348,724 23,229 32,836 56,065 12.67 37.69 3.51 53.87 32.28 86.15 5.74 8.11 13.85 % $ 41,264 134,703 17,670 193,637 96,977 290,614 22,698 73,467 96,165 % 10.67 34.83 4.57 50.07 25.07 75.14 5.87 18.99 24.86 % 31.94 1.90 (2.63) 8.67 3.72 6.82 4.85 14.83 10.69 % 24.26 13.26 (19.62) 12.60 34.76 20.00 2.34 (55.31) (41.70) TOTAL DEPOSITS $ 434,557 100.00 % $ 404,789 100.00 % $ 386,779 100.00 % 7.35 % 4.66 % Noninterest Expense Controlling noninterest expense is ever more challenging with increased regulatory burdens and demands of technological enhancements; however, we believe we have made satisfactory progress in terms of balancing costs to drive more revenue to the Corporation on a cost-benefit basis. In 2012, we reduced our efficiency ratio to 67.95% from 68.43%, which is a product of our cost control efforts and growth in noninterest income. The Corporation’s overall non-interest expense base remains slightly below peer at 2.88% of total assets and should continue to move downward with the improvements in asset quality noted above. In terms of personnel expense, the Corporation continues to operate at below peer levels as it has for several years at 1.50% as a percentage of total assets compared to peer levels of 1.56%. We have been successful in controlling most other areas of noninterest expense and will continue to focus on becoming even more efficient. Capital In August 2012, we issued 2.140 million shares of common stock in a rights offering and through a capital investment by Steinhardt Capital Investors, LLLP which netted $11.500 million. This issuance of common stock gives us the capital necessary for exploring several 2013 initiatives, including a partial redemption of our preferred stock. Looking Forward In 2013, we will continue with the execution of our core banking plan to further enhance earnings and ensure balance sheet risk on both sides is prudently managed and controlled. This basic initiative includes maintaining strong credit quality and discipline in pricing and structure in the management of our assets to maintain margins and limit interest rate risk. We look for increased momentum from the successes in 2012 and continue to pivot to a more offensive strategy while still maintaining strong risk management systems to keep pace with the changing risk profile of the company, in order to accelerate growth in shareholder value. The Corporation is, and will remain dedicated to the primary strategic objective of enhancing franchise and shareholder value by building a strong banking franchise in our local markets and serving the communities that provide the business opportunities for the company to prosper. We graciously thank you for your continued support as a shareholder, and many who are clients as well, we thank you for your steadfast trust in being a customer of the corporation. Sincerely, Paul D. Tobias Chairman and CEO Mackinac Financial Corporation Kelly W. George President and CEO mBank 4 (This page has been left blank intentionally.) 5 Five Year Overview 6 Five Year Overview 7 Regional Review – Upper Peninsula BRANCH LOCATIONS ESCANABA 2224 N. Lincoln Road Escanaba, MI 49829 (906) 233-9443 Manager: April J. Stropich MANISTIQUE 130 South Cedar Street Manistique, MI 49854 (906) 341-2413 Manager: Kendra L. Lander MARQUETTE 300 North McClellan Marquette, MI 49855 (906) 226-5000 Manager: Teresa M. Same NEWBERRY 414 Newberry Avenue Newberry, MI 49868 (906) 293-5165 Manager: Angie E. Buckingham MANISTIQUE - LAKESHORE Located in Jack’s Supervalu Manistique, MI 49854 (906) 341-7190 Manager: Kendra L. Lander SAULT STE. MARIE 138 Ridge Street Sault Ste. Marie, MI 49783 (906) 635-3992 Manager: Lori A. McKerchie STEPHENSON S216 Menominee Street Stephenson, MI 49887 (906) 753-2225 Manager: Barbara A. Parrett BALANCE SHEET HIGHLIGHTS (dollars in thousands) Loans Core Deposits Loan Production* Core Deposit Growth At December 31, 2012 2012 Activity Escanaba Manistique Marquette Newberry Sault Ste. Marie Stephenson $ 11,121 82,779 99,396 15,540 32,915 9,032 $ 5,134 40,990 43,966 34,213 22,069 35,520 $ 15,436 28,495 75,389 4,336 8,823 1,779 $ (65) 5,663 33 288 (497) (1,047) TOTAL UPPER PENINSULA $ 250,783 $ 181,892 $ 134,258 $ 4,375 * Includes production of mortgage loans sold on the secondary market. CONTRIBUTION TO OTHER INCOME (dollars in thousands) Production/Sold Gains/Fee Income Production/Sold Gains/Fee Income Secondary Market SBA/USDA Escanaba Manistique Marquette Newberry Sault Ste. Marie Stephenson $ 8,030 6,319 34,996 1,580 2,770 1,189 $ 163 121 623 34 64 26 - $ 6,654 2,036 - 302 - - $ 640 207 - 33 - TOTAL UPPER PENINSULA $ 54,884 $ 1,031 $ 8,992 $ 880 8 Regional Review – Upper Peninsula Excluding the branch sales, which were predominantly transactional accounts, total deposits grew $58.4 million in the five year period. Core deposits are defined as demand deposits, interest bearing checking accounts, money markets, savings and CDs less than $100,000. Total loan production over the five year period amounted to $365.6 million. Nonperforming assets in the Upper Peninsula totaled $3.445 million at the end of 2012, which included $1.315 million of OREO and $2.130 million of nonperforming loans. Nonperforming loans as a percent of total loans was .85%. 9 Regional Review – Northern Lower Peninsula BRANCH LOCATIONS GAYLORD 1955 South Otsego Avenue Gaylord, MI 49735 (989) 732-3750 TRAVERSE CITY 3530 North Country Drive Traverse City, MI 49684 (231) 929-5600 Manager: Daniel P. Galbraith KALEVA 14429 Wuoksi Avenue Kaleva, MI (231) 362-3223 Manager: Barb J. Miller BALANCE SHEET HIGHLIGHTS (dollars in thousands) Loans Core Deposits Loan Production* Core Deposit Growth At December 31, 2012 2012Activity Gaylord Kaleva Traverse City $ 36,942 415 50,727 $ 60,604 15,242 63,949 $ 19,249 88 18,519 $ 6,802 1,142 2,060 TOTAL NORTHERN LOWER PENINSULA $ 88,084 $ 139,795 $ 37,856 $ 10,004 * Includes production of mortgage loans sold on the secondary market. CONTRIBUTION TO OTHER INCOME (dollars in thousands) Production/Sold Gains/Fee Income Production/Sold Gains/Fee Income Secondary Market SBA/USDA Gaylord Kaleva Traverse City $ 12,580 - 6,678 $ 198 - 137 - $ - 354 - $ - 14 TOTAL NORTHERN LOWER PENINSULA $ 19,258 $ 335 $ 354 $ 14 10 Regional Review – Northern Lower Peninsula Total core deposit growth amounted to $104.6 million over the five year period, largely in transactional accounts. Core deposits are defined as demand deposits, interest bearing checking accounts, money markets, savings and CDs less than $100,000. Total loan production over the five year period amounted to $146.3 million. Nonperforming assets in the Northern Lower Peninsula totaled $2.687 million at the end of 2012 which included $.147 million of OREO and $2.540 million of nonperforming loans. Nonperforming loans as a percent of total loans was 2.88%. 11 Regional Review – Southeast Michigan BRANCH LOCATION BIRMINGHAM 260 East Brown Street, Suite 300 Birmingham, MI 48009 (248) 290-5900 Manager: Elena Dritsas (dollars in thousands) Birmingham At December 31, 2012 2012 Activity Loans Core Deposits Loan Production Core Deposit Growth $ 110,310 $ 50,809 $ 41,989 $ 9,393 BALANCE SHEET HIGHLIGHTS CONTRIBUTION TO OTHER INCOME (dollars in thousands) Production/Sold Gains/Fee Income Production/Sold Gains/Fee Income Secondary Market SBA/USDA Birmingham $ - $ - $ 2,615 $ 281 12 Regional Review – Southeast Michigan Total core deposit growth amounted to $38.9 million over the five year period, largely in transactional accounts. Core deposits are defined as demand deposits, interest bearing checking accounts, money markets, savings and CDs less than $100,000. Total loan production over the five year period amounted to $101.7 million. Nonperforming assets in Southeast Michigan totaled $1.7658 million at the end of 2012, which included $1.751 million of OREO and $.017 million of nonperforming loans. Nonperforming loans as a percent of total loans was negligible. 13 Selected Financial Highlights (Dollars in Thousands, Except Per Share Data) (Dollars in thousands, except per share data) Selected Financial Condition Data (at end of period) : Assets Loans Investment securities Deposits Borrowings Common Shareholders' Equity Shareholders' equity Selected Statements of Income Data: Net interest income Income before taxes and preferred dividend Net income available to common shareholders Income per common share - Basic Income per common share - Diluted Weighted average shares outstanding Weighted average shares outstanding- Diluted Selected Financial Ratios and Other Data: Performance Ratios: Net interest margin Efficiency ratio Return on average assets Return on average common equity Return on average equity Average total assets Average common shareholders' equity Average total shareholders' equity Average loans to average deposits ratio Common Share Data at end of period: Market price per common share Book value per common share Common shares outstanding Other Data at end of period: Allowance for loan losses Non-performing assets Allowance for loan losses to total loans Non-performing assets to total assets Texas ratio Number of: Branch locations FTE Employees December 31, 2012 December 31, 2011 (Unaudited) $ 545,980 449,177 43,799 434,557 35,925 61,448 72,448 $ 19,824 6,165 6,458 1.51 1.51 4,285,043 4,285,043 $ 498,311 401,246 38,727 404,789 35,997 44,342 55,263 $ 17,929 3,316 1,452 .42 .41 3,419,736 3,500,204 4.17 67.95 1.23 12.43 10.26 $ 526,740 51,978 62,939 99.45 % % 4.06 68.43 .30 3.30 2.66 $ 489,539 43,940 54,561 98.05 % % $ $ 7.09 11.05 5,559,859 $ $ 5.42 12.97 3,419,736 $ $ 5,218 7,899 1.16 1.47 10.25 $ $ 5,251 11,155 1.31 2.24 18.56 % % % % % % 11 121 11 116 The above summary should be read in connection with the related consolidated financial statements and notes included elsewhere in this report. 14 Quarterly Financial Summary Quarter Ended December 31, 2012 September 30, 2012 June 30, 2012 March 31, 2012 December 31, 2011 September 30, 2011 June 30, 2011 March 31, 2011 December 31, 2010 Average Assets Average Loans Average Deposits $ 545,661 545,788 511,681 503,412 487,304 497,333 494,481 478,861 488,320 $ 438,168 424,461 422,887 404,048 396,197 397,665 378,250 380,066 385,296 $ 433,573 439,327 416,657 409,250 390,941 403,957 404,549 386,743 393,266 Average Shareholders' Equity $ 72,936 67,327 55,915 55,418 55,219 54,998 54,138 53,870 55,015 % Return on Average Assets Equity 5.03 5.29 29.39 3.62 (.82) 5.10 4.47 1.92 (15.09) .67 % .65 3.21 .40 (.09) .56 .49 .22 (1.70) Net Interest Margin Efficiency Ratio % 4.11 4.10 4.30 4.17 4.38 4.14 3.79 3.92 3.88 % 70.52 67.29 63.61 71.01 67.51 67.39 67.84 75.73 65.05 Net Income Book Value Per Share Per Share* 11.05 .21 $ $ 11.14 .21 14.43 .97 13.19 .12 12.97 (.03) 13.05 .21 12.86 .18 12.67 .07 12.63 (.61) *Net income per share data for 2012 restated for common stock issuance ___________________________________________________________________________________________________ 15 Report of Independent Registered Public Accounting Firm Report of Independent Registered Public Accounting Firm Board of Directors Mackinac Financial Corporation, Inc. We have audited the consolidated statement of financial condition of Mackinac Financial Corporation, Inc. as of December 31, 2012 and 2011 and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for each year in the three-year period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Mackinac Financial Corporation, Inc. as of December 31, 2012 and 2011 and the consolidated results of their operations and their cash flows for each year in the three-year period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America. Grand Rapids, Michigan March 29, 2013 16 Consolidated Balance Sheets MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES December 31, 2012 and 2011 (Dollars in Thousands) _____________________________________________________________________________________________ ASSETS Cash and due from banks Federal funds sold Cash and cash equivalents Interest-bearing deposits in other financial institutions Securities available for sale Federal Home Loan Bank stock Loans: Commercial Mortgage Installment Total Loans Allowance for loan losses Net loans Premises and equipment Other real estate held for sale Deferred tax asset Other assets TOTAL ASSETS LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Non-interest-bearing deposits Interest-bearing deposits: NOW, Money Market, Checking Savings CDs<$100,000 CDs>$100,000 Brokered Total deposits Borrowings Other liabilities Total liabilities Shareholders' equity: Preferred stock - No par value: Authorized 500,000 shares, 11,000 shares issued and outstanding Common stock and additional paid in capital - No par value Authorized - 18,000,000 shares Issued and outstanding - 5,559,859 and 3,419,736 shares respectively Retained earnings Accumulated other comprehensive income Total shareholders' equity December 31, 2012 December 31, 2011 $ 26,958 3 26,961 $ 20,071 13,999 34,070 10 43,799 3,060 342,841 95,413 10,923 449,177 (5,218) 443,959 10,633 3,212 9,131 5,215 10 38,727 3,060 311,215 83,106 6,925 401,246 (5,251) 395,995 9,627 3,162 8,427 5,233 $ 545,980 $ 498,311 $ 67,652 $ 51,273 155,465 13,829 135,550 24,355 37,706 434,557 35,925 3,050 473,532 152,563 14,203 130,685 23,229 32,836 404,789 35,997 2,262 443,048 11,000 10,921 53,797 6,727 924 72,448 43,525 492 325 55,263 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 545,980 $ 498,311 See accompanying notes to consolidated financial statements. 17 Consolidated Statements of Operations MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES Years Ended December 31, 2012, 2011, and 2010 (Dollars in Thousands, Except Per Share Data) ___________________________________________________________________________________________________ For the Years Ended December 31, 2011 2010 2012 INTEREST INCOME: Interest and fees on loans: Taxable Tax-exempt Interest on securities: Taxable Tax-exempt Other interest income Total interest income INTEREST EXPENSE: Deposits Borrowings Total interest expense Net interest income Provision for loan losses Net interest income after provision for loan losses OTHER INCOME: Deposit service fees Net security gains (losses) Income from secondary market loans sold SBA/USDA loan sale gains Mortgage servicing income Other Total other income OTHER EXPENSE: Salaries and employee benefits Occupancy Furniture and equipment Data processing Professional service fees Loan and deposit Writedowns and losses on other real estate held for sale FDIC insurance assessment Telephone Advertising Other Total other expenses Income (loss) before provision for income taxes Provision for (benefit of) income taxes NET INCOME (LOSS) Preferred dividend and accretion of discount $ 23,197 116 $ 21,627 147 $ 21,091 188 948 27 139 24,427 3,946 657 4,603 19,824 945 18,879 699 - 1,390 1,176 417 361 4,043 8,288 1,372 885 991 1,196 877 489 459 233 376 1,591 16,757 6,165 (922) 7,087 629 1,162 28 108 23,072 4,530 613 5,143 17,929 2,300 15,629 832 (1) 700 1,500 400 225 3,656 7,275 1,376 827 761 756 1,137 1,137 849 215 351 1,285 15,969 3,316 1,098 2,218 766 1,406 28 127 22,840 5,607 848 6,455 16,385 6,500 9,885 990 215 539 868 - 183 2,795 6,918 1,313 806 740 627 910 2,753 957 193 297 1,084 16,598 (3,918) (3,500) (418) 742 NET INCOME (LOSS) AVAILABLE TO COMMON SHAREHOLDERS $ 6,458 $ 1,452 $ (1,160) INCOME (LOSS) PER COMMON SHARE: Basic Diluted $ $ 1.51 1.51 $ $ .42 .41 $ $ (.34) (.34) See accompanying notes to consolidated financial statements. 18 Consolidated Statements of Comprehensive Income MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES Years Ended December 31, 2012, 2011, and 2010 (Dollars in Thousands) _____________________________________________________________________________________________ December 31, 2011 2010 2012 Net income $ 7,087 $ 2,218 $ (418) Net change in net unrealized gains and losses on securities available for sale: Unrealized gains (losses) arising during the period Less: reclassification adjustment for gains included in net income Net securities gain (loss) during the period Tax effect Other comprehensive income (loss) 907 - 907 (308) 599 (433) 1 (432) 145 (287) (944) 215 (729) 248 (481) Total comprehensive income $ 7,686 $ 1,931 $ (899) See accompanying notes to consolidated financial statements. 19 Consolidated Statements of Changes in Shareholders’ Equity MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES Years Ended December 31, 2012, 2011, and 2010 (Dollars in Thousands) __________________________________________________________________________________________ Shares of Common Stock Preferred Stock Series A Common Stock and Additional Paid in Capital Retained Earnings (Accumulated Deficit) Accumulated Other Comprehensive Income Total Balance, January 1, 2010 3,419,736 $ 10,514 $ 43,493 $ 199 $ 1,093 $ 55,299 Net (loss) Other comprehensive income (loss): Net unrealized (loss) on securities available for sale Total comprehensive (loss) Stock compensation Dividend on preferred stock Accretion of preferred stock discount - - - - - - - - - 192 - - 32 - - Balance, December 31, 2010 3,419,736 10,706 43,525 Net income Other comprehensive income (loss): Net unrealized (loss) on securities available for sale Total comprehensive income Dividend on preferred stock Accretion of preferred stock discount Other - - - - - - - - 215 - - - - - - Balance, December 31, 2011 3,419,736 10,921 43,525 Net income Other comprehensive income: Net unrealized income on securities available for sale Total comprehensive income Stock compensation Issuance of common stock Divided on common stock Purchase of common stock warrants Dividend on preferred stock Accretion of preferred stock discount - - 2,140,123 - - - - - - - - - - 79 - 66 11,506 - (1,300) - - (418) - (418) - (481) - (550) (192) (961) 2,218 - - - 612 - - (287) (551) (215) 1 492 7,087 - - - (223) - (550) (79) - - - 325 599 - - - - - - (481) (899) 32 (550) - 53,882 2,218 (287) 1,931 (551) - 1 55,263 7,087 599 7,686 66 11,506 (223) (1,300) (550) - Balance, December 31, 2012 5,559,859 $ 11,000 $ 53,797 $ 6,727 $ 924 $ 72,448 See accompanying notes to consolidated financial statements. 20 Consolidated Statements of Cash Flows MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES Years Ended December 31, 2012, 2011, and 2010 (Dollars in Thousands) _____________________________________________________________________________________________ Cash Flows from Operating Activities: Net income (loss) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization Provision for loan losses Provision for (benefit of) income taxes (Gain) loss on sales/calls of securities available for sale (Gain) on sale of secondary market loans Origination of loans held for sale in secondary market Proceeds from secondary market loans held for sale Loss on sale of premises, equipment, and other real estate held for sale Writedown of other real estate held for sale Stock compensation Change in other assets Change in other liabilities Net cash provided by operating activities Cash Flows from Investing Activities: Net (increase) in loans Net (increase) decrease in interest-bearing deposits in other financial institutions Purchase of securities available for sale Proceeds from maturities, sales, calls or paydowns of securities available for sale Capital expenditures Proceeds from sale of premises, equipment, and other real estate Redemption of FHLB stock Net cash provided by (used in) investing activities Cash Flows from Financing Activities: Net increase (decrease) in deposits Net proceeds from common stock issuance Dividend on common stock Repurchase of common stock warrants Dividend on preferred stock Principal payments on borrowings Net cash provided by (used in) financing activities Net (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period 2012 2011 2010 $ 7,087 $ 2,218 $ (418) 1,547 945 (922) - (1,077) (74,142) 75,219 31 496 66 (61) 788 9,977 (50,351) - (15,209) 10,668 (2,098) 775 - (56,215) 29,768 11,506 (223) (1,300) (550) (72) 39,129 (7,109) 34,070 1,419 2,300 1,098 1 (477) (38,971) 39,448 282 855 - (325) 296 8,144 (26,015) 703 (21,260) 15,607 (1,034) 5,456 363 (26,180) 18,010 - - - (551) (72) 17,387 (649) 34,719 1,643 6,500 (3,500) (215) (445) (36,678) 37,217 48 2,703 32 13,174 (583) 19,478 (9,355) (35) (5,000) 16,788 (606) 2,876 371 5,039 (34,610) - - - (550) (71) (35,231) (10,714) 45,433 Cash and cash equivalents at end of period $ 26,961 $ 34,070 $ 34,719 Supplemental Cash Flow Information: Cash paid during the year for: Interest Income taxes Noncash Investing and Financing Activities: Transfers of Foreclosures from Loans to Other Real Estate Held for Sale (net of adjustments made through the allowance for loan losses) $ 4,172 125 $ 4,664 75 $ 6,548 75 1,352 4,194 5,373 See accompanying notes to consolidated financial statements. 21 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting policies of Mackinac Financial Corporation (the “Corporation”) and Subsidiaries conform to accounting principles generally accepted in the United States and prevailing practices within the banking industry. Significant accounting policies are summarized below. Principles of Consolidation The consolidated financial statements include the accounts of the Corporation and its wholly owned subsidiaries, mBank (the “Bank”) and other minor subsidiaries, after elimination of intercompany transactions and accounts. Nature of Operations The Corporation’s and the Bank’s revenues and assets are derived primarily from banking activities. The Bank’s primary market area is the Upper Peninsula, the northern portion of the Lower Peninsula of Michigan, and Oakland County in Lower Michigan. The Bank provides to its customers commercial, real estate, agricultural, and consumer loans, as well as a variety of traditional deposit products. A portion, less than 1.0% of the Bank’s commercial loan portfolio consists of leases to commercial and governmental entities, which are secured by various types of equipment. These leases are dispersed geographically throughout the country. Less than 1.0% of the Corporation’s business activity is with Canadian customers and denominated in Canadian dollars. While the Corporation’s chief decision makers monitor the revenue streams of the various Corporation products and services, operations are managed and financial performance is evaluated on a Corporation-wide basis. Accordingly, all of the Corporation’s banking operations are considered by management to be aggregated in one reportable operating segment. Use of Estimates in Preparation of Financial Statements The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of investment securities, the valuation of foreclosed real estate, deferred tax assets, and mortgage servicing rights. Cash and Cash Equivalents For purposes of reporting cash flows, cash and cash equivalents include cash on hand, noninterest-bearing deposits in correspondent banks, and federal funds sold. Generally, federal funds are purchased and sold for one-day periods. Securities The Corporation’s securities are classified and accounted for as securities available for sale. These securities are stated at fair value. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. Unrealized holding gains and losses on securities available for sale are reported as accumulated other comprehensive income within shareholders’ equity until realized. When it is determined that securities or other investments are impaired and the impairment is other than temporary, an impairment loss is recognized in earnings and a new basis in the affected security is established. Gains and losses on the sale of securities are recorded on the trade date and determined using the specific-identification method. 22 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Federal Home Loan Bank Stock As a member of the Federal Home Loan Bank (FHLB) system, the Bank is required to hold stock in the FHLB based on the anticipated level of borrowings to be advanced. This stock is recorded at cost, which approximates fair value. Transfer of the stock is substantially restricted. Interest Income and Fees on Loans Interest income on loans is reported on the level-yield method and includes amortization of deferred loan fees and costs over the loan term. Net loan commitment fees or costs for commitment periods greater than one year are deferred and amortized into fee income or other expense on a straight-line basis over the commitment period. The accrual of interest on loans is discontinued when, in the opinion of management, it is probable that the borrower may be unable to meet payments as they become due as well as when required by regulatory provisions. Upon such discontinuance, all unpaid accrued interest is reversed. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. Interest income on impaired and nonaccrual loans is recorded on a cash basis. Mortgage Servicing Rights Servicing assets are recognized as separate assets when rights are acquired through purchase or through sale of financial assets. Capitalized servicing rights are reported in other assets and are amortized into noninterest income in proportion to, and over the period of, the estimated future net servicing income of the underlying financial assets. Servicing assets are evaluated for impairment based on the fair value of the rights compared to amortized cost. Impairment is determined by using prices for similar assets with similar characteristics, such as interest rates and terms. Fair value is determined by using prices for similar assets with similar characteristics, when available, or based on discounted cash flows using market- based assumptions. Impairment is recognized through a valuation allowance for an individual stratum, to the extent that fair value is less than the capitalized amount for the stratum. Allowance for Loan Losses The allowance for loan losses includes specific allowances related to commercial loans which have been judged to be impaired. A loan is impaired when, based on current information, it is probable that the Corporation will not collect all amounts due in accordance with the contractual terms of the loan agreement. These specific allowances are based on discounted cash flows of expected future payments using the loan’s initial effective interest rate or the fair value of the collateral if the loan is collateral dependent. The Corporation also has a general allowance for loan losses for loans not considered impaired. The allowance for loan losses is maintained at a level which management believes is adequate to provide for probable loan losses. Management periodically evaluates the adequacy of the allowance using the Corporation’s past loan loss experience, known and inherent risks in the portfolio, composition of the portfolio, current economic conditions, and other factors. The allowance does not include the effects of expected losses related to future events or future changes in economic conditions. This evaluation is inherently subjective since it requires material estimates that may be susceptible to significant change. Loans are charged against the allowance for loan losses when management believes the collectability of the principal is unlikely. In addition, various regulatory agencies periodically review the allowance for loan losses. These agencies may require additions to the allowance for loan losses based on their judgments of collectability. In management’s opinion, the allowance for loan losses is adequate to cover probable losses relating to specifically identified loans, as well as probable losses inherent in the balance of the loan portfolio as of the balance sheet date. 23 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Troubled Debt Restructuring Troubled debt restructuring of loans is undertaken to improve the likelihood that the loan will be repaid in full under the modified terms in accordance with a reasonable repayment schedule. All modified loans are evaluated to determine whether the loans should be reported as a Troubled Debt Restructure (TDR). A loan is a TDR when the Corporation, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower by modifying or renewing a loan that the Corporation would not otherwise consider. To make this determination, the Corporation must determine whether (a) the borrower is experiencing financial difficulties and (b) the Corporation granted the borrower a concession. This determination requires consideration of all of the facts and circumstances surrounding the modification. An overall general decline in the economy or some deterioration in a borrower’s financial condition does not automatically mean the borrower is experiencing financial difficulties. Other Real Estate Held for Sale Other real estate held for sale consists of assets acquired through, or in lieu of, foreclosure and other long-lived assets to be disposed of by sale, whether previously held and used or newly acquired. Other real estate held for sale is initially recorded at the lower of cost or fair value, less costs to sell, establishing a new cost basis. Valuations are periodically performed by management, and the assets’ carrying values are adjusted to the lower of cost basis or fair value less costs to sell. Impairment losses are recognized for any initial or subsequent write-downs. Net revenue and expenses from operations of other real estate held for sale are included in other expense. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation. Maintenance and repair costs are charged to expense as incurred. Gains or losses on disposition of premises and equipment are reflected in income. Depreciation is computed on the straight-line method over the estimated useful lives of the assets. Stock Compensation Plans On May 22, 2012, the Company’s shareholders approved the Mackinac Financial Corporation 2012 Incentive Compensation Plan, under which current and prospective employees, non-employee directors and consultants may be awarded incentive stock options, non-statutory stock options, shares of restricted stock units (“RSUs”), or stock appreciation rights. The aggregate number of shares of the Company’s common stock issuable under the plan is 757,848. The Corporation sponsors three stock option plans. One plan was approved during 2000 and applies to officers, employees, and nonemployee directors. This plan was amended as a part of the December 2004 stock offering and recapitalization. The amendment, approved by shareholders, increased the shares available under this plan by 428,587 shares from the original 25,000 (adjusted for the 1:20 reverse stock split), to a total authorized share balance of 453,587. The other two plans, one for officers and employees and the other for nonemployee directors, were approved in 1997. A total of 30,000 shares (adjusted for the 1:20 split), were made available for grant under these plans. Options under all of the plans are granted at the discretion of a committee of the Corporation’s Board of Directors. Options to purchase shares of the Corporation’s stock were granted at a price equal to the market price of the stock at the date of grant. The committee determined the vesting of the options when they were granted as established under the plan. No new options may be issued under the plans. Comprehensive Income (Loss) Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) is composed of unrealized gains and losses on securities available for sale, net of tax. 24 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Earnings per Common Share Earnings per share are based upon the weighted average number of shares outstanding. The issuance of shares as a result of stock options, restricted stock units and common stock warrants issued under the TARP Capital Purchase Program is shown in the table below. The common stock warrants were retired in December 2012. The following shows the computation of basic and diluted earnings per share for the year ended December 31, 2012, 2011 and 2010 (dollars in thousands, except per share data): Year Ended December 31, 2012 2011 2010 Net income (loss) Preferred stock dividends and accretion of discount Net income (loss) available to common shareholders $ $ $ $ 7,087 629 6,458 2,218 766 1,452 $ (418) 742 (1,160) $ Weighted average shares outstanding Effect of dilutive stock options, vesting of restricted stock units, and common stock warrants outstanding Diluted weighted average shares outstanding Income (loss) per common share: Basic Diluted 4,285,043 3,419,736 3,419,736 - 4,285,043 80,468 3,500,204 60,161 3,479,897 $ $ 1.51 1.51 $ $ .42 .41 $ $ (.34) (.34) The effect of dilutive common stock warrants was not taken into account when calculating the loss per share in 2010, since it was anti-dilutive. Income Taxes Deferred income taxes have been provided under the liability method. Deferred tax assets and liabilities are determined based upon the difference between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences are expected to reverse. Deferred tax expense (benefit) is the result of changes in the deferred tax asset and liability. A valuation allowance is provided against deferred tax assets when it is more likely than not that some or all of the deferred asset will not be realized. Off-Balance-Sheet Financial Instruments In the ordinary course of business, the Corporation has entered into off-balance-sheet financial instruments consisting of commitments to extend credit, commitments under credit card arrangements, commercial letters of credit, and standby letters of credit. For letters of credit, the Corporation recognizes a liability for the fair market value of the obligations it assumes under that guarantee. Recent Developments During 2012, the Corporation adopted new guidance related to the presentation of comprehensive income in the financial statements. Among other changes, the new guidance eliminated the option to only present comprehensive income in the statement of equity. The Corporation has elected to report comprehensive income in a separate statement of comprehensive income that begins with net income. The change in presentation has been applied retrospectively and the 2011 financial statements have been restated to conform to the new presentation method. Other than the change in presentation of comprehensive income and related disclosures, the new guidance did not have a material effect on the financial statements. 25 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) In 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. This update applies to all creditors, both public and non-public, and was introduced to provide clarification surrounding troubled debt restructurings (“TDR”). The primary characteristics that previously caused a restructuring to qualify as a TDR still exist: (1) the restructuring constitutes a concession to the borrower and (2) the borrower is experiencing financial difficulties. The update provides additional details and examples to provide clarity surrounding these items. The update also prohibits the use of the effective interest rate test when determining whether the restructuring constitutes a concession. The update is effective for annual reporting periods ending on or after December 15, 2012 (therefore, December 31, 2012, for the Corporation). Lastly, the disclosure requirements set forth by ASU 2010-20 regarding troubled debt restructurings, and later deferred by ASU 2011-1 until December 31, 2012 for the Corporation, are included in Note 4, “Loans”. Other than the additional disclosures, these updates did not have a significant impact on the financial statements. In 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820) - Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS. This update to Fair Value Measurement (Topic 820) results in common fair value measurement and disclosure requirements in U.S. GAAP and IFRS. The amendments in this update explain how to measure fair value. They do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. However, this update does require expanded disclosure related to the nature and significance of inputs that are used in estimating and measuring the fair value of financial instruments. The amendments in this update are to be applied prospectively and are effective for annual reporting periods beginning after December 15, 2011 (therefore, December 31, 2012, for the Corporation). This update did not have a significant impact on the financial statements. Reclassifications Certain amounts in the 2011 and 2010 consolidated financial statements have been reclassified to conform to the 2012 presentation. NOTE 2 – RESTRICTIONS ON CASH AND CASH EQUIVALENTS Cash and cash equivalents in the amount of $4.049 million were restricted on December 31, 2012 to meet the reserve requirements of the Federal Reserve System. In the normal course of business, the Corporation maintains cash and due from bank balances with correspondent banks. Balances in these accounts may exceed the Federal Deposit Insurance Corporation’s insured limit of $250,000. Management believes that these financial institutions have strong credit ratings and the credit risk related to these deposits is minimal. 26 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 3 – SECURITIES AVAILABLE FOR SALE The carrying value and estimated fair value of securities available for sale are as follows (dollars in thousands): December 31, 2012 Amortized Cost Unrealized Gains Unrealized Losses Estimated Fair Value Corporate US Agencies US Agencies - MBS Obligations of states and political subdivisions $ 18,763 10,267 7,962 5,407 $ 237 137 412 637 $ (23) - - - $ 18,977 10,404 8,374 6,044 Total securities available for sale $ 42,399 $ 1,423 $ (23) $ 43,799 December 31, 2011 US Agencies - MBS US Agencies Corporate Obligations of states and political subdivisions Other asset backed $ 11,111 10,407 8,314 5,448 2,954 $ 387 168 - 110 - - $ - (136) (2) (34) $ 11,498 10,575 8,178 5,556 2,920 Total securities available for sale $ 38,234 $ 665 $ (172) $ 38,727 At December 31, 2012 and 2011, the mortgage backed securities portfolio was $8.374 million (19.12%) and $11.498 million (29.69%), respectively, of the securities portfolio. At December 31, 2012, the entire mortgage backed securities portfolio consisted of securities issued and guaranteed by either the Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corporation (FHLMC); United States government-sponsored agencies. Other asset backed securities are collateralized with government guaranteed student loans. Following is information pertaining to securities with gross unrealized losses at December 31, 2012 and 2011 aggregated by investment category and length of time these individual securities have been in a loss position (dollars in thousands): Less Than Twelve Months Gross Unrealized Losses Fair Value Over Twelve Months Gross Unrealized Losses Fair Value December 31, 2012 Corporate US Agencies - MBS Obligations of states and political subdivisions $ (23) - - $ 5,566 - - $ - - - $ - - - Total securities available for sale $ (23) $ 5,566 $ - $ - December 31, 2011 US Agencies - MBS Corporate Obligations of states and political subdivisions - $ (136) - $ 2,920 8,178 - - - (2) - - 250 Total securities available for sale $ (136) $ 11,098 $ (2) $ 250 There was one security in an unrealized loss position in 2012 and three in 2011. The gross unrealized losses in the current portfolio are considered temporary in nature and related to interest rate fluctuations. The Corporation has both the ability and intent to hold the investment securities until their respective maturities and therefore does not anticipate the realization of the temporary losses. 27 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 3 – SECURITIES AVAILABLE FOR SALE (CONTINUED) Following is a summary of the proceeds from sales and calls of securities available for sale, as well as gross gains and losses for the years ended December 31 (dollars in thousands): Proceeds from sales and calls Gross gains on sales Gross (losses) on sales and calls 2012 2011 2010 $ 2,601 - - $ 76 - (1) $ 8,302 216 (1) The carrying value and estimated fair value of securities available for sale at December 31, 2012, by contractual maturity, are shown below (dollars in thousands): Due in one year or less Due after one year through five years Due after five years through ten years Due after ten years Subtotal US Agencies - MBS Amortized Cost Estimated Fair Value $ 7,569 22,411 - 4,457 34,437 7,962 $ 7,629 22,745 - 5,051 35,425 8,374 Total $ 42,399 $ 43,799 Contractual maturities may differ from expected maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. See Note 9 for information on securities pledged to secure borrowings from the Federal Home Loan Bank. NOTE 4 - LOANS The composition of loans at December 31 is as follows (dollars in thousands): Commercial real estate Commercial, financial, and agricultural One to four family residential real estate Construction : Consumer Commerical Consumer 2012 2011 $ 244,966 80,646 87,948 $ 199,201 92,269 77,332 7,465 17,229 10,923 5,774 19,745 6,925 Total loans $ 449,177 $ 401,246 An analysis of the allowance for loan losses for the years ended December 31 is as follows (dollars in thousands): 2012 2011 2010 Balance, January 1 Recoveries on loans previously charged off Loans charged off Provision $ 5,251 278 (1,256) 945 $ 6,613 138 (3,800) 2,300 $ 5,225 374 (5,486) 6,500 Balance, December 31 $ 5,218 $ 5,251 $ 6,613 28 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) In 2012, net charge off activity was $.978 million, or .23% of average loans outstanding compared to net charge-offs of $3.662 million, or .94% of average loans, in the same period in 2011 and $5.112 million, or 1.33% of average loans, in 2010. During 2012, a provision of $.945 million was made to increase the allowance. This provision was made in accordance with the Corporation’s allowance for loan loss reserve policy, which calls for a measurement of the adequacy of the reserve at each quarter end. This process includes an analysis of the loan portfolio to take into account increases in loans outstanding and portfolio composition, historical loss rates, and specific reserve requirements of nonperforming loans. A breakdown of the allowance for loan losses and recorded balances in loans at December 31, 2012 is as follows (dollars in thousands): Commercial real estate Commercial, financial and agricultural Commercial construction One to four family residential real estate Consumer construction Consumer Unallocated Total Allowance for loan loss reserve: Beginning balance ALLR Charge-offs Recoveries Provision Ending balance ALLR Loans: Ending balance Ending balance ALLR Net loans Ending balance ALLR: Individually evaluated Collectively evaluated Total Ending balance Loans: Individually evaluated Collectively evaluated Total 2,823 (729) 52 1,121 3,267 244,966 (3,267) 241,699 1,662 1,605 3,267 22,910 222,056 244,966 1,079 (40) 201 (548) 692 80,646 (692) 79,954 155 537 692 6,070 74,576 80,646 207 (6) - (76) 125 17,229 (125) 17,104 10 115 125 858 16,371 17,229 $ $ $ $ $ $ 1,114 (399) 7 258 980 $ - - - - $ - $ - (82) 18 64 $ - 28 - - 126 154 5,251 (1,256) 278 945 5,218 $ $ $ $ $ $ $ $ $ $ $ $ 87,948 (980) 86,968 7,465 - 7,465 10,923 - 10,923 $ - (154) (154) $ $ $ 449,177 (5,218) 443,959 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 112 868 980 796 87,152 87,948 - $ - $ - - $ - $ - - $ 154 154 $ - $ 7,465 7,465 $ - $ 10,923 10,923 $ - $ - $ - $ $ 1,939 3,279 5,218 $ 30,634 418,543 449,177 $ Impaired loans, by definition, are individually evaluated. A breakdown of the allowance for loan losses, the activity for the period, and recorded balances in loans for the year ended December 31, 2011 is as follows (dollars in thousands): Commercial real estate Commercial, financial and Commercial construction agricultural One to four family residential real estate Consumer construction Consumer Unallocated Total Allowance for loan loss reserve: Beginning balance ALLR Charge-offs Recoveries Provision Ending balance ALLR Loans: Ending balance Ending balance ALLR Net loans Ending balance ALLR: Individually evaluated Collectively evaluated Total Ending balance Loans: Individually evaluated Collectively evaluated Total $ $ $ $ $ $ 3,460 (2,267) 32 1,598 2,823 1,018 (579) 21 619 1,079 389 (412) 75 155 207 1,622 (490) 1 (19) 1,114 - $ - - - $ - - $ (52) 9 43 $ - 124 - - (96) 28 6,613 (3,800) 138 2,300 5,251 $ $ $ $ $ $ $ $ $ $ $ $ $ 199,201 (2,823) 196,378 92,269 (1,079) 91,190 19,745 (207) 19,538 77,332 (1,114) 76,218 5,774 - 5,774 6,925 - 6,925 $ - (28) (28) $ $ $ 401,246 (5,251) 395,995 $ $ $ $ $ $ $ $ $ $ $ 926 1,897 2,823 160 919 1,079 1,707 90,562 92,269 $ $ 13,628 185,573 199,201 $ $ 114 1,000 1,114 $ - - $ - $ - - $ - $ - 28 28 $ - $ 5,774 5,774 $ - $ 6,925 6,925 $ - $ - $ - $ $ 1,200 4,051 5,251 $ 17,265 383,981 401,246 $ $ $ 1,930 75,402 77,332 Impaired loans, by definition, are individually evaluated. $ - 207 207 $ $ - 19,745 19,745 $ 29 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) A breakdown of the allowance for loan losses, the activity for the period, and recorded balances in loans for the year ended December 31, 2010 is as follows (dollars in thousands): Commercial real estate Commercial, financial and Commercial construction agricultural One to four family residential real estate Consumer construction Consumer Unallocated Total Allowance for loan loss reserve: Beginning balance ALLR Charge-offs Recoveries Provision Ending balance ALLR Loans: Ending balance Ending balance ALLR Net loans Ending balance ALLR: Individually evaluated Collectively evaluated Total Ending balance Loans: Individually evaluated Collectively evaluated Total 3,284 (2,426) 18 2,584 3,460 $ $ 194,859 (3,460) 191,399 1,601 1,859 3,460 18,610 176,249 194,859 1,135 (1,804) 260 1,427 1,018 68,858 (1,018) 67,840 330 688 1,018 2,696 66,162 68,858 386 (720) 67 656 389 33,330 (389) 32,941 39 350 389 2,437 30,893 33,330 $ $ $ $ $ $ $ $ $ $ $ $ 23 (416) - 2,015 1,622 - $ - - - $ - $ 13 (9) 15 (19) $ - 384 (111) 14 (163) 124 5,225 (5,486) 374 6,500 6,613 $ $ $ $ $ $ $ $ $ $ 75,074 (1,622) 73,452 5,682 - 5,682 5,283 - 5,283 $ - (124) (124) $ $ $ 383,086 (6,613) 376,473 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 696 926 1,622 5,238 69,836 75,074 - $ - $ - - $ - $ - - $ 124 124 $ - $ 5,682 5,682 $ - $ 5,283 5,283 $ - $ - $ - $ $ 2,666 3,947 6,613 $ 28,981 354,105 383,086 $ Impaired loans, by definition, are individually evaluated. As part of the management of the loan portfolio, risk ratings are assigned to all commercial loans. Through the loan review process, ratings are modified as believed to be appropriate to reflect changes in the credit. Our ability to manage credit risk depends in large part on our ability to properly identify and manage problem loans. To do so, we operate a credit risk rating system under which our credit management personnel assign a credit risk rating to each loan at the time of origination and review loans on a regular basis to determine each loan’s credit risk rating on a scale of 1 through 8, with higher scores indicating higher risk. The credit risk rating structure used is shown below. In the context of the credit risk rating structure, the term Classified is defined as a problem loan which may or may not be in a nonaccrual status, dependent upon current payment status and collectability. Excellent (1) Borrower is not vulnerable to sudden economic or technological changes and is in a non-seasonal business or industry. These loans generally would be characterized by having good experienced management and a strong liquidity position with minimal leverage. Good (2) Borrower shows limited vulnerability to sudden economic change with modest seasonal effect. Borrower has “above average” financial statements and an acceptable repayment history with minimal leverage and a profitability that exceeds peers. Average (3) Generally, a borrower rated as average may be susceptible to unfavorable changes in the economy and somewhat affected by seasonal factors. Some product lines may be affected by technological change. Borrowers in this category exhibit stable earnings, with a satisfactory payment history. Acceptable (4) The loan is an otherwise acceptable credit that warrants a higher level of administration due to various underlying weaknesses. These weaknesses, however, have not and may never deteriorate to the point of a Special Mention rating or Classified status. This rating category may include new businesses not yet having established a firm performance record. 