Mackinac Financial Corp.
Annual Report 2014

Plain-text annual report

A N N U A L R E P O R T Table of Contents To Our Shareholders .............................................................................................................................. 1 Five-Year Overview .............................................................................................................................. 6 Regional Review ................................................................................................................................... 8 Selected Financial Highlights .............................................................................................................. 14 Report of Independent Registered Public Accounting Firm ............................................................... 15 Consolidated Balance Sheets ............................................................................................................... 16 Consolidated Statements of Operations ............................................................................................... 17 Consolidated Statements Comprehensive Income .............................................................................. 18 Consolidated Statements of Changes in Shareholders’ Equity ........................................................... 19 Consolidated Statements of Cash Flows ............................................................................................. 20 Notes to Consolidated Financial Statements ....................................................................................... 21 Selected Financial Data ....................................................................................................................... 57 Summary Quarterly Financial Information ......................................................................................... 58 Market Information ............................................................................................................................. 60 Shareholder Return Performance Graph ............................................................................................. 61 Forward-Looking Statements .............................................................................................................. 62 Management’s Discussion and Analysis of Financial Condition and Results of Operations ................................................................................................ 64 Directors and Officers ......................................................................................................................... 85 ______________________________________________________________________________________ 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 $740 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 17 branch locations; thirteen 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, 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 1,600 shareholders of record as of March 30, 2015. To Our Shareholders March 30, 2015 TO OUR SHAREHOLDERS: It was an eventful and productive year on numerous fronts for your company. We successfully completed the corporation’s first acquisition (Peninsula Financial Corporation) since the 2004 recapitalization. We are very pleased with the transaction and believe our patience has been rewarded (we will comment more about this later in the letter). We also maintained focus on core operations without materially increasing the overall risk profile of the company. Total assets surpassed $740 million in part to the acquisition as well as the $50 million of organic balance sheet loan growth at the bank. Your company earned $1.7 million or $.30 per share despite onetime deal related expenses having a negative $1.810 million impact on earnings. Excluding these expenses your company earned about $3.5 million or $.62 per share, this would be an improvement over 2013 earnings of $.61 per share when excluding onetime gains. Even with the aforementioned acquisition activity, the per share book price increased from $11.77 at year end 2013 to $11.81 at year end 2014. By increasing the book price in the same year as executing an acquisition, we believe we have created intrinsic shareholder value and strengthened future earnings capability of the corporation through increased scale. We believe this will bode well for long-term value creation. 2014 OVERVIEW We are pleased with the progress in 2014 in what continues to be a very challenging economic, regulatory and overall community banking environment. The following are some specific highlights from the year: (cid:2) In a compressed and stagnant interest rate environment our Net Interest Margin increased from 4.17% in 2013 to 4.19% in 2014. We attribute the ability to maintain spread to continued discipline of loan and deposit pricing at the bank level. As we move closer to a potential raising rate environment, we believe we are well positioned in terms of our loan and funding mix to mitigate interest rate risk. Increased interest rates will likely benefit your company and should increase overall profitability. (cid:2) Total loan production at the bank remained fairly consistent and did not suffer greatly as a result of loan pricing parameters and the significant industry-wide slowdown in mortgage lending. 2014 saw sustained loan growth and production totaling approximately $183 million with net organic balance sheet growth of about $50 million. All three regions within Michigan contributed to loan origination success. Total assets of the corporation grew 29.85% to $743.785 as of December 31, 2014 due to both organic growth and the acquisition. (cid:2) Credit quality remains an important focus for the company as we believe the loan book is truly the cornerstone of risk management within any community bank. Nonperforming assets equated to $6.949 million or .93% of total assets at the end of the period. All of our asset quality metrics compare very favorably to our peers even as we continue to navigate the highly competitive lending environment within our various regions. We continue to be true to our underwriting and credit culture, which has proven to be effective over time. (cid:2) As the company increases in size, we maintain a close eye on financial efficiency i.e. how efficient operations are in creating profits. We pay particular attention to Non-interest Expense as a percentage of Average Assets as an indicator of success and the company continues to compare favorably to peers in this metric. This is another area where scale is beneficial given increased overall cyber security, regulatory and compliance oversight has contributed to generally higher operating expenses across the industry. Increased size allows us to spread these costs over more earning assets and create more efficient earnings. 1 To Our Shareholders (cid:2) Capital levels for both the Bank and Corporation remain above regulatory guidelines following the acquisition. Strong capital levels as well as earnings allowed for an annualized dividend payment increase from $.20 per common share in 2013 to $.30 per common share in 2014. (cid:2) We also experienced growth in our deposits at the bank, primarily through the acquisition. As we grow our asset base, we prefer to fund our loans by using core deposits that are generally less expensive than alternative funding sources. The increased core deposit portfolio should support future loan origination in the markets we entered through the acquisition. (cid:2) Due to competition and difficult market conditions (a shortage of work out loans from other banks), our asset based lending subsidiary, Mackinac Commercial Credit, LLC (MCC) took longer to reach profitability than anticipated. However, the company was on-track to reach sustained profitability beginning in January 2015. We still believe the addition of MCC provides another diversified line of business and revenue stream to augment overall company earnings in the future. PENINSULA BANK ACQUISITION As we have communicated in the past, our posture on M&A activity is to be opportunistic but also mindful of strategic and financial benefits of any transaction. In early December 2014 we successfully completed the acquisition of Peninsula Financial Corporation the holding company for Peninsula Bank (Pen), a company that met both requirements. Pen was a 127-year old state chartered bank located in Ishpeming, Michigan. Ishpeming is located in western Marquette County in the Upper Peninsula. The bank was deeply rooted in the communities it served and shared similar customer centric cultures with your company. The $125 million asset size and $100 million in core deposits were a good fit and the price allowed for immediate earnings accretion and an acceptable tangible book value earn back period. Given mBank’s presence in the city of Marquette in the eastern part of the county, the acquisition added complimentary markets to the current footings with low execution risk in the largest economic center in the Upper Peninsula. It is believed that there continues to be growth opportunities through the new branch network which all remained open and staffed by many of the same employees who worked for Pen. We believe the employee and cultural transition and data system conversion processes have gone well with much of the credit going to the employees and management who have worked tirelessly on the project. The goal is to continue to serve our new clients and communities and offer best in class banking products and services to meet their needs. GENERAL COMMENTARY All of the aforementioned strategic initiatives and the operating metrics that they will most directly impact are focused on creating increased long-term value for our stakeholders. We believe your company continues to be well positioned to achieve continued success in the ever changing banking landscape and will provide good operating results through a stable low risk operating platform, a well embedded company culture, and a highly experienced management team and Board of Directors. EARNINGS RECAP To add further detail to earnings commentary and the impact of “one-time” items, 2014 income of the company was $1.700 million, or $.30 per share, compared to net income available to common shareholders of $5.629 million, or $1.01, per share for 2013. In 2013, a deferred tax benefit of $2.250 million was recorded which equated to $.40 per share. In connection with this acquisition and other strategic initiatives, the Corporation had nonrecurring transaction related expenses totaling $2.475 million. These “one-time” costs reduced the reported net income in 2014 by $1.810 million, or $.32 per share, on an after tax basis. The adjusted net income for 2014 (not inclusive of the nonrecurring transaction related expenses) would equate to $3.510 million, or $.62 per share, compared to adjusted net income of $3.379 million in 2013 (not including the deferred tax benefit), or $.61 per share. Weighted average shares for 2014 totaled 5,592,738 compared to 5,558,383 shares in 2013. 2 To Our Shareholders The Bank recorded net income of $4.070 million for 2014 compared to $4.939 million in 2013, as adjusted for the $2.250 million deferred tax benefit. In 2014, the Bank recorded $.786 million, after tax, of nonrecurring transaction related expenses. The adjusted income for 2014 would have been $4.856 million, compared to the adjusted income of $4.939 million in 2013. The slight reduction in core income for the bank was largely attributable to large reductions year to year in secondary market mortgage lending activities seen throughout the industry and some smaller reductions in our SBA originations for sale. While our performance in these lines of business remains solid, external economic factors will effect, to a certain extent, the volume of these products both on a macro (industry) and micro (bank) scale. These reductions were offset by strong gains in net interest income of approximately $1.1 million through continued strong balance sheet growth and sustained margin. Total assets of the Corporation at December 31, 2014 were $743.785 million, up 29.85% from the $572.800 million reported at December 31, 2013. LOAN GENERATION / CREDIT QUALITY Total loans at December 31, 2014 were $600.935 million compared to $483.832 million at 2013 year end. Loans acquired from Peninsula Bank were $67 million, and the Corporation had organic growth in 2014 of $50 million. In addition to the aforementioned balance sheet totals, the company