30 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) Special Mention (5) The loan is not considered as a Classified status, however may exhibit material weaknesses that, if not corrected, may cause future problems. Borrowers in this category warrant special attention but have not yet reached the point of concern for loss. The borrower may have deteriorated to the point that they would have difficulty refinancing elsewhere. Similarly, purchasers of these businesses would not be eligible for bank financing unless they represent a significantly lessened credit risk. Substandard (6) The loan is Classified and exhibits a number of well-defined weaknesses that jeopardize normal repayment. The assets are no longer adequately protected due to declining net worth, lack of earning capacity or insufficient collateral offering the distinct possibility of the loss of a portion of the loan principal. Loans within this category clearly represent troubled and deteriorating credit situations requiring constant supervision and an action plan must be developed and approved by the appropriate officers to mitigate the risk. Doubtful (7) Loans in this category exhibit the same weaknesses used to describe the substandard credit; however, the traits are more pronounced. Loans are frozen with collection improbable. Such loans are not yet rated as Charge-off because certain actions may yet occur which would salvage the loan. Charge-off/Loss (8) Loans in this category are largely uncollectible and should be charged against the loan loss reserve immediately. General Reserves: For loans with a credit risk rating of 5 or better and any loans with a risk rating of 6 or 7 with no specific reserve, reserves are established based on the type of loan collateral, if any, and the assigned credit risk rating. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogenous loans based on historical loss experience, and consideration of current environmental factors and economic trends, all of which may be susceptible to significant change. Using a historical average loss by loan type as a base, each loan graded as higher risk is assigned a specific percentage. Within the commercial loan portfolio, the historical loss rates are used for specific industries such as hospitality, gaming, petroleum, and forestry. The residential real estate and consumer loan portfolios are assigned a loss percentage as a homogenous group. If, however, on an individual loan the projected loss based on collateral value and payment histories are in excess of the computed allowance, the allocation is increased for the higher anticipated loss. These computations provide the basis for the allowance for loan losses as recorded by the Corporation. In 2012 and 2011, commercial construction loans of $3.468 million and $3.694 million, respectively, did not receive a specific risk rating. These amounts represent loans made for land development and unimproved land purchases. Below is a breakdown of loans by risk category as of December 31, 2012 (dollars in thousands): Commercial real estate Commercial, financial and agricultural Commercial construction One-to-four family residential real estate Consumer construction Consumer (1) Excellent (2) Good (3) Average (4) Acceptable (5) Sp. Mention (6) Substandard (7) Doubtful Rating Unassigned Total $ 4,807 $ 20,491 $ 84,164 $ 113,379 $ 16,754 $ 5,189 $ 182 $ - $ 244,966 5,026 - - - - 3,936 1,038 1,969 - 359 23,821 5,103 3,635 - 71 41,785 5,784 4,791 - 257 4,296 759 - - - 1,782 1,077 646 - 6 - - - - - - 3,468 76,907 7,465 10,230 80,646 17,229 87,948 7,465 10,923 Total loans $ 9,833 $ 27,793 $ 116,794 $ 165,996 $ 21,809 $ 8,700 $ 182 $ 98,070 $ 449,177 31 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) Below is a breakdown of loans by risk category as of December 31, 2011 (dollars in thousands) Commercial real estate Commercial, financial and agricultural Commercial construction One-to-four family residential real estate Consumer construction Consumer (1) Excellent (2) Good (3) Average (4) Acceptable (5) Sp. Mention (6) Substandard (7) Doubtful Rating Unassigned Total $ 3,083 $ 16,946 $ 47,154 $ 118,259 $ 5,198 $ 7,642 $ 919 $ - $ 199,201 4,416 209 7,875 552 17,738 4,542 - - - - - - 3,359 - 105 60,498 10,415 5,910 - 599 201 313 2,023 - - 1,541 20 - - - - - - - - - 3,694 66,040 5,774 6,221 92,269 19,745 77,332 5,774 6,925 Total loans $ 7,708 $ 25,373 $ 72,898 $ 195,681 $ 7,735 $ 9,203 $ 919 $ 81,729 $ 401,246 Impaired Loans Nonperforming loans are those which are contractually past due 90 days or more as to interest or principal payments, on nonaccrual status, or loans, the terms of which have been renegotiated to provide a reduction or deferral on interest or principal. The interest income recorded during impairment and that which would have been recognized were $.054 million and $.313 million for the year ended December 31, 2012. For the year ended December 31, 2011, the amounts were $.118 million and $.363 million. The accrual of interest on loans is discontinued when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Loans are considered impaired when, based on current information and events, it is probable the Corporation will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loans basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible. 32 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) The following is a summary of impaired loans and their effect on interest income (dollars in thousands): Nonaccrual Basis Accrual Basis Average Investment Related Valuation Reserve Interest Income Recognized During Impairment Interest Income on Accrual Basis December 31, 2012 With no valuation reserve: Commercial real estate Commercial, financial and agricultural Commercial construction One to four family residential real estate Consumer construction Consumer With a valuation reserve: Commercial real estate Commercial, financial and agricultural Commercial construction One to four family residential real estate Consumer construction Consumer Total: Commercial real estate Commercial, financial and agricultural Commercial construction One to four family residential real estate Consumer construction Consumer Total December 31, 2011 With no valuation reserve: Commercial real estate Commercial, financial and agricultural Commercial construction One to four family residential real estate Consumer construction Consumer With a valuation reserve: Commercial real estate Commercial, financial and agricultural Commercial construction One to four family residential real estate Consumer construction Consumer Total: Commercial real estate Commercial, financial and agricultural Commercial construction One to four family residential real estate Consumer construction Consumer Total $ 132 - 675 230 - - $ 2,939 436 - 275 - - 3,071 436 675 505 - - 4,687 $ 1,313 16 - 608 - - $ 1,049 1,095 - 1,389 20 - 2,362 1,111 - 1,997 20 - 5,490 - $ - - - - - - $ - - - - - - $ - - - - - $ - $ - - - - - - $ 2,400 - - 103 - - 2,400 - - 103 - - 2,503 $ 1,550 1,063 675 1,074 16 3 $ 3,173 504 - 281 - - - $ - - - - - - $ - - - - - $ 37 19 15 41 1 - $ 1,315 109 - 95 - - $ 54 - - - - - $ 177 17 - 6 - - $ $ $ $ $ $ $ $ $ $ 54 - - - - - 54 86 29 - 3 - - 118 214 36 15 47 1 - 313 147 49 11 155 1 - 363 $ 2,519 542 176 1,727 4 2 $ 807 282 - 1,121 9 - $ - - - - - - $ 700 173 - 150 4 - $ 66 29 - - - - $ 20 - - 3 - - $ 116 35 11 99 - - $ 31 14 - 56 1 - $ $ $ $ $ $ $ $ $ $ $ $ 1,315 109 - 95 - - 1,519 700 173 - 150 4 - 1,027 4,723 1,567 675 1,355 16 3 8,339 3,326 824 176 2,848 13 2 7,189 33 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) A summary of past due loans at December 31, is as follows (dollars in thousands): Commercial real estate Commercial, financial and agricultural Commercial construction One to four family residential real estate Consumer construction Consumer 30-89 days Past Due (accruing) 2012 90+ days Past Due/ Nonaccrual $ 575 71 - 291 - 14 $ 3,071 436 675 505 - - Total $ 3,646 507 675 796 - 14 30-89 days Past Due (accruing) 2011 90+ days Past Due/ Nonaccrual $ 15 137 - 188 - 14 $ 2,362 1,111 - 1,997 20 - Total $ 2,377 1,248 - 2,185 20 14 Total past due loans $ 951 $ 4,687 $ 5,638 $ 354 $ 5,490 $ 5,844 A roll-forward of nonaccrual activity during the year ended December 31, 2012 (dollars in thousands): Commercial Real Estate Commercial, Financial and Agricultural Commercial Construction One to four family residential real estate Consumer Construction Consumer Total NONACCRUAL Beginning balance $ 2,362 $ 1,111 $ - $ 1,997 $ 20 $ - $ 5,490 Principal payments Charge-offs Advances Class transfers Transfers to OREO Transfers to accruing Transfers from accruing Other (1,569) (463) - - (675) - 3,377 39 (1,385) - - - - - 716 (6) - - - - - - 675 - (1,068) (387) - - (662) - 617 8 - (5) - - (15) - - - - (3) - - - - 3 (4,022) (858) - - (1,352) - 5,388 41 Ending balance $ 3,071 $ 436 $ 675 $ 505 $ - $ - $ 4,687 A roll-forward of nonaccrual activity during the year ended December 31, 2011 (dollars in thousands): Commercial Real Estate Commercial, Financial and Agricultural Commercial Construction One to four family residential real estate Consumer Construction Consumer Total NONACCRUAL Beginning balance $ 3,522 $ 760 $ 458 $ 1,129 $ 52 $ - $ 5,921 Principal payments Charge-offs Advances Class transfers Transfers to OREO Transfers to accruing Transfers from accruing Other (1,458) (1,950) - - (1,203) (892) 4,301 42 (767) (557) - - (262) - 1,938 (1) (14) (62) - - (382) - - - (47) (601) - - (1,948) - 3,273 191 - - - - (53) - 20 1 - (27) - - - - 27 - (2,286) (3,197) - - (3,848) (892) 9,559 233 Ending balance $ 2,362 $ 1,111 $ - $ 1,997 $ 20 $ - $ 5,490 34 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) Troubled Debt Restructuring Troubled debt restructurings (“TDR”) are determined on a loan-by-loan basis. Generally, restructurings are related to interest rate reductions, loan term extensions and short term payment forbearance as means to maximize collectability of troubled credits. If a portion of the TDR loan is uncollectible (including forgiveness of principal), the uncollectible amount will be charged off against the allowance at the time of the restructuring. In general, a borrower must make at least six consecutive timely payments before the Corporation would consider a return of a restructured loan to accruing status in accordance with FDIC guidelines regarding restoration of credits to accrual status. The Corporation has, in accordance with generally accepted accounting principles and per recently enacted accounting standard updates, evaluated all loan modifications to determine the fair value impact of the underlying asset. The carrying amount of the loan is compared to the expected payments to be received, discounted at the loan’s original rate, or for collateral dependent loans, to the fair value of the collateral. A summary of troubled debt restructurings that occurred during the years ended December 31 is as follows (dollars in thousands): 2012 2011 Number of Modifications Recorded Investment Number of Modifications Recorded Investment Commercial real estate Commercial, financial and agricultural Commercial construction One to four family residential real estate Consumer construction Consumer Total troubled debt restructurings 3 1 3 1 - - 8 $ 4,614 1,221 860 102 - - $ 6,797 1 - - - - - 1 $ 2,400 - - - - - $ 2,400 35 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) A roll-forward of troubled debt restructuring during the year ended December 31, 2012 (dollars in thousands): Commercial Real Estate Commercial, Financial and Agricultural Commercial Construction One to four family residential real estate Consumer and Consumer Construction Total ACCRUING Beginning balance $ 2,400 $ - $ - $ 103 $ - $ 2,503 Principal payments Charge-offs Advances New restructured Transferred out of TDR Transfers to nonaccrual Ending Balance NONACCRUAL (84) - - 3,695 - (2,400) - - - 1,221 - - (2) - - 860 - - (1) - - - - - - - - - - - (87) - - 5,776 - (2,400) $ 3,611 $ 1,221 $ 858 $ 102 $ - $ 5,792 Beginning balance $ - $ - $ - $ - $ - $ - Principal payments Charge-offs Advances New restructured Transfers to foreclosed properties Transfers from accruing Ending Balance TOTALS (432) (772) 47 919 - 2,400 - - - - - - - - - - - - - - - 102 - - - - - - - - (432) (772) 47 1,021 - 2,400 $ 2,162 $ - $ - $ 102 $ - $ 2,264 Beginning balance $ 2,400 $ - $ - $ 103 $ - $ 2,503 Principal payments Charge-offs Advances New restructured Transfers out of TDRs Tansfers to nonaccrual Transfers to foreclosed properties Transfers from accruing (516) (772) 47 4,614 - (2,400) - 2,400 - - - 1,221 - - - - (2) - - 860 - - - - (1) - - 102 - - - - - - - - - - - - (519) (772) 47 6,797 - (2,400) - 2,400 Ending Balance $ 5,773 $ 1,221 $ 858 $ 204 $ - $ 8,056 36 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) A roll-forward of troubled debt restructuring during the year ended December 31, 2011 (dollars in thousands): Commercial Real Estate Commercial, Financial and Agricultural Commercial Construction One to four family residential real estate Consumer and Consumer Construction Total ACCRUING Beginning balance $ 4,537 $ - $ - $ 105 $ - $ 4,642 Principal payments Charge-offs Advances New restructured Transferred out of TDRs Transfers to nonaccrual Ending Balance NONACCRUAL Beginning balance Principal payments Charge-offs Advances New restructured Transfers to foreclosed properties Transfers from accruing - - - 2,400 (582) (3,955) - - - - - - - - - - - - (2) - - - - - - - - - - - (2) - - 2,400 (582) (3,955) $ 2,400 $ - $ - $ 103 $ - $ 2,503 $ - $ - $ - $ - $ - $ - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Ending Balance $ - $ - $ - $ - $ - $ - TOTALS Beginning balance $ 4,537 $ - $ - $ 105 $ - $ 4,642 Principal payments Charge-offs Advances New restructured Transfers out of TDRs Transfers to nonaccrual Transfers to foreclosed properties Transfers from accruing - - - 2,400 (582) (3,955) - - - - - - - - - - - - - - - - - - (2) - - - - - - - - - - - - - - - (2) - - 2,400 (582) (3,955) - - Ending Balance $ 2,400 $ - $ - $ 103 $ - $ 2,503 Insider Loans The Bank, in the ordinary course of business, grants loans to the Corporation’s executive officers and directors, including their families and firms in which they are principal owners. Activity in such loans is summarized below (dollars in thousands): Loans outstanding, January 1 New loans Net activity on revolving lines of credit Repayment 2012 2011 $ 8,827 3,911 233 (1,674) $ 9,532 933 69 (1,707) Loans outstanding, December 31 $ 11,297 $ 8,827 There were no loans to related-parties classified substandard as of December 31, 2012 and 2011. In addition to the outstanding balances above, there were unfunded commitments of $.058 million to related parties at December 31, 2012. 37 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 5 – PREMISES AND EQUIPMENT Details of premises and equipment at December 31 are as follows (dollars in thousands): Land Buildings and improvements Furniture, fixtures, and equipment Construction in progress Total cost basis Less - accumulated depreciation 2012 2011 $ 2,062 13,151 5,916 19 21,148 10,515 $ 1,811 12,141 4,933 196 19,081 9,454 Net book value $ 10,633 $ 9,627 Depreciation of premises and equipment charged to operating expenses amounted to $1.092 million in 2012, $1.067 million in 2011, and $1.098 million in 2010. NOTE 6 – OTHER REAL ESTATE HELD FOR SALE An analysis of other real estate held for sale for the years ended December 31 is as follows (dollars in thousands): 2012 2011 Balance, January 1 Other real estate transferred from loans due to foreclosure Other real estate sold Writedowns of other real estate held for sale Loss on other real estate held for sale $ 3,162 1,352 (775) (496) (31) $ 5,562 4,194 (5,457) (855) (282) Balance, December 31 $ 3,212 $ 3,162 NOTE 7 – DEPOSITS The distribution of deposits at December 31 is as follows (dollars in thousands): Noninterest bearing NOW, money market, checking Savings CDs <$100,000 CDs >$100,000 Brokered Total deposits 2012 2011 $ 67,652 155,465 13,829 135,550 24,355 37,706 $ 51,273 152,563 14,203 130,685 23,229 32,836 $ 434,557 $ 404,789 Maturities of non-brokered time deposits outstanding at December 31, 2012 are as follows (dollars in thousands): 2013 2014 2015 2016 2017 Thereafter Total $ 71,289 43,892 18,900 23,827 1,997 - $ 159,905 38 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 8 – MORTGAGE SERVICING RIGHTS Mortgage servicing rights (“MSRs”) are recorded when loans are sold in the secondary market with servicing retained. As of December 31, 2012, the Corporation had obligations to service approximately $97 million of residential first mortgage loans. The valuation is based upon the net present value of the projected revenues over the expected life of the loans being serviced, as reduced by estimated internal costs to service these loans. The fair value of the capitalized servicing rights approximates the carrying value. The key economic assumptions used in determining the fair value of the mortgage servicing rights include an annual constant prepayment speed of 15.90 months and a discount rate of 7.50% for December 31, 2012. The following summarizes mortgage servicing rights capitalized and amortized, along with the aggregate activity in related valuation allowances (dollars in thousands): December 31, 2012 December 31, 2011 Balance at beginning of period Additions from loans sold with servicing retained Amortization $ 400 344 (106) - $ 415 (15) Book value of MSRs at end of period $ 638 $ 400 NOTE 9 – BORROWINGS Borrowings consist of the following at December 31 (dollars in thousands): Federal Home Loan Bank fixed rate advances at December 31, 2012 with a weighted average rate of 1.82% maturing in 2013, 2014 and 2016 USDA Rural Development, fixed-rate note payable, maturing August 24, 2024 interest payable at 1% 2012 2011 $ 35,000 $ 35,000 925 997 $ 35,925 $ 35,997 The Federal Home Loan Bank borrowings are collateralized at December 31, 2012 by the following: a collateral agreement on the Corporation’s one to four family residential real estate loans with a book value of approximately $42.231 million; mortgage related and municipal securities with an amortized cost and estimated fair value of $6.770 million and $7.136 million, respectively; and Federal Home Loan Bank stock owned by the Bank totaling $3.060 million. Prepayment of the advances is subject to the provisions and conditions of the credit policy of the Federal Home Loan Bank of Indianapolis in effect as of December 31, 2012. The USDA Rural Development borrowing is collateralized by loans totaling $.152 million originated and held by the Corporation’s wholly owned subsidiary, First Rural Relending and an assignment of a demand deposit account in the amount of $.857 million, and guaranteed by the Corporation. Maturities and principal payments of borrowings outstanding at December 31, 2012 are as follows (dollars in thousands): 2013 2014 2015 2016 2017 Thereafter Total $ 10,073 10,074 74 15,075 76 553 $ 35,925 39 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 10 – INCOME TAXES The components of the federal income tax provision (credit) for the years ended December 31 are as follows (dollars in thousands): Current tax expense (benefit) Change in valuation allowance Deferred tax expense (benefit) 2012 2011 2010 - $ (3,000) 2,078 $ 314 - 784 $ - (2,136) (1,364) Provision for (benefit of) income taxes $ (922) $ 1,098 $ (3,500) A summary of the source of differences between income taxes at the federal statutory rate and the provision (credit) for income taxes for the years ended December 31 is as follows (dollars in thousands): Tax expense at statutory rate Increase (decrease) in taxes resulting from: Tax-exempt interest Change in valuation allowance Other 2012 2011 2010 $ 2,096 $ 1,127 $ (1,332) (49) (3,000) 31 (59) - 30 (73) (2,136) 41 Provision for (benefit of) income taxes, as reported $ (922) $ 1,098 $ (3,500) Deferred income taxes are provided for the temporary differences between the financial reporting and tax bases of the Corporation’s assets and liabilities. The major components of net deferred tax assets at December 31 are as follows (dollars in thousands): Deferred tax assets: NOL carryforward Allowance for loan losses Alternative Minimum Tax Credit OREO Tax basis > book basis Tax credit carryovers Deferred compensation Stock compensation Depreciation Intangible assets Other Total deferred tax assets Valuation allowance Deferred tax liabilities: FHLB stock dividend Unrealized gain on securities Mortgage servicing rights Total deferred tax liabilities 2012 2011 $ 7,149 1,774 1,463 1,025 672 185 265 174 60 170 $ 9,073 1,785 1,463 1,050 672 217 172 225 77 110 12,937 14,844 $ (3,010) $ (6,010) (103) (476) (217) (796) (103) (168) (136) (407) Net deferred tax asset $ 9,131 $ 8,427 40 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 10 – INCOME TAXES (CONTINUED) A valuation allowance is provided against deferred tax assets when it is more likely than not that some or all of the deferred tax asset will not be realized. The Corporation, as of December 31, 2012 had a net operating loss and tax credit carryforwards for tax purposes of approximately $21.235 million, and $2.136 million, respectively. The Corporation will continue to evaluate the future benefits from these carryforwards and at such time as it becomes “more likely than not” that they would be utilized prior to expiration will recognize the additional benefits as an adjustment to the valuation allowance. The net operating loss carryforwards expire twenty years from the date they originated. These carryforwards, if not utilized, will begin to expire in the year 2023. A portion of the NOL, approximately $8.4 million, and all of the credit carryforwards are subject to the limitations for utilization as set forth in Section 382 of the Internal Revenue Code. The annual limitation is $1.404 million for the NOL and the equivalent value of tax credits, which is approximately $.476 million. These limitations for use were established in conjunction with the recapitalization of the Corporation in December 2004. The Corporation recognized a deferred tax benefit of approximately $.922 million for the year ended December 31, 2012 and a deferred tax liability of $1.098 million for the year ended December 31, 2011. The valuation allowance at December 31, 2012 was approximately $3.0 million. The Corporation reduced the valuation allowance by $3.0 million at June 30, 2012 since it was determined that it was “more likely than not” that these benefits would be realized. The Corporation made this determination after a thorough review of projected earnings and the composition and sustainability of those earnings over the projected tax carryover period. This analysis substantiated the ability to utilize these deferred tax assets. Management evaluated the deferred tax valuation allowance as of December 31, 2012 and determined that an adjustment to the valuation allowance was not warranted. The Corporation will continue to evaluate the future benefits from these carryforwards and at such time as it becomes “more likely than not” that they would be utilized prior to expiration will recognize the additional benefits as an adjustment to the valuation allowance. NOTE 11 – OPERATING LEASES The Corporation currently maintains three operating leases for office locations. The first operating lease, for our location in Birmingham, was originated in September 2005 and had an original term of 66 months with an option to renew for an additional five year period. The original term of this was extended during 2011 for an additional three year term. The second operating lease, for a second location in Manistique, was executed in April 2010, the terms of which began at that time. The original term of this lease is three years and will automatically renew and extend for four additional consecutive terms of two years each. The third operating lease, for a loan production office in Traverse City, was executed in May 2012, the terms of which began in August 2012. The original term of this lease is three years with options for two consecutive renewal terms of three years each. Future minimum payments, by year and in the aggregate, under the initial terms of the operating lease agreements, consist of the following (dollars in thousands): 2013 2014 2015 Total $ 249 190 34 $ 473 Rent expense for all operating leases amounted to $269,000 in 2012, $260,000 in 2011, and $270,000 in 2010. 