services $224 million of sold mortgage loans and $46 million of sold SBA and USDA loans. Total loans under management total $871 million as of year end. New loan production totaled $183 million with the Upper Peninsula contributing $105 million, the Northern Lower Peninsula $40 million and Southeast Michigan $38 million. Commercial loan production accounted for $110 million of the 2014 total, with consumer loans, primarily 1-4 family mortgages, of $73 million. Nonperforming loans totaled $3.939 million, .66% of total loans at December 31, 2014 compared to $2.024 million, or .42% of total loans at December 31, 2013. Nonperforming assets were $6.949 million, .93% of total assets compared to $3.908 million, .68% of assets at 2013 year end with the increase primarily a result of the Pen acquisition. DEPOSITS Total deposits of $606.973 million at 2014 year end included $101 million deposits acquired with the Pen acquisition. The organic growth of deposits was approximately $40 million from 2013 year-end and was comprised primarily of wholesale deposit funding. THE FOLLOWING TABLES AND COMMENTARY FURTHER ILLUSTRATE OUR ON-GOING PERFORMANCE IN DEVELOPING OUR LOAN PRODUCTION, CORE LINES OF BUSINESS’S AND OTHER KEY DRIVERS TO INCREASE SHAREHOLDER VALUE. Loan Growth/Production Three year loan production for our geographical regions is shown below: The Corporation has seen strong sustained loan production continue over the three year period even with the recent increasingly competitive landscape. (dollars in thousands) For the Year Ending December 31, 2014 2013 2012 REGION Upper Peninsula Northern Lower Peninsula Southeast Michigan $ 104,601 40,133 38,669 $ 124,836 48,004 18,078 $ 134,257 37,856 41,989 TOTAL $ 183,403 $ 190,918 $ 214,102 3 To Our Shareholders Government Guaranteed Lending Programs Our total production of sold loans for the last three years was $27 million, with $2.837 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 generates an acceptable internal rate of return. Continued demand from buyers has kept pricing strong and we believe there is opportunity in this line of business for further growth. # Loans 2014 SBA Amount Premium SBA/USDA Loans Originated For the Year Ended December 31, 2013 SBA Amount # Loans Premium # Loans 2012 SBA Amount Premium UP NLP SEM Total 8 1 4 13 Key Performance Metrics $ $ $ $ $ $ 4,123 149 2,803 7,075 424 8 278 710 11 2 1 14 7,285 750 359 8,394 819 89 43 951 13 2 2 17 8,993 354 2,615 11,962 881 14 281 1,176 $ $ $ $ $ $ The following table illustrates stable operating metrics in several key performance areas. The Efficiency Ratio for year end is slightly skewed given the period-end fell in the middle of the operations integration of Pen and the slightly longer than expected period for Mackinac Commercial Credit to reach profitability. We expect that number to normalize over the first half of 2015. Net Interest Margin Efficiency Ratio Credit Quality (Texas Ratio) Noninterest Expense to Average Assets 2014 2013 2012 4.19% 74.43% 9.37% 3.28% 4.17% 67.46% 5.59% 3.22% 4.17% 67.95% 10.25% 3.09% Capital The Corporation and Bank’s capital levels are strong and exceed regulatory “well-capitalized” levels as shown in the table below. The holding company remains a solid source of strength to support both bank and non-bank subsidiaries as needed and, perhaps most importantly, we maintain strong capital position post transaction. Tier 1 Capital to Average Assets Tier 1 Capital to Risk Weighted Assets Total Capital to Risk Weighed Assets Bank Consolidated 9.11% 8.57% 10.98% 10.23% 11.82% 11.07% LOOKING FORWARD: As we look forward to 2015, we are keeping a close watch on industry trends that may potentially affect the company. Interest rate pressure and the potential for rates to begin to increase in 2015 will necessitate continued focus on Net Interest Margin, funding and loan portfolio pricing especially the ratio of fixed to floating rate loans. It will be important to maintain consistent underwriting and credit culture as competitive and interest rate pressure continues across the industry. Increased use of technology and banking solutions including mobile & online banking will require attention to customer demand for new products and services. IT infrastructure and capabilities must keep pace with demand as security will remain a high priority with the increased use of technology as a banking platform and given the continued increase in attempted cybercrimes across all industries. Your management team continues to look for ways to enhance shareholder value through exploration of expansion opportunities within our current markets by way of bank or branch acquisition and potentially additional complimentary lines of business. We have a stable management team and experienced personnel with capacity to support future growth. 4 To Our Shareholders We will continue to cultivate strong company culture which remains dedicated to serving the communities in which we live and work. Finally, as we have committed to in the past, we will be patient in evaluating and executing any external growth strategy while continuing with the daily execution of organic franchise development with increased operational efficiencies. In closing, on behalf of the mBank Board of Directors, Management and employees, we would like to both thank our long time shareholders and welcome new owners to the company for their both their support and patronage as clients of the bank. We are fortunate to work for Mackinac Financial Corporation with a talented and hardworking team, we are all looking forward to success in 2015 and beyond. Sincerely, Paul D. Tobias Chairman and CEO Mackinac Financial Corporation Kelly W. George President and CEO mBank 5 Five Year Overview 6 Five Year Overview Loans outstanding at 2014 year end include $64.123 million of PFC loans outstanding. (1) Mackinac Financial Corporation acquired Peninsula Financial Corporation (“PFC”) on December 5, 2014. The data above reflects the impact of the acquisition. 7 Regional Review – Upper Peninsula BRANCH LOCATIONS ESCANABA 2224 N. Lincoln Road Escanaba, MI 49829 (906) 233-9443 Manager: April J. Stropich ISHPEMING – DOWNTOWN 100 S. Main Street Ishpeming, MI 49849 (906) 485-6333 Manager: Anita G. Sandberg ISHPEMING – JUBILEE Located in Jubilee Foods Ishpeming, MI 49849 (906) 486-9595 Manager: Jill C. Dompierre MANISTIQUE – LAKESHORE Located in Jack’s Supervalu Manistique, MI 49854 (906) 341-7190 Manager: Kendra L. Lander MARQUETTE 857 W. Washington Street Marquette, MI 49855 (906) 226-5000 Manager: Teresa M. Same MARQUETTE – MCCLELLAN 175 S. McClellan Avenue Marquette, MI 49855 (906) 228-3933 Manager: Tia M. Rodda NEWBERRY 414 Newberry Avenue Newberry, MI 49868 (906) 293-5165 Manager: Angela E. Buckingham ISHPEMING – WEST US 41 West & 170 N. Daisy Street Ishpeming, MI 49849 (906) 485-5717 Manager: Jill C. Dompierre MARQUETTE – MEDICAL CENTER 1414 W. Fair Avenue, Suite 140 Marquette, MI 49855 (906) 226-0581 Manager: Tia M. Rodda SAULT STE. MARIE 138 Ridge Street Sault Ste. Marie, MI 49783 (906) 635-3992 Manager: Lori A. McKerchie MANISTIQUE 130 South Cedar Street Manistique, MI 49854 (906) 341-8401 Manager: Kendra L. Lander NEGAUNEE Located in Super One Foods Negaunee, MI 49866 (906) 475-0120 Manager: Jill C. Dompierre STEPHENSON S216 Menominee Street Stephenson, MI 49887 (906) 753-2225 Manager: Barbara A. Parrett (dollars in thousands) Escanaba Ishpeming Manistique Marquette Negaunee Newberry Sault Ste. Marie Stephenson BALANCE SHEET HIGHLIGHTS At December 31, 2014 Loans Core Deposits 2014 Loan Production* $ 21,934 41,466 93,315 140,080 1,166 16,505 44,303 9,168 $ 17,221 73,267 42,919 64,063 2,490 34,945 22,344 35,868 $ 17,772 - 27,195 45,599 - 4,338 8,604 1,093 TOTAL UPPER PENINSULA $ 367,937 $ 293,117 $ 104,601 * Includes production of mortgage loans sold on the secondary market. 8 Regional Review – Upper Peninsula Core deposit increases were primarily a result of the acquisition of PFC on December 5, 2014. 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 $514.2 million. Nonperforming assets in the Upper Peninsula totaled $6.705 million at the end of 2014, which included $3.010 million of OREO and $3.695 million of nonperforming loans. Nonperforming loans as a percent of total loans was 1.32%. 9 Regional Review – Northern Lower Peninsula BRANCH LOCATIONS GAYLORD 1955 South Otsego Avenue Gaylord, MI 49735 (989) 732-3750 Manager: Jessica M. Beals 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 (dollars in thousands) Gaylord Kaleva Traverse City BALANCE SHEET HIGHLIGHTS At December 31, 2014 Loans Core Deposits 2014 Loan Production* $ 35,044 412 63,022 $ 59,727 16,717 57,438 $ 9,015 79 31,039 TOTAL NORTHERN LOWER PENINSULA $ 98,478 $ 133,882 $ 40,133 * Includes production of mortgage loans sold on the secondary market. 10 Regional Review – Northern Lower Peninsula 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 $185.2 million. Nonperforming assets in the Northern Lower Peninsula totaled $.244 million at the end of 2014, all nonperforming loans. Nonperforming loans as a percent of total loans was .25%. 11 Regional Review – Southeast Michigan BRANCH LOCATION BIRMINGHAM 260 East Brown Street, Suite 300 Birmingham, MI 48009 (248) 290-5900 Manager: Mary B. Schroeder BALANCE SHEET HIGHLIGHTS At December 31, 2014 (dollars in thousands) Loans Core Deposits 2014 Loan Production Birmingham $ 125,816 $ 44,030 $ 38,669 The Corporation’s asset based lending subsidiary, Mackinac Commercial Credit (“MCC”), is also based in Southeast Michigan. The subsidiary began operations late in 2013, with 2014 year end loan balances of $8.704 million. The subsidiary reached sustained profitability in early 2015. 12 Regional Review – Southeast Michigan 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 $138.7 million. There were no nonperforming assets in Southeast Michigan at 2014 year end. 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 December 31, 2014 December 31, 2013 (Unaudited) $ 743,785 600,935 65,832 606,973 49,846 73,996 73,996 $ 572,800 483,832 44,388 466,299 37,852 65,249 65,249 Selected Statements of Income Data: Net interest income Income before taxes and preferred dividend Net income Income per common share - Basic Income per common share - Diluted Dividends paid per share 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 Tangible book value per 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 $ $ 23,527 2,829 1,700 .30 .30 .225 5,592,738 5,653,811 21,399 5,534 5,629 1.01 1.00 .170 5,558,313 5,650,058 $ $ % 4.19 74.43 .28 2.57 2.57 % 4.17 67.46 1.01 9.07 8.26 $ 605,612 66,249 66,249 103.98 $ 555,152 62,082 68,172 103.46 % % $ $ $ 11.85 11.81 11.01 6,266,756 $ $ $ 9.90 11.77 11.77 5,541,390 $ $ $ $ % % % % % % 5,140 4,668 .86 .63 9.37 4,661 3,908 .96 .68 5.59 17 160 11 133 The above summary should be read in connection with the related consolidated financial statements and notes included elsewhere in this report. 14 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 accompanying consolidated balance sheet of Mackinac Financial Corp. (the Corporation) as of December 31, 2014 and 2013, and the related consolidated statements of operations, comprehensive income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2014. These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these 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 Corporation is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit 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 Corporation’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes 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 financial position of Mackinac Financial Corp. as of December 31, 2014 and 2013, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2014, in conformity with accounting principles generally accepted in the United States of America. March 30, 2015 Auburn Hills, Michigan 15 Consolidated Balance Sheets MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES December 31, 2014 and 2013 (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 Consumer Total Loans Allowance for loan losses Net loans Premises and equipment Other real estate held for sale Deferred Tax Asset Deposit based intangible Goodwill Other assets TOTAL ASSETS LIABILITIES AND SHAREHOLDERS' EQUITY LIABILITIES: Deposits: Noninterest bearing deposits NOW, money market, interest 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, Issued and outstanding - none and 11,000 shares Common stock and additional paid in capital - No par value Authorized - 18,000,000 shares Issued and outstanding - 6,266,756 and 5,541,390, shares respectively Retained earnings Accumulated other comprehensive income Total shareholders' equity December 31, 2014 December 31, 2013 $ 21,947 - 21,947 $ 18,216 3 18,219 5,797 65,832 2,973 433,566 148,984 18,385 600,935 (5,140) 595,795 12,658 3,010 11,498 1,196 3,805 19,274 10 44,388 3,060 359,368 110,663 13,801 483,832 (4,661) 479,171 10,210 1,884 9,933 - - 5,925 $ 743,785 $ 572,800 $ 95,498 212,565 28,015 134,951 30,316 105,628 606,973 $ 72,936 149,123 13,039 140,495 23,159 67,547 466,299 49,846 12,970 669,789 - 61,679 11,804 513 73,996 37,852 3,400 507,551 - 53,621 11,412 216 65,249 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 743,785 $ 572,800 See accompanying notes to consolidated financial statements. 