41 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 12 – RETIREMENT PLAN The Corporation has established a 401(k) profit sharing plan. Employees who have completed three months of service and attained the age of 18 are eligible to participate in the plan. Eligible employees can elect to have a portion, not to exceed 80%, of their annual compensation paid into the plan. In addition, the Corporation may make discretionary contributions into the plan. Retirement plan contributions charged to operations totaled $161,000, $125,000, and $110,000 in 2012, 2011, and 2010, respectively. NOTE 13 – DEFERRED COMPENSATION PLAN Prior to the recapitalization in 2004, as an incentive to retain key members of management and directors, the Corporation established a deferred compensation plan, with benefits based on the number of years the individuals have served the Corporation. This plan was discontinued and no longer applies to current officers and directors. A liability was recorded on a present value basis and discounted using the rates in effect at the time the deferred compensation agreement was entered into. The liability may change depending upon changes in long-term interest rates. The liability at December 31, 2012 and 2011, for vested benefits under this plan, was $.545 million and $.638 million, respectively. These benefits were originally contracted to be paid over a ten to fifteen-year period. The final payment is scheduled to occur in 2023. The deferred compensation plan is unfunded; however, the Bank maintains life insurance policies on the majority of the plan participants. The cash surrender value of the policies was $1.545 million and $1.626 million at December 31, 2012 and 2011, respectively. Deferred compensation expense for the plan was $30,000, $35,000, and $43,000 for 2012, 2011, and 2010, respectively. NOTE 14 – REGULATORY MATTERS The Corporation is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory—and possibly additional discretionary—actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation must meet specific capital guidelines that involve quantitative measures of the Corporation’s assets, liabilities, and certain off-balance- sheet items as calculated under regulatory accounting practices. The Corporation’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Corporation to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets. Management has determined that, as of December 31, 2012, the Corporation is well capitalized. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. In addition, federal banking regulators have established capital classifications beyond the minimum requirements in order to risk-rate deposit insurance premiums and to provide trigger points for prompt corrective action. 42 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 14 – REGULATORY MATTERS (CONTINUED) The Corporation’s and the Bank’s actual capital and ratios compared to generally applicable regulatory requirements as of December 31 are as follows (dollars in thousands): Actual Amount Ratio Adequacy Purposes Amount Ratio Action Provisions Amount Ratio 2012 Total capital to risk weighted assets: Consolidated mBank Tier 1 capital to risk weighted assets: Consolidated mBank Tier 1 capital to average assets: Consolidated mBank 2011 Total capital to risk weighted assets: Consolidated mBank Tier 1 capital to risk weighted assets: Consolidated mBank Tier 1 capital to average assets: Consolidated mBank $ $ 69,573 56,879 14.9% > 12.2% > $ $ 37,283 37,262 > 8.0% > 8.0% > N/A $ 46,577 N/A 10.0% $ $ 64,355 51,701 13.8% > 11.1% > $ $ 18,642 18,631 > 4.0% > 4.0% > N/A $ 27,946 N/A 6.0% $ $ 64,355 51,701 12.0% > 9.6% > $ $ 21,486 21,481 > 4.0% > 4.0% > N/A $ 26,851 N/A 5.0% $ $ 53,604 49,551 12.9% 11.9% > > $ $ 33,314 33,309 > 8.0% > 8.0% N/A $ 41,637 > N/A 10.0% $ $ 48,398 44,346 11.6% 10.7% > > $ $ 16,657 16,655 > 4.0% > 4.0% N/A $ 24,982 > N/A 6.0% $ $ 48,398 44,346 10.1% 9.2% > > $ $ 19,205 19,196 > 4.0% > 4.0% N/A $ 23,995 > N/A 5.0% NOTE 15 – STOCK COMPENSATION PLANS On May 22, 2012, the Company’s shareholders approved the Mackinac Financial Corporation 2012 Incentive Compensation Plan, under which current and prospective employees, non-employee directors and consultants may be awarded incentive stock options, non-statutory stock options, shares of restricted stock units (“RSUs”), or stock appreciation rights. The aggregate number of shares of the Company’s common stock issuable under the plan is 757,848. The Corporation also has three various stock compensation plans which are now expired. One plan was approved during 2000 and applied to officers, employees, and nonemployee directors. This plan was amended as a part of the December 2004 stock offering and recapitalization. The amendment, approved by shareholders, increased the shares available under this plan by 428,587 shares from the original 25,000 (adjusted for the 1:20 reverse stock split), to a total authorized share balance of 453,587. The other two plans, one for officers and employees and the other for nonemployee directors, were approved in 1997. A total of 30,000 shares (adjusted for the 1:20 split), were made available for grant under these plans. Options under all of the plans were granted at the discretion of a committee of the Corporation’s Board of Directors. Options to purchase shares of the Corporation’s stock were granted at a price equal to the market price of the stock at the date of grant. The committee determined the vesting of the options when they were granted as established under the plan. 43 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 15 – STOCK COMPENSATION PLANS (CONTINUED) The Corporation, in August 2012, granted 148,500 Restricted Stock Units (“RSU’s”) to members of the Board of Directors and Management. These RSU’s were granted at a market value of $7.91 and will vest equally over a four year term. In exchange for the grant of RSU’s various previously issued stock option awards were surrendered. The RSUs were awarded at no cost to the employee and vest ratably over a four-year period. Compensation cost to be recognized over the four –year vesting period, net of income tax, is $.775 million. As of December 31, 2012, none of the RSUs were vested and unrecognized compensation expense, net of income tax, was $.709 million. A summary of stock option transactions for the years ended December 31 is as follows: Outstanding shares at beginning of year Granted during the year Exercised during the year Expired / forfeited during the year Surrendered/exchanged for restricted stock 2012 2011 392,152 - - - (150,000) 394,072 - - (1,920) - Outstanding shares at end of year 242,152 392,152 Exercisable shares at end of year 126,361 148,861 Weighted average exercise price per share at end of year $ 9.88 $ 10.27 Shares available for grant at end of year - - Following is a summary of the options outstanding and exercisable at December 31, 2012: Exercise Price $ $ $ $ 9.16 9.75 10.65 12.00 Outstanding Number of Shares Exercisable Unvested Options 2,500 217,152 12,500 10,000 242,152 1,000 120,861 2,500 2,000 126,361 1,500 96,291 10,000 8,000 115,791 Weighted Average Remaining Contractual Life-Years 2.96 1.96 2.75 2.46 2.10 Options issued since the Corporation’s recapitalization in December of 2004 call for 20% immediate vesting upon issue and subsequent vesting to occur over a two to five year period, based upon the market value appreciation of the underlying Corporation’s stock. Compensation related to these options was expensed based upon the vesting period without consideration given to market value appreciation. There are no future compensation expenses related to existing option programs. 44 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 16 – SHAREHOLDERS’ EQUITY In August 2012 the corporation consummated the previously announced $7.000 million rights offering and the investment by Steinhardt Capital Investors, LLLP (“SCI”) by issuing 2,140,123 shares of common stock for net proceeds of $11.506 million. Also, in August 2012, the Corporation exited the TARP Capital Purchase Program (“CPP”) when the Corporations 11,000 Series A Preferred Shares, issued in April, 2009 to the U.S. Treasury, were publically offered and sold. The Corporation repurchased the 379,310 of Common Stock Warrants issued to the U.S. Treasury under the CPP in December, 2012 for $1.3 million. Participation in the TARP Capital Purchase Program On April 24, 2009, the Corporation entered into and closed a Letter Agreement, including the Securities Purchase Agreement-Standard Terms (collectively, the “Securities Purchase Agreement”), related to the CPP. Pursuant to the Securities Purchase Agreement, the Corporation issued and sold to the Treasury (i) 11,000 shares of the Corporation’s Series A Preferred Shares, and (ii) a 10-year Warrant to purchase 379,310 shares of the Corporation’s Common Shares, at an exercise price of $4.35 per share (subject to certain anti-dilution and other adjustments), for aggregate proceeds of $11.000 million in cash. Amounts recorded for Preferred Stock and Warrant Common Stock were estimated based on an allocation of the total proceeds from the issuance on the relative fair values of both instruments. Fair value of the Preferred Stock was determined based on assumptions regarding the discount rate (market rate) on the Preferred Stock (estimated 12%). Fair value of the Warrant Common Stock is based on the value of the underlying Preferred Stock based on an estimate for a three year term. The allocation of the proceeds received resulted in the recording of a discount on the Preferred Stock and a premium on the Warrant Common Stock. The discount on the preferred was accreted on an effective yield basis over a three-year term. The allocated carrying value of the Preferred Stock and Warrant Common Stock on the date of issuance (based on their relative fair values) was $10.382 million and $.618 million, respectively. Cumulative dividends on the Preferred Stock are payable at 5% annum for the first five years and at a rate of 9% per annum thereafter on the liquidation preference of $1,000 per share. The Company is prohibited from paying any dividend with respect to shares of common stock unless all accrued and unpaid dividends are paid in full on the Preferred Stock for all past dividend periods. The Preferred Stock is non-voting, other than class voting rights on matters that could adversely affect the Preferred Stock. The Preferred Stock was auctioned by the Treasury in 2012 and is now held by various investors. The Preferred Stock may be redeemed at any time with regulatory approval. NOTE 17 - COMMITMENTS, CONTINGENCIES, AND CREDIT RISK Financial Instruments with Off-Balance-Sheet Risk The Corporation is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets. 45 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 17 - COMMITMENTS, CONTINGENCIES, AND CREDIT RISK (CONTINUED) The Corporation’s exposure to credit loss, in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit, is represented by the contractual amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on- balance-sheet instruments. These commitments at December 31 are as follows (dollars in thousands): Commitments to extend credit: Variable rate Fixed rate Standby letters of credit - Variable rate Credit card commitments - Fixed rate 2012 2011 $ 39,782 18,427 2,879 3,060 $ 28,495 15,453 3,523 3,019 $ 64,148 $ 50,490 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The commitments are structured to allow for 100% collateralization on all standby letters of credit. Credit card commitments are commitments on credit cards issued by the Corporation’s subsidiary and serviced by other companies. These commitments are unsecured. Legal Proceedings and Contingencies At December 31, 2012, there were no pending material legal proceedings to which the Corporation is a party or to which any of its property was subject, except for proceedings which arise in the ordinary course of business. In the opinion of management, pending legal proceedings will not have a material effect on the consolidated financial position or results of operations of the Corporation. Concentration of Credit Risk The Bank grants commercial, residential, agricultural, and consumer loans throughout Michigan. The Bank’s most prominent concentration in the loan portfolio relates to commercial real estate loans to operators of nonresidential buildings. This concentration at December 31, 2012 represents $95.151 million, or 27.75%, compared to $75.391 million, or 24.22%, of the commercial loan portfolio on December 31, 2011. The remainder of the commercial loan portfolio is diversified in such categories as hospitality and tourism, real estate agents and managers, new car dealers, gaming, petroleum, forestry, agriculture, and construction. Due to the diversity of the Bank’s locations, the ability of debtors of residential and consumer loans to honor their obligations is not tied to any particular economic sector. 46 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 18 - FAIR VALUE Fair value estimates, methods, and assumptions are set forth below for the Corporation’s financial instruments: Cash, cash equivalents, and interest-bearing deposits - The carrying values approximate the fair values for these assets. Securities - Fair values are based on quoted market prices where available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals. Federal Home Loan Bank stock – Federal Home Loan Bank stock is carried at cost, which is its redeemable value and approximates its fair value, since the market for this stock is limited. Loans - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, residential mortgage, and other consumer. The fair value of loans is calculated by discounting scheduled cash flows using discount rates reflecting the credit and interest rate risk inherent in the loan. The methodology in determining fair value of nonaccrual loans is to average them into the blended interest rate at 0% interest. This has the effect of decreasing the carrying amount below the risk-free rate amount and, therefore, discounts the estimated fair value. Impaired loans are measured at the estimated fair value of the expected future cash flows at the loan’s effective interest rate or the fair value of the collateral for loans which are collateral dependent. Therefore, the carrying values of impaired loans approximate the estimated fair values for these assets. Deposits - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits and savings, is equal to the amount payable on demand at the reporting date. The fair value of time deposits is based on the discounted value of contractual cash flows applying interest rates currently being offered on similar time deposits. Borrowings - Rates currently available for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt. The fair value of borrowed funds due on demand is the amount payable at the reporting date. Accrued interest - The carrying amount of accrued interest approximates fair value. Off-balance-sheet instruments - The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the current interest rates, and the present creditworthiness of the counterparties. Since the differences in the current fees and those reflected to the off-balance-sheet instruments at year-end are immaterial, no amounts for fair value are presented. 47 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 18 - FAIR VALUE (CONTINUED) The following table presents information for financial instruments at December 31 (dollars in thousands): Financial assets: Cash and cash equivalents Interest-bearing deposits Securities available for sale Federal Home Loan Bank stock Net loans Accrued interest receivable Total financial assets Financial liabilities: Deposits Borrowings Accrued interest payable Total financial liabilties Level in Fair Value Hierarchy Carrying Amount Estimated Fair Value December 31, 2012 December 31, 2011 Carrying Amount Estimated Fair Value Level 1 Level 2 Level 2 Level 2 Level 2 Level 2 Level 2 Level 2 Level 2 $ 26,961 10 43,799 3,060 443,959 1,319 $ 26,961 10 43,799 3,060 439,239 1,319 $ 34,070 10 38,727 3,060 395,995 1,261 $ 34,070 10 38,727 3,060 394,463 1,261 $ 519,108 $ 514,388 $ 473,123 $ 471,591 $ 434,557 35,925 214 $ 434,227 35,729 214 $ 404,789 35,997 202 $ 404,821 35,634 202 $ 470,696 $ 470,170 $ 440,988 $ 440,657 Limitations - Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Corporation’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Corporation’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on-and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial assets or liabilities include premises and equipment, other assets, and other liabilities. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates. The following is information about the Corporation’s assets and liabilities measured at fair value on a recurring basis at December 31, 2012 and the valuation techniques used by the Corporation to determine those fair values. Level 1: liabilities that the Corporation has the ability to access. In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or Level 2: 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 and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3: Level 3 inputs are unobservable inputs, including inputs available in situations where there is little, if any, market activity for the related asset or liability. The fair value of all investment securities at December 31, 2012 and December 31, 2011 were based on level 2 inputs. There are no other assets or liabilities measured on a recurring basis at fair value. For additional information regarding investment securities, please refer to “Note 3 – Investment Securities.” The Corporation had no Level 3 assets or liabilities on a recurring basis as of December 31, 2012 or December 31, 2011. 48 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 18 - FAIR VALUE (CONTINUED) In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Corporation’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability. The Corporation also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets include loans and other real estate held for sale. The Corporation has estimated the fair values of these assets using Level 3 inputs, specifically discounted cash flow projections. Assets Measured at Fair Value on a Nonrecurring Basis at December 31, 2012 Balance at December 31, 2012 Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Significant Other Observable Unobservable Inputs (Level 2) Inputs (Level 3) Total Losses for Year Ended December 31, 2012 (dollars in thousands) Assets Impaired loans Other real estate held for sale $ 4,687 3,212 $ - - $ - - $ 4,687 3,212 $ 1,151 489 $ 1,640 (dollars in thousands) Assets Assets Measured at Fair Value on a Nonrecurring Basis at December 31, 2011 Balance at December 31, 2011 Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Total Losses for Year Ended December 31, 2011 Impaired loans Other real estate held for sale $ 7,993 3,162 - $ - - $ - $ 7,993 3,162 $ 3,200 1,137 $ 4,337 The Corporation had no investments subject to fair value measurement on a nonrecurring basis. Impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Corporation estimates 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). 