16 Consolidated Statements of Operations MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES Years Ended December 31, 2014, 2013, and 2012 (Dollars in Thousands, Except Per Share Data) ___________________________________________________________________________________________________ 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 Income from loans sold on the secondary market SBA/USDA loan sale gains Mortgage servicing income Net security gains Other Total other income OTHER EXPENSE: Salaries and employee benefits Occupancy Furniture and equipment Data processing Advertising Professional service fees Loan and deposit Writedowns and losses on other real estate held for sale FDIC insurance assessment Telephone Nonrecurring transaction related expenses Other Total other expenses Income before income taxes Provision (benefit of) for income taxes NET INCOME Preferred dividend and accretion of discount For the Years Ended December 31, 2013 2014 2012 $ 26,461 30 $ 24,295 105 $ 23,197 116 962 64 152 27,669 3,218 924 4,142 23,527 1,200 22,327 701 637 757 675 54 288 3,112 10,303 2,129 1,268 1,150 449 1,163 699 280 362 327 2,475 2,005 22,610 2,829 1,129 1,700 - 961 34 128 25,523 3,468 656 4,124 21,399 1,675 19,724 667 1,028 951 790 73 429 3,938 9,351 1,481 1,102 1,071 436 1,069 617 265 385 303 - 2,048 18,128 5,534 (403) 5,937 308 948 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 1,372 885 991 376 1,196 877 489 459 233 - 1,591 16,757 6,165 (922) 7,087 629 NET INCOME AVAILABLE TO COMMON SHAREHOLDERS $ 1,700 $ 5,629 $ 6,458 INCOME PER COMMON SHARE: Basic Diluted Cash dividends per share $ $ $ .30 .30 .225 $ $ $ 1.01 1.00 .170 $ $ $ 1.51 1.51 .120 See accompanying notes to consolidated financial statements. 17 Consolidated Statement of Comprehensive Income MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES Years Ended December 31, 2014, 2013, and 2012 (Dollars in Thousands) _____________________________________________________________________________________________ Net income Other comprehensive income Change in securities available for sale: Unrealized gains (losses) arising during the period Reclassification adjustment for securities gains included in net income Tax effect Unrealized gains (losses) on available for sale securities Defined benefit pension plans: Net unrealized actuarial loss on defined benefit pension obligation Amortization of net loss and settlement cost recognized in income Tax effect Changes from defined benefit pension plans Other comprehensive income (loss), net of tax For the year ended December 31, 2013 2014 2012 $ 1,700 $ 5,937 $ 7,087 578 (54) (178) 346 (74) - 25 (49) 297 (999) (73) 364 (708) - - - - (708) 907 - (308) 599 - - - - 599 Total comprehensive income $ 1,997 $ 5,229 $ 7,686 See accompanying notes to consolidated financial statements. 18 Consolidated Statements of Changes in Shareholders’ Equity MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES Years Ended December 31, 2014, 2013, and 2012 (Dollars in Thousands) __________________________________________________________________________________________ Balance, January 1, 2012 3,419,736 $ 10,921 $ 43,525 $ 492 $ 325 $ 55,263 Shares of Common Stock Preferred Stock Series A Common Stock and Additional Paid in Capital Retained Earnings (Accumulated Deficit) Accumulated Other Comprehensive Income Total 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 Balance, December 31, 2012 5,559,859 11,000 Net income Other comprehensive income (loss): Net unrealized gain on securities available for sale Total comprehensive income Stock compensation Issuance of common stock Repurchase of common stock Dividend on common stock Dividend on preferred stock Redemption of Preferred Series A - - 37,125 (55,594) - - - - - - - - (11,000) - 66 11,506 - (1,300) - - 53,797 - 333 - (509) - - - 7,087 - - - (223) - (550) (79) 6,727 5,937 - - - - (944) (308) - 7,087 599 7,686 66 11,506 (223) (1,300) (550) - 72,448 5,937 (708) 5,229 333 - (509) (944) (308) (11,000) 599 - - - - - - 924 (708) - - - - - - Balance, December 31, 2013 5,541,390 $ - $ 53,621 $ 11,412 $ 216 $ 65,249 Net income Other comprehensive income (loss): Net unrealized gain on securities available for sale Actuarial loss on defined benefit pension obligation Total comprehensive income Stock compensation Issuance of common stock: Acquisition - Peninsula Financial Corp Stock option exercise Restricted stock award vesting Total issuance of common stock Repurchase of common stock Dividend on common stock - - - - - 695,361 6,580 37,125 739,066 (13,700) - - - - - - - - - - - - - - - - 429 7,804 (32) - 7,772 (143) - 1,700 - 1,700 - - - - - - - - - (1,308) 346 (49) 297 - - - - - - 346 - (49) 1,997 429 - 7,804 (32) - 7,772 (143) (1,308) Balance, December 31, 2014 6,266,756 $ - $ 61,679 $ 11,804 $ 513 $ 73,996 See accompanying notes to consolidated financial statements. 