49 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 19 - PARENT COMPANY ONLY FINANCIAL STATEMENTS BALANCE SHEETS December 31, 2012 and 2011 (Dollars in Thousands) ASSETS Cash and cash equivalents Investment in subsidiaries Other assets TOTAL ASSETS LIABILITIES AND SHAREHOLDERS' EQUITY Other liabilities Shareholders' equity: Preferred stock - no par value: Authorized 500,000 shares, 11,000 shares issued and outstanding Common stock and additional paid in capital - no par value Authorized 18,000,000 shares Issued and outstanding - 5,559,859 and 3,419,736 shares respectively Retained earnings Accumulated other comprehensive income Total shareholders' equity 2012 2011 $ 12,943 59,854 117 $ 4,301 51,381 245 $ 72,914 $ 55,927 $ 466 $ 664 11,000 10,921 53,797 6,727 924 72,448 43,525 492 325 55,263 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 72,914 $ 55,927 50 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 19 - PARENT COMPANY ONLY FINANCIAL STATEMENTS (CONTINUED) STATEMENTS OF OPERATIONS Years Ended December 31, 2012, 2011, and 2010 (Dollars in Thousands) INCOME: Interest income Total income EXPENSES: Salaries and benefits Professional service fees Other Total expenses Income (loss) before income taxes and equity in undistributed net income (loss) of subsidiaries Provision for (benefit of) income taxes 2012 2011 2010 $ 3 $ 3 $ 11 $ 3 $ 3 $ 11 280 562 340 1,182 (1,179) (393) 180 245 223 648 (645) (211) 218 136 147 501 (490) - (490) 72 (418) 742 (Loss) before equity in undistributed net income (loss) of subsidiaries (786) (434) Equity in undistributed net income of subsidiaries Net income (loss) Preferred dividend and accretion of discount 7,873 7,087 629 2,652 2,218 766 NET INCOME (LOSS) AVAILABLE TO COMMON SHAREHOLDERS $ 6,458 $ 1,452 $ (1,160) 51 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 19 - PARENT COMPANY ONLY FINANCIAL STATEMENTS (CONTINUED) STATEMENTS OF CASH FLOWS Years Ended December 31, 2012, 2011, and 2010 (Dollars in Thousands) Cash Flows from Operating Activities: Net income (loss) Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed net (income) of subsidiaries Increase in capital from stock compensation Change in other assets Change in other liabilities Net cash (used in) operating activities Cash Flows from Financing Activities: Proceeds from issuance of common stock Purchase of common stock warrants Dividend on preferred stock Dividend on common stock Investments in subsidiaries Net cash (used in) provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period 2012 2011 2010 $ 7,087 $ 2,218 $ (418) (7,873) 66 92 (163) (791) 11,506 (1,300) (550) (223) - 9,433 8,642 4,301 (2,652) - 29 (97) (502) - - (551) - - (551) (1,053) 5,354 (72) 32 31 (149) (576) - - (550) - (1,000) (1,550) (2,126) 7,480 Cash and cash equivalents at end of period $ 12,943 $ 4,301 $ 5,354 52 Selected Financial Data MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES SELECTED FINANCIAL DATA (Unaudited) (Dollars in Thousands, Except Per Share Data) Years Ended December 31 SELECTED FINANCIAL CONDITION DATA: Total assets Loans Securities Deposits Borrowings Common shareholders' equity Total shareholders' equity 2012 2011 2010 2009 2008 $ 545,980 449,177 43,799 434,557 35,925 61,448 72,448 $ 498,311 401,246 38,727 404,789 35,997 44,342 55,263 $ 478,696 383,086 33,860 386,779 36,069 43,176 53,882 $ 515,377 384,310 46,513 421,389 36,140 44,785 55,299 $ 451,431 370,280 47,490 371,097 36,210 41,552 41,552 SELECTED OPERATIONS DATA: Interest income Interest expense Net interest income Provision for loan losses Net security gains (losses) Other income Other expenses Income (loss) before income taxes Provision (credit) for income taxes Net income (loss) Preferred dividend and accretion of discount Net income available to common shareholders PER SHARE DATA: Earnings (loss) - Basic Earnings (loss) - Diluted Cash dividends declared Book value Market value - closing price at year end FINANCIAL RATIOS: Return on average common equity Return on average total equity Return on average assets Dividend payout ratio Average equity to average assets Efficiency ratio Net interest margin $ $ $ $ $ 24,427 4,603 19,824 945 - 4,043 (16,757) 6,165 (922) 7,087 629 6,458 23,072 5,143 17,929 2,300 (1) 3,657 (15,969) 3,316 1,098 2,218 766 1,452 22,840 6,455 16,385 6,500 215 2,580 (16,598) (3,918) (3,500) (418) 742 (1,160) 23,708 7,421 16,287 3,700 1,471 3,280 (13,802) 3,536 1,120 2,416 509 1,907 24,562 11,698 12,864 2,300 64 4,589 (12,558) 2,659 787 1,872 - 1,872 $ $ $ $ $ $ 1.51 1.46 .04 11.05 7.09 $ .42 .41 - 12.97 5.42 $ (.34) (.34) - 12.63 4.58 $ .56 .56 - 13.10 4.64 $ .55 .55 - 12.15 4.40 % 12.43 10.26 1.23 2.65 11.95 67.95 4.17 % 3.30 2.66 .30 N/A 11.15 68.43 4.06 % (2.64) (2.06) (.23) N/A 11.17 72.57 3.66 % 4.42 3.77 .39 N/A 10.24 72.24 3.59 % 4.61 4.61 .44 N/A 9.55 85.51 3.23 53 Summary Quarterly Financial Information MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES SUMMARY QUARTERLY FINANCIAL INFORMATION (Unaudited) (Dollars in Thousands, Except per Share Data) BALANCE SHEET Total loans Allowance for loan losses Total loans, net Intangible assets Total assets Core deposits Noncore deposits (1) Total deposits Total borrowings Common shareholder' equity Total shareholders' equity Total tangible equity Total shares outstanding Weighted average shares outstanding AVERAGE BALANCE SHEET Total loans Allowance for loan losses Total loans, net Intangible assets Total assets Core deposits Noncore deposits (1) Total deposits Total borrowings Total shareholders' equity ASSET QUALITY RATIOS Nonperforming loans/total loans Nonperforming assets/total assets Allowance for loan losses/total loans Allowance for loan losses/nonperforming loans Net charge-offs/average loans Texas Ratio (2) CAPITAL ADEQUACY RATIOS Tier 1 leverage ratio Tier 1 capital to risk weighted assets Total capital to risk weighted assets Average equity/average assets Tangible equity/tangible assets FOR THE QUARTER ENDED 2012 FOR THE QUARTER ENDED 2011 12/31 9/30 6/30 3/31 12/31 9/30 6/30 3/31 $ 449,177 (5,218) 443,959 - 545,980 372,496 62,061 434,557 35,925 61,448 72,448 71,810 5,559,859 5,559,859 $ 433,958 (5,186) 428,772 - 551,117 372,500 66,863 439,363 35,925 61,945 72,945 72,374 5,559,859 4,722,029 $ 419,453 (5,083) 414,370 - 524,366 357,933 67,448 425,381 35,997 49,352 60,352 59,827 3,419,736 3,419,736 $ 414,402 (5,382) 409,020 - 506,496 355,186 56,902 412,088 35,997 45,119 56,095 55,645 3,419,736 3,419,736 $ 401,246 (5,251) 395,995 - 498,311 348,724 56,065 404,789 35,997 55,263 55,263 54,863 3,419,736 3,419,736 $ 391,903 (5,838) 386,065 - 498,598 346,843 58,215 405,058 35,997 55,479 55,479 55,179 3,419,736 3,419,736 $ 394,812 (6,155) 388,657 - 492,373 329,958 69,709 399,667 36,069 54,784 54,784 54,784 3,419,736 3,419,736 $ 374,609 (6,184) 368,425 - 492,790 315,638 85,145 400,783 36,069 54,097 54,097 54,097 3,419,736 3,419,736 $ 438,168 (5,287) 432,881 - 545,661 371,684 61,889 433,573 35,925 72,936 $ 424,461 (5,212) 419,249 - 545,788 369,994 69,333 439,327 35,973 67,327 $ 422,887 (5,187) 417,700 - 511,681 358,133 58,524 416,657 35,997 55,915 $ 404,048 (5,277) 398,771 - 503,412 357,298 57,048 409,250 35,997 55,418 $ 396,197 (5,251) 390,946 - 487,304 347,700 43,241 390,941 38,117 55,219 $ 397,665 (6,070) 391,595 - 497,333 342,294 61,663 403,957 36,045 54,998 $ 378,250 (6,371) 371,879 - 494,481 322,119 82,430 404,549 36,069 54,138 $ 380,066 (6,687) 373,379 - 478,861 298,241 88,502 386,743 36,609 53,870 % 1.04 1.45 1.16 111.33 .23 10.25 % 11.98 13.81 14.93 13.37 13.17 % % 1.23 1.61 1.20 96.99 .28 11.35 10.16 12.87 14.12 10.93 13.15 % % 1.28 1.70 1.21 94.57 .20 13.70 9.95 11.55 12.80 11.01 11.42 % 1.65 2.04 1.30 78.49 .10 16.96 % 10.08 11.62 12.87 11.33 11.00 % 1.99 2.24 1.18 65.69 .48 18.56 % 10.08 11.62 12.87 11.33 11.33 % % 2.47 2.99 1.49 60.35 .18 24.39 9.73 11.65 12.97 11.06 11.06 % % 2.39 2.89 1.56 65.19 .17 23.38 9.50 11.40 12.66 10.95 10.95 % 2.47 2.99 1.49 60.35 .11 24.96 % 9.70 11.69 12.94 11.25 11.25 (1) Noncore deposits include brokered deposits and CDs greater than $100,000 (2) Texas Ratio: Nonperforming Assets Divided by Total Tangible Equity plus Allowance for Loan Losses 54 Summary Quarterly Financial Information MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES SUMMARY QUARTERLY FINANCIAL INFORMATION (Unaudited) (Dollars in Thousands, Except per Share Data) FOR THE QUARTER ENDED 2012 FOR THE QUARTER ENDED 2011 12/31 9/30 6/30 3/31 12/31 9/30 6/30 3/31 INCOME STATEMENT Net interest income Provision for loan losses Net interest income after provision Total noninterest income Total noninterest expense Income before taxes Provision for income taxes Net income $ 5,112 $ 4,930 $ 5,019 $ 4,763 $ 4,901 $ 4,709 $ 4,178 $ 4,141 150 4,962 983 4,349 1,596 536 1,060 150 4,780 1,149 4,367 1,562 528 1,034 150 4,869 1,305 4,207 1,967 (2,335) 4,302 495 4,268 606 3,834 1,040 349 691 1,300 3,601 725 4,221 105 27 78 400 4,309 1,006 3,960 1,355 455 900 600 3,578 1,348 3,729 1,197 402 795 - 4,141 577 4,059 659 214 445 Preferred dividend and accretion of discount Net income available to common shareholders 138 922 $ 137 897 $ 161 4,141 $ 193 498 $ 192 (114) $ 193 707 $ 192 603 $ 189 256 $ PER SHARE DATA Earnings (loss) - basic* Earnings (loss) - diluted* Book value Market value PROFITABILITY RATIOS Return on average assets Return on average common equity Return on average total equity Net interest margin Efficiency ratio Average loans/average deposits $ .21 $ .21 $ .97 $ .12 $ (.03) $ .21 $ .18 $ .07 .21 11.05 7.09 .20 11.14 7.60 .94 14.43 5.99 .11 13.19 7.00 .03 12.97 5.42 .20 13.05 5.46 .17 12.86 6.00 .07 12.67 6.02 .67 % .65 % 3.21 % .40 % (.09) % .56 % .49 % .22 % 5.93 5.03 4.11 70.52 99.45 6.33 5.29 4.10 67.29 96.62 36.57 29.39 4.30 63.61 101.50 4.53 3.62 4.17 71.01 98.73 (1.02) (.82) 4.38 67.51 101.34 6.35 5.10 4.14 67.39 96.96 5.58 4.47 3.79 67.84 96.19 2.40 1.92 3.92 75.73 98.27 *Earnings per share data for 2012 restated for common stock issuance 55 Market Information MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES MARKET INFORMATION (Unaudited) The Corporation’s common stock is traded on the NASDAQ Capital Market under the symbol MFNC. The following table sets forth the range of high and low trading prices of the Corporation’s common stock from January 1, 2011 through December 31, 2012, as reported by NASDAQ. 2012 High Low Close Book value 2011 High Low Close Book value For the Quarter Ended March 31 $ 7.74 5.00 7.00 13.19 June 30 $ 7.28 5.61 5.99 14.43 September 30 8.00 $ 5.73 7.60 11.14 December 31 7.90 $ 6.81 7.09 11.05 $ 6.52 4.58 6.02 12.67 $ 6.20 4.85 6.00 12.86 $ 7.01 4.96 5.46 13.05 $ 5.94 4.63 5.42 12.97 The Corporation had approximately 1,200 shareholders of record as of March 30, 2013. The holders of the Corporation’s common stock are entitled to dividends when, and if declared by the Board of Directors of the Corporation, out of funds legally available for that purpose. In determining dividends, the Board of Directors considers the earnings, capital requirements and financial condition of the Corporation and its subsidiary bank, along with other relevant factors. The Corporation’s principal source of funds for cash dividends is the dividends paid by the Bank. The ability of the Corporation and the Bank to pay dividends is subject to regulatory restrictions and requirements. There were no dividends declared or paid by the Bank in 2010, 2011 and 2012. The Corporation declared a $.04 dividend per share on its common stock in the fourth quarter of 2012. There were no sales of unregistered securities in 2012, nor were there any repurchases of the Corporation’s common stock in 2012. 56 Shareholder Return Performance Graph MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES Shown below is a line graph comparing the yearly percentage change in the cumulative total shareholder return on the Corporation’s common stock with that of the cumulative total return on the NASDAQ Bank Index and the NASDAQ Composite Index for the five-year period ended December 31, 2012. The following information is based on an investment of $100, on December 31, 2007 in the Corporation’s common stock, the NASDAQ Bank Index, and the NASDAQ Composite Index, with dividends reinvested. This graph and other information contained in this section shall not be deemed to be “soliciting” material or to be “filed” with the Securities and Exchange Commission or subject to Regulation 14A or 14C, or to the liabilities of Section 18 of the Securities Exchange Act of 1934, as amended. 57 Forward Looking Statements/Risk Factors FORWARD LOOKING STATEMENTS This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Corporation intends such forward- looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and is including this statement for purposes of these safe harbor provisions. Forward-looking statements which are based on certain assumptions and describe future plans, strategies, or expectations of the Corporation, are generally identifiable by use of the words “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project”, or similar expressions. The Corporation’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could cause actual results to differ from the results in forward-looking statements include, but are not limited to: RISK FACTORS Risks Related to our Lending and Credit Activities (cid:2) Our business may be adversely affected by conditions in the financial markets and economic conditions generally, as our borrowers’ ability to repay loans and the value of the collateral securing our loans decline. (cid:2) Weakness in the markets for residential or commercial real estate, including the secondary residential mortgage loan markets, could reduce our net income and profitability. (cid:2) Our allowance for loan losses may be insufficient. Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, and other factors, both within and outside of our control, may require an increase in our allowance for loan losses. Risks Related to Our Operations (cid:2) We are subject to interest rate risk. Our earnings and cash flows are largely dependent upon our net interest income, which is the difference between interest income on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. There are many factors which influence interest rates that are beyond our control, including but not limited to general economic conditions and governmental policy, in particular, the policies of the FRB. (cid:2) Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition. (cid:2) Our controls and procedures may fail or be circumvented. (cid:2) Impairment of deferred income tax assets could require charges to earnings, which could result in an adverse impact on our results of operations. In assessing the realizability of deferred income tax assets, management considers whether it is more likely than not that some allowance requires management to evaluate all available evidence, both negative and positive. Positive evidence necessary to overcome the negative evidence includes whether future taxable income in sufficient amounts and character within the carry back and carry forward periods is available under the tax law, including the use of tax planning strategies. When negative evidence (e.g. cumulative losses in recent years, history of operating loss or tax credit carry forwards expiring unused) exists, more positive evidence than negative evidence will be necessary. At December 31, 2012, net deferred tax assets are approximately $9.131 million. If a valuation allowance becomes necessary with respect to such balance, it could have a material adverse effect on our business, results of operations and financial condition. (cid:2) Our information systems may experience an interruption of breach in security. 58 Forward Looking Statements/Risk Factors Risks Related to Legal and Regulatory Compliance (cid:2) We operate in a highly regulated environment, which could increase our cost structure or have other negative impacts on our operations. (cid:2) The full impact of the recently enacted Dodd-Frank Act is currently unknown given that many of the details and substance of the new laws will be implemented through agency rulemaking. Among the many requirements if the Dodd-Frank Act for new banking regulations is a requirement for new capital regulations to be adopted within 18 months. These regulations must be at least as stringent as, and may call for higher levels of capital than, current regulations. Strategic Risks (cid:2) Maintaining or increasing our market share may depend on lowering prices and market acceptance of new products and services. (cid:2) Future growth or operating results may require us to raise additional capital but that capital may not be available. Reputation Risks (cid:2) Unauthorized disclosure of sensitive of confidential client or customer information, whether through a breach of our computer system or otherwise, could severely harm our business. Liquidity Risks (cid:2) We could experience an unexpected inability to obtain needed liquidity. The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure, its ability to liquidate assets and its access to alternative sources of funds. We seek to ensure our funding needs are met by maintaining an appropriate level of liquidity through asset/liability management. Risks Related to an Investment in Our Common Stock (cid:2) Limited trading activity for shares of our common stock may contribute to price volatility. (cid:2) Our securities are not an insured deposit. (cid:2) You may not receive dividends on your investment in common stock. Our ability to pay dividends is dependent upon our receipt of dividends from the Bank, which is subject to regulatory restrictions. Such restrictions, which govern state-chartered banks, generally limit the payment of dividends on bank stock to the bank’s undivided profits after all payments of all necessary expenses, provided that the bank’s surplus equals or exceeds its capital. These risks and uncertainties should be considered in evaluating forward-looking statements. Further information concerning the Corporation and its business, including additional factors that could materially affect the Corporation’s financial results, is included in the Corporation’s filings with the Securities and Exchange Commission. All forward- looking statements contained in this report are based upon information presently available and the Corporation assumes no obligation to update any forward-looking statements. 59 Management’s Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW The following discussion and analysis presents the more significant factors affecting the Corporation’s financial condition as of December 31, 2012 and 2011 and the results of operations for 2010 through 2012. This discussion also covers asset quality, liquidity, interest rate sensitivity, and capital resources for the years 2011 and 2012. The information included in this discussion is intended to assist readers in their analysis of, and should be read in conjunction with, the consolidated financial statements and related notes and other supplemental information presented elsewhere in this report. Throughout this discussion, the term “Bank” refers to mBank, the principal banking subsidiary of the Corporation. Taxable equivalent adjustments are the result of increasing income from tax-free loans and investments by an amount equal to the taxes that would be paid if the income were fully taxable based on a 34% federal tax rate, thus making tax-exempt yields comparable to taxable asset yields. Dollar amounts in tables are stated in thousands, except for per share data. EXECUTIVE SUMMARY The purpose of this section is to provide a brief summary of the 2012 results of operations and financial condition. A more detailed analysis of the results of operations and financial condition follows this summary. The Corporation reported a profit available to common shareholders in 2012 of $6.458 million, or $1.51 per share, compared to $1.452 million, $.42 per share, in 2011 and net loss in 2010 of $1.160 million, $.34 per share. Total assets of the Corporation at December 31, 2012, were $545.980 million, an increase of $47.699 million, or 9.57% from total assets of $498.311 million reported at December 31, 2011. In 2012, the Corporation showed increased balances in both investments and loans, which were funded primarily with Bank core deposit growth. At December 31, 2012, the Corporation’s loans stood at $449.177 million, an increase of $47.931 million, or 11.95%, from 2011 year-end balances of $401.246 million. Total loan production in 2012 amounted to $214.102 million, which included $74.142 million of secondary market mortgage loans sold. The Corporation also sold $11.962 million of SBA/USDA guaranteed loans. Loan balances were also impacted by normal amortization and paydowns, some of which related to payoffs on participation loans. Nonperforming loans totaled $4.687million, or 1.04% of total loans at December 31, 2012. Nonperforming assets at December 31, 2012, were $7.899 million, 1.45% of total assets, compared to $11.155 million or 2.24% of total assets at December 31, 2011. Total deposits increased from $404.789 million at December 31, 2011, to $434.557 million at December 31, 2012, an increase of 7.35%. The increase in deposits in 2012 was comprised of a decrease in wholesale deposits of $5.996 million and an increase in core deposits of $23.772 million. Shareholders’ equity totaled $72.448 million at December 31, 2012, compared to $55.263 million at the end of 2011, an increase of $17.185 million. This increase reflects the proceeds from a common stock rights offering of $11.506 million, consolidated net income of $6.458 million, the redemption at $1.300 million of the common stock warrants previously issued as part of TARP, the after tax decrease in the market value of available-for-sale investments, which amounted to $.599 million, the increase from the accretion of the discount on preferred stock of $.079 million, and recognition of compensation expense associated with restricted stock awards if $.066 million. The book value per common share at December 31, 2012, amounted to $11.05 compared to $12.97 at the end of 2011. 60 Management’s Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS (dollars in thousands, except per share data) 2012 2011 2010 Taxable-equivalent net interest income Taxable-equivalent adjustment Net interest income, per income statement Provision for loan losses Other income Other expense Income before provision for income taxes Provision for (benefit of) income taxes Net income (loss) Preferred dividend expense $ 19,898 (74) $ 18,019 (90) $ 16,496 (111) 19,824 945 4,043 16,757 6,165 (922) 17,929 2,300 3,656 15,969 3,316 1,098 16,385 6,500 2,795 16,598 (3,918) (3,500) $ 7,087 629 $ 2,218 766 $ (418) 742 Net income (loss) available to common shareholders $ 6,458 $ 1,452 $ (1,160) Earnings (loss) per common share Basic Diluted Return on average assets Return on average common equity Return on average equity $ $ 1.51 1.51 $ $ .42 .41 $ $ (.34) (.34) % 1.23 12.43 10.26 % .30 3.30 2.66 % (.23) (2.64) (2.06) Summary The Corporation reported net income available to common shareholders of $6.458 million in 2012, compared to net income of $1.452 million in 2011 and a net loss of $1.160 million in 2010. The 2012 results include significantly reduced credit related expenses and a decreased loan loss provision. In 2012, the loan loss provision was $.945 million, with write-downs and losses on other real estate of $.489 million. In 2012, the Corporation also recognized income from SBA/USDA loan sales of $1.176 million and fees and gains on the sale of secondary market loans of $1.390 million. In 2011, the loan loss provision was $2.300 million, with write-downs and losses on other real estate held for sale of $1.137 million. Also included in 2011 results are income of $1.500 million from SBA/USDA loan sales and the initial valuation of mortgage servicing rights of $.400 million. The 2010 results reflected elevated costs associated with nonperforming assets, including loan loss provisions of $6.500 million and write-downs and losses on other real estate held for sale of $2.753 million. Net Interest Income Net interest income is the Corporation’s primary source of core earnings. Net interest income represents the difference between the average yield earned on interest-earning assets and the average rate paid on interest-bearing funding sources. Net interest revenue is the Corporation’s principal source of revenue, representing 86% of total revenue in 2012. The net interest income is impacted by economic and competitive factors that influence rates, loan demand, and the availability of funding. Net interest income on a taxable equivalent basis increased $1.879 million from $18.019 million in 2011 to $19.898 million in 2012. In 2012, interest rates were stable with the prime rate at 3.25% for the entire year. The Corporation experienced a decrease, 9 basis points, in the overall rates on earnings assets from 5.24% in 2011 to 5.15% in 2012. Interest bearing funding sources declined, by 18 basis points, from 1.33% in 2011 to 1.15% in 2012. The combination of these effective rate changes resulted in an improved net interest margin from 4.08% in 2011 to 4.18% in 2012. In 2011, the Corporation realized an increase of $1.544 million in net interest income. This increase was largely attributed to lower rates on funding liabilities with an increased level of earning assets. 61 Management’s Discussion and Analysis of Financial Condition and Results of Operations In 2012, the Corporation benefited from higher levels of low interest transactional deposit instruments and repricing of term deposits. In addition to the benefits derived from repriced deposit liabilities and a higher level of transactional deposits, the corporation experienced solid loan growth. The following table details sources of net interest income for the three years ended December 31 (dollars in thousands): Interest Income Loans Funds sold Taxable securities Nontaxable securities Other interest-earning assets Total earning assets Interest Expense NOW, money markets, checking Savings CDs <$100,000 CDs >$100,000 Brokered deposits Borrowings Total interest-bearing funds 2012 Mix 2011 Mix 2010 Mix $ 23,313 18 948 27 121 24,427 548 16 2,429 433 520 657 4,603 95.44 .07 3.88 .11 .50 100.00 11.91 0.35 52.77 9.41 11.30 14.27 100.00 % % % % $ 21,774 21 1,162 28 87 23,072 1,002 36 2,064 383 1,045 613 5,143 94.37 .09 5.04 .12 .38 100.00 19.48 0.70 40.13 7.45 20.32 11.92 100.00 % % % % $ 21,279 58 1,406 28 69 22,840 1,218 97 1,756 449 2,087 848 6,455 93.17 .25 6.16 .12 .30 100.00 18.87 1.50 27.20 6.96 32.34 13.14 100.00 % % % % Net interest income $ 19,824 $ 17,929 $ 16,385 Average Rates Earning assets Interest-bearing funds Interest rate spread % 5.14 1.15 3.99 % 5.22 1.33 3.89 % 5.10 1.60 3.50 As shown in the table above, income on loans provides more than 95% of the Corporation’s interest revenue. The Corporation’s loan portfolio has approximately $297.380 of variable rate loans that predominantly reprice with changes in the prime rate and $151.797 million of fixed rate loans. A majority of the variable rate loans, 58%, or $173.832 million, have interest rate floors. These loans will not reprice until the prime rate increases to the extent necessary to surpass the interest rate floor. A prime rate increase of 100 basis points or more will reprice $98.105 million of these loans with floors, while the remainder will reprice with an additional 100 basis point increase in the prime rate. The majority of interest bearing liabilities do not reprice automatically with changes in interest rates, which provides flexibility to manage interest income. Management monitors the interest sensitivity of earning assets and interest bearing liabilities to minimize the risk of movements in interest rates. 62 Management’s Discussion and Analysis of Financial Condition and Results of Operations The following table presents the amount of taxable equivalent interest income from average interest-earning assets and the yields earned on those assets, as well as the interest expense on average interest-bearing obligations and the rates paid on those obligations. All average balances are daily average balances. (dollars in thousands) ASSETS: Loans (1,2,3) Taxable securities Nontaxable securities (2) Federal Funds sold Other interest-earning assets Total earning assets Reserve for loan losses Cash and due from banks Fixed assets Other real estate owned Other assets Years ended December 31, Average Balance 2012 Interest Average Rate Average Balance $ 422,440 38,094 850 11,127 3,070 475,581 (5,232) 28,561 10,254 3,392 14,184 51,159 $ 23,373 948 41 18 121 24,501 % 5.53 2.49 4.82 .16 3.94 5.15 $ 388,115 36,155 850 13,102 3,504 441,726 (6,027) 25,622 9,630 4,581 14,007 47,813 2011 Interest $ 21,850 1,162 42 21 87 23,162 Average Rate Average Balance % 5.63 3.21 4.94 .16 2.48 5.24 $ 384,347 35,475 853 22,934 4,448 448,057 (5,539) 29,291 10,002 6,196 14,986 54,936 2010 Interest $ 21,376 1,406 42 58 69 22,951 Average Rate % 5.56 3.96 4.92 .25 1.55 5.12 TOTAL ASSETS $ 526,740 $ 489,539 $ 502,993 LIABILITIES AND SHAREHOLDERS' EQUITY: NOW and Money Markets Interest checking Savings deposits CDs <$100,000 CDs >$100,000 Brokered deposits Borrowings Total interest-bearing liabilities Demand deposits Other liabilities Shareholders' equity $ 406 142 16 2,429 433 520 657 4,603 $ 119,053 31,837 13,682 138,767 25,128 36,569 35,973 401,009 59,730 3,062 62,939 125,731 % .34 .45 .12 1.75 1.72 1.42 1.83 1.15 % $ 762 240 36 2,064 383 1,045 613 5,143 $ 124,575 26,962 16,242 112,464 22,909 45,906 36,579 385,637 46,773 2,568 54,561 103,902 % .61 .89 .22 1.84 1.67 2.28 1.68 1.33 $ 99,411 18,987 19,503 84,841 26,273 118,615 36,116 403,746 39,704 3,372 56,171 99,247 $ 943 275 97 1,756 449 2,087 848 6,455 % .95 1.45 .50 2.07 1.71 1.76 2.35 1.60 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 526,740 $ 489,539 $ 502,993 Rate spread Net interest margin/revenue, tax equivalent basis $ 19,898 4.00 4.18 % $ 18,019 3.91 4.08 % % $ 16,496 3.52 3.68 % % (1) (2) (3) For purposes of these computations, non-accruing loans are included in the daily average loan amounts outstanding. The amount of interest income on nontaxable securities and loans has been adjusted to a tax equivalent basis, using a 34% tax rate. Interest income on loans includes loan fees. 63 Management’s Discussion and Analysis of Financial Condition and Results of Operations The following table presents the dollar amount, in thousands, of changes in taxable equivalent interest income and interest expense for major components of interest-earning assets and interest-bearing obligations. It distinguishes between changes related to higher or lower outstanding balances and changes due to the levels and fluctuations in interest rates. For each category of interest-earning assets and interest-bearing obligations, information is provided for changes attributable to (i) changes in volume (i.e. changes in volume multiplied by prior period rate) and (ii) changes in rate (i.e. changes in rate multiplied by prior period volume). For purposes of this table, changes attributable to both rate and volume are shown as a separate variance. 2012 vs. 2011 2011 vs. 2010 Years ended December 31, Increase (Decrease) Due to Increase (Decrease) Due to Volume Rate $ 1,932 62 - (3) (11) $ (376) (262) (1) - 51 Volume and Rate $ (33) (14) - - (6) Total Increase (Decrease) Volume Rate Volume and Rate Total Increase (Decrease) $ 1,523 (214) (1) (3) 34 $ 210 27 - (25) (15) $ 262 (266) - (21) 41 2 $ (5) - 9 (8) $ 474 (244) - (37) 18 Interest earning assets: Loans Taxable securities Nontaxable securities Federal funds sold Other interest earning assets Total interest earning assets $ 1,980 $ (588) $ (53) $ 1,339 $ 197 $ 16 $ (2) $ 211 Interest bearing obligations: NOW and money market deposits Interest checking Savings deposits CDs <$100,000 CDs >$100,000 Brokered deposits Borrowings $ (34) 43 (6) 483 37 (213) (10) $ (337) (120) (17) (95) 12 (392) 55 $ 15 (22) 3 (22) 1 80 (1) $ (356) (99) (20) 366 50 (525) 44 $ 239 116 (16) 573 (57) (1,278) 11 $ (335) (106) (54) (199) (10) 612 (243) $ (85) (45) 9 (66) 1 (376) (3) $ (181) (35) (61) 308 (66) (1,042) (235) Total interest bearing obligations $ 300 $ (894) $ 54 $ (540) $ (412) $ (335) $ (565) $ (1,312) Net interest income, tax equivalent basis $ 1,879 $ 1,523 Provision for Loan Losses The Corporation records a provision for loan losses when it believes it is necessary to adjust the allowance for loan losses to maintain an adequate level after considering factors such as loan charge-offs and recoveries, changes in identified levels of risk in the loan portfolio, changes in the mix of loans in the portfolio, loan growth, and other economic factors. During 2012, the Corporation recorded a provision for loan loss of $.945 million, compared to a provision of $2.300 million in 2011 and $6.500 million in 2010. Noninterest Income Noninterest income was $4.043 million, $3.656 million, and $2.795 million in 2012, 2011, and 2010, respectively. The principal recurring sources of noninterest income are the gains on the sale of SBA/USDA guaranteed loans and secondary market loans. In 2012, revenues from these two business lines totaled $2.566 million compared to $2.200 million in 2011 and $1.407 million in 2010. The Corporation, in recent years, expanded its efforts to generate increased income from secondary market loans by adding additional staff and centralizing processing activities. In 2010, the Bank initiated the new business of retaining the servicing rights on mortgage loans sold to the secondary market. This line of business attained profitability during 2011, and as such, a valuation of the future revenue stream was recognized as income and booked as an asset at the Bank. In 2012, income from servicing mortgages amounted to $.417 million, compared to $.400 million in 2011. Late in 2011, the bank also established its own title insurance agency which offers title services for both commercial and retail based mortgage transactions. Income from this line of business in 2012 was $.060 million, and it is expected that this line of business will provide increased revenues in 2013 and beyond. Deposit related income totaled $.699 million in 2012 compared to $.832 million in 2011 and $.990 million in 2010. The Corporation has experienced continued decline in deposit related income as a result of changes in the assessments mandated by new consumer regulations. The current regulatory environment may limit the Corporation’s ability to grow these revenue sources. 64 Management’s Discussion and Analysis of Financial Condition and Results of Operations The following table details noninterest income for the three years ended December 31 (dollars in thousands): Deposit service charges NSF Fees Gain on sale of secondary market loans Secondary market fees generated SBA Fees Mortgage servicing rights Other Subtotal Net security gains 2012 2011 2010 2012-2011 2011-2010 $ 110 $ 123 $ 128 (10.57) % (3.91) % % Increase (Decrease) 589 1,077 313 1,176 417 361 4,043 - 709 477 223 1,500 400 225 3,657 (1) 862 445 94 868 - 183 2,580 215 (16.93) 125.79 40.36 (21.60) 4.25 60.44 10.56 (17.75) 7.19 137.23 72.81 - 22.95 41.74 (100.00) (100.47) Total noninterest income $ 4,043 $ 3,656 $ 2,795 10.59 % 30.81 % Noninterest Expense Noninterest expense was $16.757 million in 2012, compared to $15.969 million and $16.598 million in 2011 and 2010, respectively. In 2012, the increase in noninterest expense totaled $.788 million, or 4.93%. Salaries and benefits, at $8.288 million, increased by $1.013 million, 13.92%, from the 2011 expenses of $7.275 million and compared to $6.918 million in 2010. Expense increases on salaries and benefits in 2012 were largely due to increase staffing combined with increased employee benefits costs relative to health insurance premium increases and stock compensation expenses related to the issuance of restricted stock. Professional service fees increased in 2012 largely due to increased costs associated with various strategic initiatives. The largest decrease in noninterest expense for 2012 occurred in write-downs and losses on the sale of other real estate, which decreased from $1.137 million in 2011 to $.489 million in 2012. We also had increased costs in data processing, which was related to technological upgrades and service changes to maintain our competitive edge. We also experienced a significant decline in our FDIC insurance premiums due to our improved asset quality and operating performance. Management will continue to review all areas of noninterest expense in order to evaluate where opportunities may exist which could reduce expenses without compromising service to customers. The following table details noninterest expense for the three years ended December 31 (dollars in thousands): Salaries and benefits Occupancy Furniture and equipment Data processing Professional service fees: Accounting Legal Consulting and other Total professional service fees Loan and deposit OREO writedowns and (gains) losses on sale FDIC insurance premiums Telephone Advertising Other operating expenses Total noninterest expense 2012 $ 8,288 1,372 885 991 2011 $ 7,275 1,376 827 761 2010 $ 6,918 1,313 806 740 368 396 432 1,196 877 489 459 233 376 1,591 16,757 $ 260 207 289 756 1,137 1,137 849 215 351 1,285 15,969 $ 269 98 260 627 910 2,753 957 193 297 1,084 16,598 $ % Increase (Decrease) % 2012 - 2011 13.92 (.29) 7.01 30.22 2011 - 2010 5.16 4.80 2.61 2.84 % 41.54 91.30 49.48 58.20 (22.87) (56.99) (45.94) 8.37 7.12 23.81 4.93 % (3.35) 111.22 11.15 20.57 24.95 (58.70) (11.29) 11.40 18.18 18.54 (3.79) % 65 Management’s Discussion and Analysis of Financial Condition and Results of Operations Federal Income Taxes A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years and contain tax carryforwards including past net operating losses and tax credits. For example, a temporary difference is created between the reported amount and the tax basis of a liability for estimated expenses if, for tax purposes, those estimated expenses are not deductible until a future year. Settlement of that liability will result in tax deductions in future years, and a deferred tax asset is recognized based on the weight of available evidence. All available evidence, both positive and negative, is considered to determine whether, based on the weight of that evidence, a valuation allowance is needed for some portion or all of a deferred tax asset. Judgment must be used in considering the relative impact of negative and positive evidence. The weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, (a) the more positive evidence is necessary and (b) the more difficult it is to support a conclusion that a valuation allowance is not needed. A valuation allowance is provided against deferred tax assets when it is more likely than not that some or all of the deferred tax assets will not be realized. The Corporation, as of December 31, 2012, had net operating loss (“NOL”) and tax credit carryforwards of approximately $21.235 million and $2.136 million, respectively. Current Federal Tax Provision In 2012, the Corporation recorded a benefit for income taxes of $.922 million, compared to a provision of $1.098 million in 2011 and a $3.500 million tax benefit in 2010. The valuation allowance at December 31, 2012 was approximately $3.0 million. Management evaluated the deferred tax valuation allowance as of December 31, 2012 and determined that an adjustment to the valuation was not warranted. The Corporation reduced the valuation allowance by $3.0 million at June 30, 2012 since it was determined that it was “more likely than not” that these benefits would be realized. The Corporation made this determination after a thorough review of projected earnings and the composition and sustainability of those earnings over the projected tax carryover period. In this assessment, the Corporation reviewed current levels of nonperforming assets, the impact of increased levels of nonperforming assets along with other factors that may negatively impact the probability of future earnings. This analysis substantiated the ability to utilize these deferred tax assets. The Corporation will continue to evaluate the future benefits from these carryforwards and at such time as it becomes “more likely than not” that they would be utilized prior to expiration will recognize the additional benefits as an adjustment to the valuation allowance. Deferred Tax Benefit – Historical Commentary The Corporation recorded a current period federal tax benefit of $3.500 million in 2010, compared to a $1.120 million provision in the same period a year earlier. In the first quarter of 2010, management evaluated the deferred tax assets associated with the net operating loss and tax credit carryforwards based upon the Corporation’s foreseen ability to utilize the benefits of these carryforwards prior to their expiration. At that time, the Corporation had net deferred tax assets of approximately $13.4 million and a valuation allowance of $8.1 million against these assets. As a part of this analysis, management considered, among other things, current asset levels and projected loan and deposit growth, current interest rate spreads and projected net interest income levels, and noninterest income and expense, along with management’s ability to control expenses and the potential for increasing contributions of noninterest income. Management also considered the impact of nonperforming assets and future period charge-off activity relative to projected provisions. Based upon the analysis of projected taxable income and the probability of achieving these projected taxable income levels, the Corporation reduced the valuation allowance on its deferred tax assets by $3.500 million. Among the criteria that management considered in evaluating the deferred tax asset was taxable income for the three most recent taxable years ending December 31, 2009 which totaled $8.2 million. This taxable income allowed the Corporation to utilize NOL carryforwards. At 2010 year end, management, in recognition of the net operating loss before taxes of $3.918 million and based upon additional analysis of deferred tax balances and future taxable income projections, made the determination to increase the valuation allowance by approximately $1.364 million, resulting in a net decrease in the valuation allowance of $2.136 million for the year. 66 Management’s Discussion and Analysis of Financial Condition and Results of Operations The Corporation recognized a federal deferred tax benefit of $7.500 million in the third quarter of 2007. The recognition of this deferred tax benefit relates to the generally accepted accounting principles applicable to the probability of utilizing the NOL and tax credit carryforwards of the Corporation. The Corporation, based upon current profitability trends largely supported by expansion of the net interest margin and controlled expenses, determined that a portion, $7.500 million, of the NOL carryforward was probable. The $7.500 million recognition was based upon assumptions of a sustained level of taxable income within the NOL carryforward period and took into account Section 382, annual limitations. This tax benefit was recorded by reducing the valuation allowance that was recorded against the deferred tax assets of the Corporation. In 2006, the Corporation recognized a portion of this benefit, $.500 million, based upon the then current probabilities. The table below details the Corporation’s deferred tax assets and liabilities (dollars in thousands): Deferred tax assets: NOL carryforward Allowance for loan losses Alternative Minimum Tax Credit OREO Tax basis > book basis Tax credit carryovers Deferred compensation Stock compensation Depreciation Intangible assets Other Total deferred tax assets Valuation allowance Deferred tax liabilities: FHLB stock dividend Unrealized gain on securities Mortgage servicing rights Total deferred tax liabilities 2012 2011 $ 7,149 1,774 1,463 1,025 672 185 265 174 60 170 $ 9,073 1,785 1,463 1,050 672 217 172 225 77 110 12,937 14,844 $ (3,010) $ (6,010) (103) (476) (217) (796) (103) (168) (136) (407) Net deferred tax asset $ 9,131 $ 8,427 As shown in the table above, the NOL and tax credit carryforwards comprise the majority of the deferred tax asset, which is reduced by the $3.000 million valuation adjustment. As of December 31, 2012, the Corporation had an NOL carryforward of approximately $21.2 million along with various credit carryforwards of $2.1 million. This NOL and credit carryforward benefit is dependent upon the future profitability of the Corporation. A portion of the NOL, approximately $15.6 million, and all of the tax credit carryforwards are also subject to the use limitations of Section 382 of the Internal Revenue Code since they originated prior to the December 2004 recapitalization of the Corporation. These carryforwards, if not utilized, will begin to expire in the year 2023. The annual limitation is $1.4 million for the NOL carryforwards and the equivalent value of tax credits, which is approximately $.477 million. The Corporation will continue to evaluate the utilization of the NOL and credit carryforwards in subsequent periods to determine if any further adjustment to the valuation allowance is necessary. The determination criteria for recognition of deferred tax benefits will include the assumption of future period taxable income based upon the projected profitability of the Corporation. The valuation allowance, which stands at $3.0 million as of December 31, 2012 is a measurement of the uncertainty related to the ultimate realization of a portion of the NOL and credit carryforwards. 