19 Consolidated Statements of Cash Flows MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES Years Ended December 31, 2014, 2013, and 2012 (Dollars in Thousands) _____________________________________________________________________________________________ For the year ended December 31, 2013 2014 2012 Cash Flows from Operating Activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Provision for loan losses Deferred income taxes, net (Gain) loss on sales/calls of securities (Gain) on sale of loans sold in the secondary market Origination of loans held for sale in secondary market Proceeds from sale of loans in the secondary market 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 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 Net cash used in Peninsula acquisition Proceeds from sale of premises, equipment, and other real estate Redemption of FHLB stock Net cash (used in) investing activities Cash Flows from Financing Activities: Net increase in deposits Net activity on line of credit Net proceeds from stock issuance Repurchase of common stock Dividend on common stock Redemption of Series A Preferred Stock Repurchase of common stock warrants Dividend on preferred stock Proceeds from term borrowing Principal payments on borrowings Net cash provided by financing activities Net (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period $ 1,700 $ 5,937 $ 7,087 1,503 1,200 1,129 (54) (493) (29,871) 30,364 81 228 429 (4,112) 6,337 8,441 (50,969) (225) (8,317) 9,449 (1,433) (4,484) 912 87 (54,980) 39,724 9,367 - (143) (1,308) - - - 3,000 (373) 50,267 3,728 18,219 1,657 1,675 (403) (73) (794) (55,973) 56,767 304 231 333 (710) 350 9,301 (37,853) - (15,709) 13,698 (1,497) - 2,410 - (38,951) 31,742 2,000 - (509) (944) (11,000) - (308) - (73) 20,908 (8,742) 26,961 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 Cash and cash equivalents at end of period $ 21,947 $ 18,219 $ 26,961 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) $ 4,119 100 $ 4,157 149 $ 4,172 125 588 932 1,352 See accompanying notes to consolidated financial statements. 20 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”), Mackinac Commercial Credit, LLC (“MCC”, formed in late 2013) 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. 21 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. Acquired Loans Loans acquired with evidence of credit deterioration since inception and for which it is probable that all contractual payments will not be received are accounted for under ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”). These loans are recorded at fair value at the time of acquisition, with no carryover of the related allowance for loan losses. Fair value of acquired loans is determined using a discounted cash flow methodology based on assumptions about the amount and timing of principal and interest payments, principal prepayments and principal defaults and losses, and current market rates. In recording the fair values of acquired impaired loans at acquisition date, management calculates a non-accretable difference (the credit component of the purchased loans) and an accretable difference (the yield component of the purchased loans). Over the life of the acquired loans, we continue to estimate cash flows expected to be collected on pools of loans sharing common risk characteristics, which are treated in the aggregate when applying various valuation techniques. We evaluate at each balance sheet date whether the present value of our pools of loans determined using the effective interest rates has decreased significantly and if so, recognize a provision for loan loss in our consolidated statement of income. For any significant increases in cash flows expected to be collected, we adjust the amount of the accretable yield recognized on a prospective basis over the pool’s remaining life. Performing acquired loans are accounted for under FASB Topic 310-20, Receivables – Nonrefundable Fees and Other Costs. Performance of certain loans may be monitored and based on management’s assessment of the cash flows and other facts available, portions of the accretable difference may be delayed or suspended if management deems appropriate. The Corporation’s policy for determining when to discontinue accruing interest on performing acquired loans and the subsequent accounting for such loans is essentially the same as the policy for originated loans. 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. 22 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) 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. 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. 23 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Goodwill and Other Intangible Assets The excess of the cost of acquired entities over the fair value of identifiable assets acquired less liabilities assumed is recorded as goodwill. In accordance with FASB ASC 350 (SFAS No. 142, Goodwill and Other Intangible Assets), amortization of goodwill and indefinite-lived assets is not recorded. However, the recoverability of goodwill and other intangible assets are annually tested for impairment. The Corporation’s core deposit intangible is currently being amortized over its estimated useful life, ten years. Stock Compensation Plans On May 22, 2012, the Corporation’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 Corporation’s common stock issuable under the plan was set at 575,000. Awards are made at the discretion of the Board of Directors. Compensation cost equal to the fair value of the award is recognized over the vesting period. 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, and unrecognized actuarial gains and losses in the defined benefit pension plan, arising during the period. These gains and losses for the period are shown as a component of other comprehensive income. The accumulated gains and losses are reported as a component of equity, net of any tax effect. At December 31, 2014, the balance in accumulated other comprehensive income consisted of an unrealized gain on available for sales securities of $.562 million and actuarial losses on the defined benefit pension obligation of $.049 million. Earnings per Common Share Diluted earnings per share, which reflects the potential dilution that could occur if outstanding stock options and warrants were exercised and stock awards were fully vested and resulted in the issuance of common stock that then shared in our earnings, is computed by dividing net income by the weighted average number of common shares outstanding and common stock equivalents, after giving effect for dilutive shares issued. The following shows the computation of basic and diluted earnings per share for the year ended December 31, 2014, 2013 and 2012 (dollars in thousands, except per share data): Year Ended December 31, 2014 2013 2012 Net income Preferred stock dividends and accretion of discount Net income available to common shareholders $ $ $ 1,700 - 1,700 5,937 308 5,629 7,087 629 6,458 $ $ $ 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 per common share: Basic Diluted 5,592,738 5,558,313 4,285,043 61,073 5,653,811 91,745 5,650,058 - 4,285,043 $ $ .30 .30 $ $ 1.01 1.00 $ $ 1.51 1.51 24 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) 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 In May 2014, the Financial Accounting Standards Board (FASB) issued guidance on the recognition of revenue from contracts with customers. Revenue recognition will depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance also requires disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. The guidance permits two methods of adoption: retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application. The guidance is effective January 1, 2017 and early adoption is not permitted. The company is currently evaluating the impact of the new guidance and the method of adoption in the consolidated financial results. Reclassifications Certain amounts in the 2013 and 2012 consolidated financial statements have been reclassified to conform to the 2014 presentation. NOTE 2 – RESTRICTIONS ON CASH AND CASH EQUIVALENTS Cash and cash equivalents in the amount of $9.519 million were restricted on December 31, 2014 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. 25 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, 2014 Amortized Cost Unrealized Gains Unrealized Losses Estimated Fair Value US Treasury Corporate US Agencies US Agencies - MBS Obligations of states and political subdivisions $ 5,287 12,558 22,667 13,461 10,930 3 $ 116 144 262 685 $ (10) - (94) (35) (142) $ 5,280 12,674 22,717 13,688 11,473 Total securities available for sale $ 64,903 $ 1,210 $ (281) $ 65,832 December 31, 2013 Corporate US Agencies US Agencies - MBS Obligations of states and political subdivisions $ 15,862 15,227 7,078 5,893 $ 218 - 281 202 $ (1) (372) - - $ 16,079 14,855 7,359 6,095 Total securities available for sale $ 44,060 $ 701 $ (373) $ 44,388 At December 31, 2014 and 2013, the mortgage backed securities portfolio was $13.688 million (20.79%) and $7.359 million (16.58%), respectively, of the securities portfolio. At December 31, 2014, 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. Following is information pertaining to securities with gross unrealized losses at December 31, 2014 and 2013 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, 2014 US Treasury Corporate US Agencies US Agencies - MBS Obligations of states and political subdivisions $ (10) - (9) (35) (142) $ 3,958 - 1,494 4,511 386 - $ - (85) - - - $ - 7,411 - - Total securities available for sale $ (196) $ 10,349 $ (85) $ 7,411 December 31, 2013 Corporate US Agencies US Agencies - MBS Obligations of states and political subdivisions $ (1) (372) - - $ 1,390 14,855 - - - $ - - - - $ - - - Total securities available for sale $ (373) $ 16,245 $ - $ - There were 17 securities in an unrealized loss position in 2014 and six in 2013. 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. 26 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 2014 2013 2012 $ 5,200 54 - $ 10,156 73 - $ 2,601 - - The carrying value and estimated fair value of securities available for sale at December 31, 2014, 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 $ 8,986 28,744 10,129 3,583 51,442 13,461 $ 8,824 29,081 10,460 3,779 52,144 13,688 Total $ 64,903 $ 65,832 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 10 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 Commercial construction Consumer Consumer construction 2014 2013 $ 315,387 101,895 139,553 16,284 18,385 9,431 $ 268,809 79,655 103,768 10,904 13,801 6,895 Total loans $ 600,935 $ 483,832 The Corporation completed the acquisition of Peninsula Financial Corporation on December 5, 2014. The acquired loans were divided into loans with evidence of credit quality deterioration, which are accounted for under ASC 310-30 (“acquired impaired”) and loans that do not meet that criteria, which are accounted for under ASC 310-20 (“acquired nonimpaired”). The acquired impaired loans totaled $10.312 million. The Corporation recorded these loans at fair value taking into account a number of factors, including remaining life, estimated loss, estimated value of the underlying collateral and net present values of cash flows. For the period of December 5, 2014 to December 31, 2014, recorded interest compared to accretable interest on acquired impaired loans was immaterial and no significant payments of principal were recorded. The table below details the acquired portfolio at acquisition date: Acquired Impaired Acquired Non-impaired Acquired Total Loans acquired - contractual payments Nonaccretable difference Expected cash flows Accretable yield Carrying balance at acquisition date $ $ $ 13,290 (2,234) 11,056 (744) 10,312 53,849 (1,575) 52,274 (525) 51,749 $ $ $ 67,139 (3,809) 63,330 (1,269) 62,061 27 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) An analysis of the allowance for loan losses for the years ended December 31 is as follows (dollars in thousands): 2014 2013 2012 Balance, January 1 Recoveries on loans previously charged off Loans charged off Provision $ 4,661 325 (1,046) 1,200 $ 5,218 200 (2,432) 1,675 $ 5,251 278 (1,256) 945 Balance, December 31 $ 5,140 $ 4,661 $ 5,218 In 2014, net charge off activity was $.721 million, or .14% of average loans outstanding compared to net charge-offs of $2.232 million, or .48% of average loans, in the same period in 2013 and $.978 million, or .23% of average loans, in 2012. During 2014, a provision of $1.200 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, 2014 is as follows (dollars in thousands): 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 Acquired with deteriorated credit quality Total Ending balance Loans: Individually evaluated Collectively evaluated Acquired with deteriorated credit quality Total $ $ $ $ $ $ $ Commercial real estate Commercial, financial and agricultural Commercial construction One to four family residential real estate 1,849 (19) 131 852 2,813 1,378 (663) 78 746 1,539 80 - 50 12 142 Consumer construction $ 25 - - (19) $ 6 516 (290) 22 37 285 Consumer Unallocated Total 148 (74) 44 (105) 13 665 - - (323) 342 4,661 (1,046) 325 1,200 5,140 $ $ $ $ $ $ $ $ $ $ $ $ $ 315,387 (2,813) 312,574 101,895 (1,539) 100,356 16,284 (142) 16,142 139,553 (285) 139,268 9,431 (6) 9,425 18,385 (13) 18,372 - $ (342) (342) $ $ $ 600,935 (5,140) 595,795 $ $ $ $ $ $ $ 704 2,109 $ 492 1,047 $ - 142 $ 19 266 - $ 6 1 $ 12 - $ 342 $ 1,216 3,924 $ - 2,813 $ - 1,539 $ - 142 $ - 285 - $ 6 $ - 13 $ - 342 $ - 5,140 $ 1,374 308,661 $ 863 100,330 $ - 16,126 $ 768 134,908 - $ 9,216 $ 72 18,305 - $ - $ 3,077 587,546 $ 5,352 315,387 702 101,895 $ 158 16,284 $ $ 3,877 139,553 215 9,431 $ 8 18,385 $ - $ - 10,312 600,935 $ Impaired loans, by definition, are individually evaluated. 