67 Management’s Discussion and Analysis of Financial Condition and Results of Operations FINANCIAL POSITION The table below illustrates the relative composition of various liability funding sources and asset make-up. (dollars in thousands) 2012 December 31, 2011 2010 Sources of funds: Deposits: Non-interest bearing transactional deposits Interest-bearing transactional depopsits CD's <$100,000 Total core deposit funding CD's >$100,000 Brokered deposits Total noncore deposit funding FHLB and other borrowings Other liabilities Shareholders' equity Balance Mix Balance Mix Balance Mix $ 67,652 169,294 135,550 372,496 24,355 37,706 62,061 35,925 3,050 72,448 % 12.39 31.01 24.83 68.23 4.46 6.91 11.37 6.58 .56 13.27 $ 51,273 166,766 130,685 348,724 23,229 32,836 56,065 35,997 2,262 55,263 % 10.29 33.47 26.23 69.99 4.66 6.59 11.25 7.22 .45 11.09 $ 41,264 152,373 96,977 290,614 22,698 73,467 96,165 36,069 1,966 53,882 % 8.62 31.83 20.26 60.71 4.74 15.35 20.09 7.53 .41 11.26 Total $ 545,980 100.00 % $ 498,311 100.00 % $ 478,696 100.00 % Uses of Funds: Net Loans Securities available for sale Federal funds sold Federal Home Loan Bank Stock Interest-bearing deposits Cash and due from banks Other assets $ 443,959 43,799 3 3,060 10 26,958 28,191 % 81.32 8.02 .00 .56 .00 4.94 5.16 $ 395,995 38,727 13,999 3,060 10 20,071 26,449 % 79.47 7.77 2.81 .61 .00 4.03 5.31 $ 376,473 33,860 12,000 3,423 713 22,719 29,508 % 78.64 7.07 2.51 .72 .15 4.75 6.16 Total $ 545,980 100.00 % $ 498,311 100.00 % $ 478,696 100.00 % Securities The securities portfolio is an important component of the Corporation’s asset composition to provide diversity in its asset base and provide liquidity. Securities increased $5.072 million in 2012, from $38.727 million at December 31, 2011 to $43.799 million at December 31, 2012. The carrying value of the Corporation’s securities is as follows at December 31 (dollars in thousands): Corporate US Agencies US Agencies - MBS Obligations of states and political subdivisions Total securities 2012 2011 $ 18,977 10,404 8,374 6,044 $ 8,178 10,575 14,418 5,556 $ 43,799 $ 38,727 The Corporation’s policy is to purchase securities of high credit quality, consistent with its asset/liability management strategies. The Corporation classifies all securities as available for sale, in order to maintain adequate liquidity and to maximize its ability to react to changing market conditions. At December 31, 2012, investment securities with an estimated fair market value of $7.286 million were pledged. 68 Management’s Discussion and Analysis of Financial Condition and Results of Operations Loans The Bank is a full service lender and offers a variety of loan products in all of its markets. The majority of its loans are commercial, which represents approximately 76% of total loans outstanding at December 31, 2012. The Corporation continued to experience strong loan demand in 2012 with approximately $214.102 million of new loan production, including $74.142 million of mortgage loans sold in the secondary market. At 2012 year-end, the Corporation’s loans stood at $449.177 million, an increase from the 2011 year-end balances of $401.246 million. In 2012, the secondary mortgage loans that were produced and sold totaled $74.142 million while the SBA/USDA loan sales amounted to $11.962 million. The production of loans was distributed among the regions, with the Upper Peninsula at $134.257 million, $37.856 million in the Northern Lower Peninsula and $41.989 million in Southeast Michigan where the market has been hit the hardest by the recession. Management believes a properly positioned loan portfolio provides the most attractive earning asset yield available to the Corporation and, with changes to the loan approval process and exception reporting, management can effectively manage the risk in the loan portfolio. Management intends to continue loan growth within its markets for mortgage, consumer, and commercial loan products while concentrating on loan quality, industry concentration issues, and competitive pricing. The Corporation is highly competitive in structuring loans to meet borrowing needs and satisfy strong underwriting requirements. The following table details the loan activity for 2011 and 2012 (dollars in thousands): Loan balances as of December 31, 2010 $ 383,086 Total production Secondary market sales SBA loan sales Loans transferred to OREO Loans charge off, net of recoveries Normal amortization/paydowns and payoffs Loan balances as of December 31, 2011 Total production Secondary market sales SBA loan sales Loans transferred to OREO Loans charge off, net of recoveries Normal amortization/paydowns and payoffs 172,577 (38,971) (18,790) (4,193) (3,662) (88,801) 401,246 214,102 (74,142) (11,962) (1,352) (978) (77,737) Loan balances as of December 31, 2012 $ 449,177 Following is a table that illustrates the balance changes in the loan portfolio from 2010 through 2012 year end (dollars in thousands): Commercial real estate Commercial, financial, and agricultural One-to-four family residential real estate Construction: Consumer Commercial Consumer 2012 2011 2010 2012-2011 2011-2010 Percent Change $ 244,966 80,646 87,948 $ 199,201 92,269 77,332 $ 194,859 68,858 75,074 22.97 % 2.23 % (12.60) 13.73 34.00 3.01 7,465 17,229 10,923 5,774 19,745 6,925 5,682 33,330 5,283 29.29 (12.74) 57.73 1.62 (40.76) 31.08 Total $ 449,177 $ 401,246 $ 383,086 11.95 % 4.74 % 69 Management’s Discussion and Analysis of Financial Condition and Results of Operations Our commercial real estate loan portfolio predominantly relates to owner occupied real estate, and our loans are generally secured by a first mortgage lien. Commercial real estate market conditions continued to be under stress in 2012, and we expect this trend to continue. These conditions may negatively affect our commercial real estate loan portfolio in future periods. We make commercial loans for many purposes, including: working capital lines, which are generally renewable annually and supported by business assets, personal guarantees and additional collateral. Commercial business lending is generally considered to involve a higher degree of risk than traditional consumer bank lending. Following is a table showing the composition of loans by significant industry types in the commercial loan portfolio as of December 31 (dollars in thousands): Real estate - operators of nonres bldgs Hospitality and tourism Commercial construction Lessors of residential buildings Real estate agents and managers Other 2012 % of Loans % of Capital % 27.75 11.90 5.03 3.54 3.70 48.09 % 131.34 56.30 23.78 16.74 17.49 227.58 Balance $ 75,391 33,306 19,745 16,499 10,617 155,657 2011 % of Loans % of Capital % 24.22 10.70 6.34 5.30 3.41 50.03 % 135.53 59.87 35.50 29.66 19.09 279.83 Balance $ 58,114 37,737 33,330 16,598 15,857 135,411 2010 % of Loans % 19.56 12.70 11.22 5.59 5.34 45.60 % of Capital 107.85 70.04 61.86 30.80 29.43 251.31 Balance $ 95,151 40,787 17,229 12,128 12,672 164,874 Total commercial loans $ 342,841 100.00 % $ 311,215 100.00 % $ 297,047 100.00 % Management recognizes the additional risk presented by the concentration in certain segments of the portfolio. On a historical basis, the Corporation’s highest concentration of credit risk was the hospitality and tourism industry. Management does not consider the current loan concentrations in hospitality and tourism to be problematic, and has no intention of further reducing loans to this industry segment. Management does not believe that its current portfolio composition has increased exposure related to any specific industry concentration as of 2012 year-end. The current concentration of real estate related loans represents a broad customer base composed of a high percentage of owner- occupied developments. Our residential real estate portfolio predominantly includes one-to-four family adjustable rate mortgages that have repricing terms generally from one to three years, construction loans to individuals and bridge financing loans for qualifying customers. As of December 31, 2012, our residential loan portfolio totaled $95.413 million, or 21% of our total outstanding loans. The Corporation has also extended credit to governmental units, including Native American organizations. Tax-exempt loans and leases decreased from $1.991 million at the end of 2011 to $1.542 million at 2012 year-end. The Corporation has elected to refrain from making tax-exempt loans, since they provide no current tax benefit, due to tax net operating loss carryforwards. Due to the seasonal nature of many of the Corporation’s commercial loan customers, loan payment terms provide flexibility by structuring payments to coincide with the customer’s business cycle. The lending staff evaluates the collectability of the past due loans based on documented collateral values and payment history. The Corporation discontinues the accrual of interest on loans when, in the opinion of management, there is an indication that the borrower may be unable to meet the payments as they become due. Upon such discontinuance, all unpaid accrued interest is reversed. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. Troubled debt restructurings (“TDR”) are determined on a loan-by-loan basis. Generally restructurings are related to interest rate reductions, loan term extensions and short term payment forbearance as means to maximize collectability of troubled credits. If a portion of the TDR loan is uncollectible (including forgiveness of principal), the uncollectible amount will be charged off against the allowance at the time of the restructuring. In general, a borrower must make at least six consecutive timely payments before the Corporation would consider a return of a restructured loan to accruing status in accordance with FDIC guidelines regarding restoration of credits to accrual status. 70 Management’s Discussion and Analysis of Financial Condition and Results of Operations The Corporation has, in accordance with generally accepted accounting principles and per recently enacted accounting standard updates, evaluated all loan modifications to determine the fair value impact of the underlying asset. The carrying amount of the loan is compared to the expected payments to be received, discounted at the loan’s original rate, or for collateral dependent loans, to the fair value of the collateral. The Corporation, at December 31, 2012, had loans totaling $8.056 million for which repayment terms were modified to the extent that they were deemed to be “restructured” loans. The $8.056 million is comprised of 11 loans, the largest of which had a December 31, 2012 balance of $2.602 million. Credit Quality The table below shows balances of nonperforming assets for the three years ended December 31 (dollars in thousands): December 31, 2012 (Unaudited) December 31, 2011 (Audited) December 31, 2010 (Audited) Nonperforming Assets : Nonaccrual loans Loans past due 90 days or more Restructured loans Total nonperforming loans Other real estate owned Total nonperforming assets Nonperforming loans as a % of loans Nonperforming assets as a % of assets Reserve for Loan Losses: At period end As a % of average loans As a % of nonperforming loans As a % of nonaccrual loans Texas Ratio $ $ $ 4,687 - - 4,687 3,212 7,899 5,490 - 2,503 7,993 3,162 11,155 5,921 - 4,642 10,563 5,562 16,125 $ $ $ 1.04 1.45 % % 1.99 2.24 % % 2.76 3.37 % % $ 5,218 1.24 111.33 111.33 10.17 $ 5,251 1.35 65.69 95.65 18.43 $ $ 388,115 3,662 .94 % % % % % $ 6,613 1.72 62.61 111.69 26.66 $ $ 384,347 5,112 1.33 % % % % % % % % % % Charge-off Information (year to date): Average loans Net charge-offs Charge-offs as a % of average loans $ $ 422,440 978 .23 Management continues to address market issues impacting its loan customer base. In conjunction with the Corporation’s senior lending staff and the bank regulatory examinations, management reviews the Corporation’s loans, related collateral evaluations, and the overall lending process. The Corporation also utilizes a loan review consultant to perform a review of the loan portfolio. The opinion of this consultant upon completion of the 2012 independent review provided findings similar to management on the overall adequacy of the reserve. The Corporation will again utilize a consultant for loan review in 2013. The following table details the impact of nonperforming loans on interest income for the three years ended December 31 (dollars in thousands): Interest income that would have been recorded at original rate Interest income that was actually recorded 2012 2011 2010 $ 313 $ 363 $ 583 54 118 141 Net interest lost $ 259 $ 245 $ 442 71 Management’s Discussion and Analysis of Financial Condition and Results of Operations Allowance for Loan Losses Management analyzes the allowance for loan losses on a quarterly basis to determine whether the losses inherent in the portfolio are properly reserved for. Net charge-offs in 2012 amounted to $.978 million, or .23% of average loans outstanding, compared to $3.662 million, or .94% of loans outstanding in 2011. The current reserve balance is representative of the relevant risk inherent within the Corporation’s loan portfolio. Additions or reductions to the reserve in future periods will be dependent upon a combination of future loan growth, nonperforming loan balances and charge-off activity. A three year history of relevant information on the Corporation’s credit quality is displayed in the following table (dollars in thousands): Allowance for Loan Losses 2012 2011 2010 Balance at beginning of period Loans charged off: Commercial, financial & agricultural One-to-four family residential real estate Consumer Total loans charged off Recoveries of loans previously charged off: Commercial, financial & agricultural One-to-four family residential real estate Consumer Total recoveries of loans previously charged off Net loans charged off Provision for loan losses $ 5,251 $ 6,613 $ 5,225 775 399 82 1,256 253 7 18 278 978 945 3,258 490 52 3,800 128 1 9 138 3,662 2,300 5,027 410 48 5,485 346 11 16 373 5,112 6,500 Balance at end of period $ 5,218 $ 5,251 $ 6,613 Total loans, period end Average loans for the year Allowance to total loans at end of year Net charge-offs to average loans Net charge-offs to beginning allowance balance $ 449,177 422,440 1.16 .23 18.63 % $ 401,246 388,115 1.31 .94 55.38 % $ 383,086 384,347 1.73 1.33 97.84 % The computation of the required allowance for loan losses as of any point in time is one of the critical accounting estimates made by management in the financial statements. As such, factors used to establish the allowance could change significantly from the assumptions made and impact future earnings positively or negatively. The future of the national and local economies and the resulting impact on borrowers’ ability to repay their loans and the value of collateral are examples of areas where assumptions must be made for individual loans, as well as the overall portfolio. The allowance for loan losses consists of specific and general components. Our internal risk system is used to identify loans that meet the criteria for being “impaired” as defined in the accounting guidance. The specific component relates to loans that are individually classified as impaired and where expected cash flows are less than carrying value. The general component covers non-impaired loans and is based on historical loss experience adjusted for qualitative factors. These qualitative factors include: 1) changes in the nature, volume and terms of loans, 2) changes in lending personnel, 3) changes in the quality of the loan review function, 4) changes in nature and volume of past-due, nonaccrual and/or classified loans, 5) changes in concentration of credit risk, 6) changes in economic and industry conditions, 7) changes in legal and regulatory requirements, 8) unemployment and inflation statistics, and 9) underlying collateral values. At the end of 2012, the allowance for loan losses represented 1.16% of total loans. In management’s opinion, the allowance for loan losses is adequate to cover probable losses related to specifically identified loans, as well as probable losses inherent in the balance of the loan portfolio. As part of the process of resolving problem credits, the Corporation may acquire ownership of real estate collateral which secured such credits. The Corporation carries this collateral in other real estate held for sale on the balance sheet. 72 Management’s Discussion and Analysis of Financial Condition and Results of Operations The following table represents the activity in other real estate held for sale (dollars in thousands): Balance at January 1, 2011 Other real estate transferred from loans due to foreclosure Other real estate sold Writedowns on other real estate held for sales Loss on other real estate held for sale Balance at December 31, 2011 Other real estate transferred from loans due to foreclosure Other real estate sold Writedowns on other real estate held for sales Loss on other real estate held for sale $ 5,562 4,194 (5,457) (855) (282) 3,162 1,352 (775) (496) (31) Balance at December 31, 2012 $ 3,212 During 2012, the Corporation received real estate in lieu of loan payments of $1.352 million. In determining the carrying value of other real estate held for sale, the Corporation generally starts with a third party appraisal of the underlying collateral and then deducts estimated selling costs to arrive at a net asset value. After the initial receipt, management periodically re-evaluates the recorded balance and records any additional reductions in the fair value as a write-down of other real estate held for sale. Deposits Total deposits at December 31, 2012 were $434.557 million, an increase of $29.768 million, or 7.35% from December 31, 2011 deposits of $404.789 million. The table below shows the deposit mix for the periods indicated (dollars in thousands): 2012 Mix 2011 Mix 2010 Mix CORE: Non-interest-bearing NOW, money market, checking Savings Certificates of Deposit <$100,000 Total core deposits NONCORE: Certificates of Deposit >$100,000 Brokered CDs Total non-core deposits $ 67,652 155,465 13,829 135,550 372,496 24,355 37,706 62,061 15.57 35.78 3.18 31.19 85.72 5.60 8.68 14.28 % $ 51,273 152,563 14,203 130,685 348,724 23,229 32,836 56,065 12.67 37.69 3.51 32.28 86.15 5.74 8.11 13.85 % $ 41,264 134,703 17,670 96,977 290,614 22,698 73,467 96,165 % 10.67 34.83 4.57 25.07 75.14 5.87 18.99 24.86 Total deposits $ 434,557 100.00 % $ 404,789 100.00 % $ 386,779 100.00 % The increase in deposits, as illustrated above, is composed of an increase in noncore deposits of $5.996 million, while core deposits increased by $23.772 million. Management has increased its efforts to grow core deposits in recent years by introducing several new deposit products and implementing a bank-wide deposit incentive program. As shown in the table above, core deposits now represent approximately 86% of total deposits. The Corporation will continue to emphasize core deposit growth in its funding sources, but will also supplement this funding with strategic utilization of wholesale brokered deposits to help manage interest rate risk. Management continues to monitor existing deposit products in order to stay competitive, both as to terms and pricing. It is the intent of management to be aggressive in its markets to grow core deposits with an emphasis placed on transactional accounts. Borrowings The Corporation also utilizes FHLB borrowings as a source of funding. At 2012 year end, this source of funding totaled $35.000 million and the Corporation secured this funding by pledging loans and investments. The $35.000 million of FHLB borrowings had a weighted average maturity of 2 years, with a weighted average rate of 1.82% at December 31, 2012. Shareholders’ Equity Changes in shareholders’ equity are discussed in detail in the “Capital and Regulatory” section of this report. 73 Management’s Discussion and Analysis of Financial Condition and Results of Operations QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Risk In general, the Corporation attempts to manage interest rate risk by investing in a variety of assets which afford it an opportunity to reprice assets and increase interest income at a rate equal to or greater than the interest expense associated with repricing liabilities. Interest rate risk is the exposure of the Corporation to adverse movements in interest rates. The Corporation derives its income primarily from the excess of interest collected on its interest-earning assets over the interest paid on its interest- bearing obligations. The rates of interest the Corporation earns on its assets and owes on its obligations generally are established contractually for a period of time. Since market interest rates change over time, the Corporation is exposed to lower profitability if it cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excess levels of interest rate risk could pose a significant threat to the Corporation’s earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to the Corporation’s safety and soundness. Loans are the most significant earning asset. Management offers commercial and real estate loans priced at interest rates which fluctuate with various indices, such as the prime rate or rates paid on various government issued securities. When loans are made with longer-term fixed rates, the Corporation attempts to match these balances with sources of funding with similar maturities in order to mitigate interest rate risk. In addition, the Corporation prices loans so it has an opportunity to reprice the loan within 12 to 36 months. At December 31, 2012 the Bank had $43.799 million of securities, with a weighted average maturity of 41.8 months. The investment portfolio is intended to provide a source of liquidity to the Corporation with limited interest rate risk. The Corporation may also elect to sell monies as investments in federal funds sold to correspondent banks, and has other interest bearing deposits with correspondent banks. These funds are generally repriced on a daily basis. The Corporation offers deposit products with a variety of terms ranging from deposits whose interest rates can change on a weekly basis to certificates of deposit with repricing terms of up to five years. Longer-term deposits generally include penalty provisions for early withdrawal. Beyond general efforts to shorten the loan pricing periods and extend deposit maturities, management can manage interest rate risk by the maturity periods of securities purchased, selling securities available for sale, and borrowing funds with targeted maturity periods, among other strategies. Also, the rate of interest rate changes can impact the actions taken, since the speed of change affects borrowers and depositors differently. Exposure to interest rate risk is reviewed on a regular basis. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect of interest rate changes on net interest income and to structure the composition of the balance sheet to minimize interest rate risk and, at the same time, maximize income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. Tools used by management include maturity and repricing analysis and interest rate sensitivity analysis. The Bank has monthly asset/ liability (“ALCO”) meetings, whose membership includes senior management, board representation and third party investment consultants. During these monthly meetings, we review the current ALCO position and strategize about future opportunities on risks relative to pricing and positioning of assets and liabilities. The difference between repricing assets and liabilities for a specific period is referred to as the gap. An excess of repricable assets over liabilities is referred to as a positive gap. An excess of repricable liabilities over assets is referred to as a negative gap. The cumulative gap is the summation of the gap for all periods to the end of the period for which the cumulative gap is being measured. Assets and liabilities scheduled to reprice are reported in the following timeframes. Those instruments with a variable interest rate tied to an index and considered immediately repricable are reported in the 1 to 90 day timeframe. The estimates of principal amortization and prepayments are assigned to the following time frames. 74 Management’s Discussion and Analysis of Financial Condition and Results of Operations The following is the Corporation’s repricing opportunities at December 31, 2012 (dollars in thousands): Interest-earning assets: Loans Securities Other (1) 1-90 Days 91-365 Days >1-5 Years Over 5 Years Total $ 287,081 - $ 10,702 7,629 $ 48,749 26,058 13 - - $ 102,645 10,112 3,060 $ 449,177 43,799 3,073 Total interest-earning assets 287,094 18,331 74,807 115,817 496,049 Interest-bearing obligations: NOW, money market, savings and interest checking Time deposits Brokered CDs Borrowings 169,294 15,372 - 10,000 - 55,921 - 10,000 - 88,407 37,706 15,000 - 205 - 925 169,294 159,905 37,706 35,925 Total interest-bearing obligations 194,666 65,921 141,113 1,130 402,830 Gap Cumulative gap $ 92,428 $ (47,590) $ (66,306) $ 114,687 $ 93,219 $ 92,428 $ 44,838 $ (21,468) $ 93,219 (1) includes Federal Home Loan Bank stock The above analysis indicates that at December 31, 2012, the Corporation had a cumulative asset sensitivity gap position of $44.838 million within the one-year timeframe. The Corporation’s cumulative asset sensitive gap suggests that if market interest rates were to increase in the next twelve months, the Corporation has the potential to earn more net interest income since more assets would reprice at higher rates than liabilities. Conversely, if market interest rates decrease in the next twelve months, the above gap position suggests the Corporation’s net interest income would decrease. A limitation of the traditional gap analysis is that it does not consider the timing or magnitude of non-contractual repricing or unexpected prepayments. In addition, the gap analysis treats savings, NOW and money market accounts as repricing within 90 days, while experience suggests that these categories of deposits are actually comparatively resistant to rate sensitivity. At December 31, 2012, the Corporation had $297.380 million of variable rate loans that reprice primarily with the prime rate index. Approximately $173.832 million of these variable rate loans have interest rate floors. This means that the prime rate will have to increase above the floor rate before these loans will reprice. At year end, $98.105 million of these floor- rate loans would reprice with a 100 basis point prime rate increase, with $173.410 million repricing with an additional 100 basis point prime rate increase. At December 31, 2011, the Corporation had a cumulative liability asset gap position of $69.219 million within the one-year time frame. The Corporation’s primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk and foreign exchange risk. The Corporation has no market risk sensitive instruments held for trading purposes. The Corporation has limited agricultural-related loan assets, and therefore, has minimal significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates are assumed to be insignificant. Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. The Corporation’s interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems, and internal controls are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of interest rate risk, the Corporation assesses the existing and potential future effects of changes in interest rates on its financial condition, including capital adequacy, earnings, liquidity, and asset quality. In addition to changes in interest rates, the level of future net interest income is also dependent on a number of variables, including: the growth, composition and levels of loans, deposits, and other earning assets and interest-bearing obligations, and economic and competitive conditions; potential changes in lending, investing, and deposit strategies; customer preferences; and other factors. 75 Management’s Discussion and Analysis of Financial Condition and Results of Operations The table below measures current maturity levels of interest-earning assets and interest-bearing obligations, along with average stated rates and estimated fair values at December 31, 2012 (dollars in thousands). Nonaccrual loans of $4.687 million are included in the table at an average interest rate of 0.00% and a maturity greater than five years. Rate Sensitive Assets Fixed interest rate securities Average interest rate Principal/Notional Amount Maturing/Repricing In: 2013 2014 2015 2016 2017 Thereafter Total Fair Value 12/31/2012 $ 7,629 $ 8,728 1.44 % 1.74 % 1.54 % $ 8,859 $ 8,312 3.59 % $ 159 5.14 $ 10,112 $ 43,799 $ 43,799 % 3.08 % 2.32 % Fixed interest rate loans Average interest rate 20,186 6.07 5,594 6.27 8,361 5.84 22,394 5.48 64,654 4.94 30,608 5.18 151,797 5.32 153,586 Variable interest rate loans Average interest rate 297,380 4.94 - - - - - - - - - - 297,380 4.94 285,653 Other assets Average interest rate 13 .15 - - - - - - - - 3,060 - 3,073 .15 3,073 Total rate sensitive assets Average interest rate $ 325,208 4.93 % $ 14,322 $ 17,220 $ 30,706 $ 64,813 $ 43,780 $ 496,049 $ 486,111 3.51 % 3.63 % 4.97 % 4.94 % 4.51 % 4.41 % Rate Sensitive Liabilities Interest-bearing savings, NOW, MMAs, interest Average interest rate Time deposits Average interest rate Fixed interest rate borrowings Average interest rate Total rate sensitive liabilities Average interest rate $ 169,294 .34 % - % - % - % $ - $ - $ - $ - % - % .34 % - $ - $ 169,294 $ 169,294 71,293 1.42 50,986 1.57 30,052 1.95 41,431 1.79 3,644 1.82 205 4.60 197,611 1.67 197,281 10,000 1.22 10,000 2.10 - - 15,000 2.03 - - 925 1.00 35,925 1.80 35,729 $ 250,587 .68 % $ 60,986 $ 30,052 $ 56,431 $ 3,644 $ 1,130 $ 402,830 $ 402,304 1.65 % 1.95 % 1.86 % 1.82 % 1.65 % 1.10 % Foreign Exchange Risk In addition to managing interest rate risk, management also actively manages risk associated with foreign exchange. The Corporation provides foreign exchange services, makes loans to, and accepts deposits from, Canadian customers primarily at its banking office in Sault Ste. Marie. To protect against foreign exchange risk, the Corporation monitors the volume of Canadian deposits it takes in and then invests these Canadian funds in Canadian commercial loans and securities. As of December 31, 2012, the Corporation had excess Canadian liabilities of $.071 million, which equated to approximately the same valuation in U.S. dollars. Management believes the exposure to short-term foreign exchange risk is minimal and at an acceptable level for the Corporation. Management intends to limit the Corporation’s foreign exchange risk by acquiring deposit liabilities approximately equal to its Canadian assets. Off-Balance-Sheet Risk Derivative financial instruments include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. The Corporation currently does not enter into futures, forwards, swaps or options. However, the Corporation is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit and involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower if deemed necessary by the Corporation. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions. 76 Management’s Discussion and Analysis of Financial Condition and Results of Operations Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Corporation until the instrument is exercised. See Note 17 to the consolidated financial statements for additional information. LIQUIDITY Liquidity is defined as the ability to generate cash at a reasonable cost to fulfill lending commitments and support asset growth, while satisfying the withdrawal demands of customers and make payments on existing borrowing commitments. The Bank’s principal sources of liquidity are core deposits and loan and investment payments and prepayments. Providing a secondary source of liquidity is the available for sale investment portfolio. As a final source of liquidity, the Bank can exercise existing credit arrangements. During 2012, the Corporation decreased cash and cash equivalents by $7.109 million. As shown on the Corporation’s consolidated statement of cash flows, liquidity was primarily impacted by cash used in investing activities. The net change in investing activities included a net increase in loans of $50.351 million and a “net” increase in securities available for sale of $4.541 million. The net increases in assets were offset by a similar increase in deposit liabilities of $29.768 million. This increase in deposits was composed of an increase in non-core deposits of $5.996 million combined with an increase in core deposits of $23.772 million. The management of bank liquidity for funding of loans and deposit maturities and withdrawals includes monitoring projected loan fundings and scheduled prepayments and deposit maturities within a 30 day period, a 30 to 90 day period and from 90 days until the end of the year. This funding forecast model is completed weekly. The Bank’s investment portfolio provides added liquidity during periods of market turmoil and overall liquidity concerns in the financial markets. As of December 31, 2012, $36.513 million of the Bank’s investment portfolio was unpledged, which makes them readily available for sale to address any short term liquidity needs. It is anticipated that during 2012, the Corporation will fund anticipated loan production with a combination of core-deposit growth and noncore funding, primarily brokered CDs. The Corporation’s primary source of liquidity on a stand-alone basis is dividends from the Bank. The Bank is currently prohibited from paying dividends because of a deficit in retained earnings. The Bank, in order to pay dividends in future periods, will need regulatory approval. The Corporation is currently exploring alternative opportunities for longer term sources of liquidity and permanent equity to support projected asset growth. Liquidity is managed by the Corporation through its Asset and Liability Committee (“ALCO”). The ALCO Committee meets monthly to discuss asset and liability management in order to address liquidity and funding needs to provide a process to seek the best alternatives for investments of assets, funding costs, and risk management. The liquidity position of the Bank is managed daily, thus enabling the Bank to adapt its position according to market fluctuations. Core deposits are important in maintaining a strong liquidity position as they represent a stable and relatively low cost source of funds. The Bank’s liquidity is best illustrated by the mix in the Bank’s core and non-core funding dependency ratio, which explains the degree of reliance on non-core liabilities to fund long-term assets. Core deposits are herein defined as demand deposits, NOW (negotiable order withdrawals), money markets, savings and certificates of deposit under $100,000. Non- core funding consists of certificates of deposit greater than $100,000, brokered deposits, and FHLB and other borrowings. At December 31, 2012, the Bank’s core deposits in relation to total funding were 79.17% compared to 79.11% in 2011. These ratios indicated at December 31, 2012, that the Bank has decreased its reliance on non-core deposits and borrowings to fund the Bank’s long-term assets, namely loans and investments. The Bank believes that by maintaining adequate volumes of short-term investments and implementing competitive pricing strategies on deposits, it can ensure adequate liquidity to support future growth. The Bank also has correspondent lines of credit available to meet unanticipated short- term liquidity needs. As of December 31, 2012, the Bank had $28.375 million of unsecured lines available and additional amounts available if secured. Management believes that its liquidity position remains strong to meet both present and future financial obligations and commitments, events or uncertainties that have resulted or are reasonably likely to result in material changes with respect to the Bank’s liquidity. From a long-term perspective, the Corporation’s liquidity plan for 2012 includes strategies to increase core deposits in the Corporation’s local markets and will continue to augment local deposit growth efforts with wholesale CD funding, to the extent necessary. 77 Management’s Discussion and Analysis of Financial Condition and Results of Operations CONTRACTUAL OBLIGATIONS AND COMMITMENTS As disclosed in the Notes to the Consolidated Financial Statements, the Corporation has certain obligations and commitments to make future payments under contracts. At December 31, 2012, the aggregate contractual obligations and commitments are (dollars in thousands): Contractual Obligations Total deposits Federal Home Loan Bank borrowings Preferred stock (1) Other borrowings Directors' deferred compensation Annual rental / purchase commitments under noncancelable leases / contracts TOTAL Other Commitments Less than 1 Year Payments Due by Period 4 to 5 Years 1 to 3 Years After 5 Years Total $ 308,239 10,000 $ 81,038 10,000 $ 45,075 15,000 $ 205 - $ 434,557 35,000 - - 123 249 11,000 - 217 224 - - 169 - - 925 36 - 11,000 925 545 473 $ 318,611 $ 102,479 $ 60,244 $ 1,166 $ 482,500 Letters of credit Commitments to extend credit Credit card commitments $ 2,879 3,060 58,209 $ - - - $ - - - $ - - - $ 2,879 3,060 58,209 TOTAL $ 64,148 $ - $ - $ - $ 64,148 (1)The Corporation issued preferred stock in April of 2009 as part of its participation in TARP. The initial term of this preferred stock is five years with an interest rate of 5%, which increases to 9% after the initial term. Although there is no contractual obligation to do so, the Corporation intends to repay this obligation within the initial term. CAPITAL AND REGULATORY As a bank holding company, the Corporation is required to maintain certain levels of capital under government regulation. There are several measurements of regulatory capital, and the Corporation is required to meet minimum requirements under each measurement. The federal banking regulators have also established capital classifications beyond the minimum requirements in order to risk-rate deposit insurance premiums and to provide trigger points for prompt corrective action in the event an institution becomes financially troubled. As of December 31, 2012, the Corporation and the Bank were well capitalized. During 2012, total capitalization increased by $17.185 million, with $11.506 million of this increase due to the issuance of common stock. Other changes in total capital occurred from recognition of net income and market value decrease of the Corporation’s investment securities. During 2012, risk based capital increased by $15.969 million, while Tier 1 Capital increased by $15.957 million. The increase in capital was also impacted by the disallowed portion of the Corporation’s deferred tax asset. The portion of the deferred tax asset which is allowed to be included in regulatory capital is only that portion that can be utilized within the next 12-month period. 78 Management’s Discussion and Analysis of Financial Condition and Results of Operations The following table details sources of capital for the three years ended December 31 (dollars in thousands): 2012 2011 2010 Capital Structure Common shareholders' equity Preferred stock Total shareholders' equity Total capitalization Tangible capital Intangible Assets Subsidiaries: Core deposit premium Other identifiable intangibles Total intangibles Risk-Based Capital Tier 1 capital: Total shareholders' equity Net unrealized (gains) losses on available for sale securities Less: disallowed deferred tax asset Less: disallowed intangibles Total Tier 1 capital Tier 2 Capital: Allowable reserve for loan losses Qualifying long-term debt Total Tier 2 capital Total risk-based capital Risk-weighted assets Capital Ratios: Tier 1 Capital to average assets Tier 1 Capital to risk-weighted assets Total Capital to risk-weighted assets $ $ $ 61,448 11,000 72,448 72,448 71,800 $ $ 44,342 10,921 55,263 55,263 54,863 $ $ 43,176 10,706 53,882 53,882 53,882 $ $ - $ 688 688 $ - $ 400 400 $ - $ - $ - $ 72,448 $ 55,263 $ 53,882 (924) (7,100) (69) 64,355 $ (325) (6,500) (40) 48,398 $ (612) (9,028) - 44,242 $ $ $ $ 5,218 - 5,218 69,573 466,039 $ $ 5,206 - 5,206 53,604 416,423 $ $ 4,890 - 4,890 49,132 389,468 $ $ 11.98% 13.81% 14.93% 10.08% 11.62% 12.87% 9.25% 11.36% 12.62% Regulatory capital is not the same as shareholders’ equity reported in the accompanying condensed consolidated financial statements. Certain assets cannot be considered assets for regulatory purposes. The Corporation’s acquisition intangibles and a portion of the deferred tax asset are examples of such assets, which was discussed earlier. Presented below is a summary of the Corporation’s and Bank’s capital position in comparison to generally applicable regulatory requirements: Regulatory minimum for capital adequacy purposes Regulatory defined well capitalized guideline The Corporation: December 31, 2012 December 31, 2011 The Bank: December 31, 2012 December 31, 2011 Equity to Year-end Assets N/A N/A Tangible Equity to Year-end Assets N/A N/A Tier 1 Capital to Average Assets Tier 1 Capital to Risk Weighted Assets Total Capital to Risk Weighted Assets 4.00% 5.00% 4.00% 6.00% 8.00% 10.00% 13.27% 11.09% 13.14% 11.01% 11.98% 10.08% 13.81% 11.62% 14.93% 12.87% 10.96% 10.30% 10.83% 10.22% 9.63% 9.24% 11.10% 10.65% 12.21% 11.90% The Corporation intends to maintain the Bank’s Tier I Capital at 8% and total capital to risk-weighted assets at a minimum of 10.00% in order to qualify for reduced FDIC deposit based insurance. 79 Management’s Discussion and Analysis of Financial Condition and Results of Operations IMPACT OF INFLATION AND CHANGING PRICES The accompanying financial statements have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and results of operations in historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Corporation’s operations. Nearly all the assets and liabilities of the Corporation are financial, unlike industrial or commercial companies. As a result, the Corporation’s performance is directly impacted by changes in interest rates, which are indirectly influenced by inflationary expectations. The Corporation’s ability to match the interest sensitivity of its financial assets to the interest sensitivity of its financial liabilities tends to minimize the effect of changes in interest rates on the Corporation’s performance. Changes in interest rates do not necessarily move to the same extent as changes in the prices of goods and services. 80 Directors and Officers DIRECTORS Mackinac Financial Corporation and mBank Walter J. Aspatore - Lead Director Chairman Methode Electronics Corp Director Since: 2004 Dennis B. Bittner Owner and President Bittner Engineering, Inc. Director Since: 2001 Joseph D. Garea Managing Partner Hancock Securities Director Since: 2007 Robert H. Orley Founding Partner O2 Investment Partners, LLC Director Since: 2004 L. Brooks Patterson County Executive Oakland County Director Since: 2006 Randolph C. Paschke Director of Community Relations & External Engagement Wayne State University, School of Business Administration Director Since: 2004 Kelly W. George President, Mackinac Financial Corporation President and CEO, mBank Director Since: 2006 David R. Steinhardt Founder and President KCPS & Company Ltd. Director Since: 2012 Robert E. Mahaney President and Owner Veridea Group, LLC Director Since: 2008 Paul D. Tobias Chairman and CEO, Mackinac Financial Corporation Chairman, mBank Director Since: 2004 81 Directors and Officers Name Paul D. Tobias Kelly W. George Ernie R. Krueger Name Bernadette C. Beaudre Shelby J. Bischoff Linda K. Bolda Catherine M. Bolm Angela E. Buckingham Jesse A. Deering Richard B. Demers Trisha L. Demars George J. Demou Elena C. Dritsas Jeremy W. Flodin Laura L. Garvin Kelly W. George Clarice A. Ghiardi Joseph T. Havican Michael J. Hoar Ernie R. Krueger David W. Leslie Magan L. MacArthur Boris Martysz Tamara R. McDowell Jacquelyn R. Menhennick Robert J. Needham Barbara A. Parrett Debra L. Peterson Scott A. Ravet Jason J. Rolling Andrew P. Sabatine Michael J. Saporito Teresa M. Same Gregory D. Schuetter Joanna B. Slaght Michael A. Slaght Jennifer A. Stempki Ann M. Stepp Daniel L. Stoudt David R. Thomas Paul D. Tobias Nicole A. Tryan Janet M. Willbee OFFICERS Mackinac Financial Corporation Title Chairman and Chief Executive Officer President EVP - Chief Financial Officer mBank Title AVP - Deposit Compliance/BSA Officer AVP - Business Development Officer SVP - Human Resources Director VP - Mortgage Loan Officer AVP - Branch Sales Manager SVP - Managing Director of Retail Branch Banking/Ops/IT VP - Commercial Banking Officer AVP - Sr. Deposit Operations Specialist VP - Senior Commercial Banking Officer AVP - Branch Sales Manager /Treasury Management Officer VP - Sr. Credit Administrator/Credit Risk Analyst VP - Commercial Portfolio Manager President and CEO VP - Mortgage Loan Officer VP - Commercial Banking Officer SVP - Information Technology/Communications Manager EVP - Chief Financial Officer SVP - SEM/Gaylord Commercial Lending Manager AVP - Mortgage Loan Officer SVP - Marquette Regional Executive EVP - Chief Credit Officer SVP - Mortgage and Consumer Lending Manager AVP - Commercial Banking Officer AVP - Branch Sales Manager/Retail Banking Officer VP - Mortgage Loan Officer VP - Commercial Banking Officer VP - Premier Client Services Regional President - NLP SVP- Chief Operations Officer AVP - Branch Sales Manager SVP - UP Commercial Lending Manager SVP - Compliance/Risk Manager VP - Commercial Banking Officer VP - Controller SVP - Branch Administration/Incentive Program Officer AVP - Mortgage Loan Officer VP - Commercial Banking Officer Chairman AVP - Sr. Loan Operations Officer VP - Mortgage Loan Officer Location Birmingham Manistique Manistique Location Manistique Marquette Manistique Marquette Newberry Birmingham Manistique Manistique Birmingham Birmingham Manistique Birmingham Manistique Marquette Marquette Manistique Manistique Birmingham Manistique Marquette Manistique Marquette Traverse City Stephenson Escanaba Escanaba Marquette Traverse City Manistique Marquette Manistique Manistique Newberry Manistique Gaylord Traverse City Sault Ste. Marie Birmingham Manistique Gaylord 82 (This page has been left blank intentionally.) 83 (This page has been left blank intentionally.) 84 Corporate Information CORPORATE HEADQUARTERS Mackinac Financial Corporation 130 South Cedar Street Manistique, Michigan 49854 (888) 343-8147 INVESTOR RELATIONS Ernie R. Krueger EVP/CFO (906) 341-7158 ekrueger@bankmbank.com TRANSFER AGENT Registrar and Transfer Company 10 Commerce Drive Cranford, NJ 07016 (800) 368-5948 WEBSITE www.bankmbank.com INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Plante Moran, PLLC Grand Rapids, Michigan STOCK LISTING AND SYMBOL NASDAQ Capital Market Symbol: MFNC SHAREHOLDER INFORMATION Copies of the Corporation’s 10-K and 10-Q reports as filed with the Securities and Exchange Commission are available upon request from the Corporation. ANNUAL SHAREHOLDERS’ MEETING The 2013 Annual Meeting of the Shareholders of Mackinac Financial Corporation will be held on May 29, 2013. Visit our website, www.bankmbank.com, for updated news releases, financial reports, SEC filings, corporate governance and other investor information. bankmbank.com 906.341.8401 | 130 S Cedar Street, Manistique, MI 49854-1438

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