28 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) A breakdown of the allowance for loan losses and recorded balances in loans at December 31, 2013 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 $ $ $ $ $ $ 980 (141) 26 (349) 516 - $ - 2 23 25 $ - $ (120) 22 246 148 $ 154 - - 511 665 5,218 (2,432) 200 1,675 4,661 $ $ $ $ $ $ 3,267 (1,539) 92 29 1,849 268,809 (1,849) 266,960 99 1,750 1,849 649 268,160 268,809 692 (632) 56 1,262 1,378 79,655 (1,378) 78,277 125 - 2 (47) 80 10,904 (80) 10,824 891 487 1,378 1,830 77,825 79,655 - $ 80 80 $ $ - 10,904 10,904 $ $ $ $ $ $ $ $ $ $ $ $ $ 103,768 (516) 103,252 6,895 (25) 6,870 13,801 (148) 13,653 $ $ $ $ $ $ $ $ $ $ $ $ 103 413 516 385 103,383 103,768 - $ 25 25 $ $ - 6,895 6,895 $ $ $ 18 130 148 $ 42 13,759 13,801 $ - $ (665) (665) $ - $ 665 665 $ $ - - $ - $ $ 483,832 (4,661) 479,171 $ $ 1,111 3,550 4,661 $ 2,906 480,926 483,832 $ 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, 2012 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 $ $ $ $ $ $ 2,823 (729) 52 1,121 3,267 1,079 (40) 201 (548) 692 207 (6) - (76) 125 1,114 (399) 7 258 980 - $ - - - $ - - $ (82) 18 64 $ - 28 - - 126 154 5,251 (1,256) 278 945 5,218 $ $ $ $ $ $ $ $ $ $ $ $ 244,966 (3,267) 241,699 80,646 (692) 79,954 17,229 (125) 17,104 87,948 (980) 86,968 7,465 - 7,465 $ $ 10,923 - 10,923 - $ (154) (154) $ $ $ 449,177 (5,218) 443,959 $ $ $ $ $ $ $ $ $ $ $ $ 1,662 1,605 3,267 22,910 222,056 244,966 155 537 692 6,070 74,576 80,646 10 115 125 858 16,371 17,229 $ $ $ $ $ $ $ $ 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. 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. 29 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) 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. Strong (1) Borrower is not vulnerable to sudden economic or technological changes. They have “strong” balance sheets and are within an industry that is very typical for our markets or type of lending culture. Borrowers also have “strong” financial and cash flow performance and excellent collateral (low loan to value or readily available to liquidate collateral) in conjunction with an impeccable repayment history. Good (2) Borrower shows limited vulnerability to sudden economic change. These borrowers have “above average” financial and cash flow performance and a very good repayment history. The balance sheet of the company is also very good as compared to peer and the company is in an industry that is familiar to our markets or our type of lending. The collateral securing the deal is also very good in terms of its type, loan to value, etc. Average (3) Borrower is typically a well-seasoned business, however may be susceptible to unfavorable changes in the economy, and could be somewhat affected by seasonal factors. The borrowers within this category exhibit financial and cash flow performance that appear “average” to “slightly above average” when compared to peer standards and they show an adequate payment history. Collateral securing this type of credit is good, exhibiting above average loan to values, etc. Acceptable (4) A borrower within this category exhibits financial and cash flow performance that appear adequate and satisfactory when compared to peer standards and they show a satisfactory payment history. The collateral securing the request is within supervisory limits and overall is acceptable. Borrowers rated acceptable could also be newer businesses that are typically susceptible to unfavorable changes in the economy, and more than likely could be affected by seasonal factors. Special Mention (5) The borrower may have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Special mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. Examples of this type of credit include a start-up company fully based on projections, a documentation issue that needs to be corrected or a general market condition that the borrower is working through to get corrected. Substandard (6) Substandard loans are classified assets exhibiting 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 classified as substandard clearly represent troubled and deteriorating credit situations requiring constant supervision. Doubtful (7) Loans in this category exhibit the same, if not more pronounced weaknesses used to describe the substandard credit. 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. 30 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) 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 2014 and 2013, commercial construction loans of $3.251 million and $2.951 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, 2014 (dollars in thousands): (1) Strong (2) Good (3) Average (4) Acceptable/ Acceptable Watch (5) Sp. Mention (6) Substandard (7) Doubtful Rating Unassigned Total $ 859 $ 28,740 $ 129,791 $ 147,624 $ - $ 8,373 $ - $ - $ 315,387 3,227 80 297 - 53 4,577 441 1,074 - - 33,794 2,282 3,207 - 3 57,295 9,324 5,882 - 10 - - - - - 3,002 906 5,745 - 11 - - - - - - 3,251 123,348 9,431 18,308 101,895 16,284 139,553 9,431 18,385 Commercial real estate Commercial, financial and agricultural Commercial construction One-to-four family residential real estate Consumer construction Consumer Total loans $ 4,516 $ 34,832 $ 169,077 $ 220,135 $ - $ 18,037 $ - $ 154,338 $ 600,935 Below is a breakdown of loans by risk category as of December 31, 2013 (dollars in thousands) (1) Strong (2) Good (3) Average (4) Acceptable/ Acceptable Watch (5) Sp. Mention (6) Substandard (7) Doubtful Rating Unassigned Total $ 1,502 $ 23,310 $ 116,702 $ 125,010 $ - $ 2,285 $ - $ - $ 268,809 3,741 30 251 - 10 4,348 479 3,074 - - 27,455 2,702 1,275 - 37 39,070 4,340 4,482 - 43 - - - - - 5,041 402 710 - 30 - - - - - - 2,951 93,976 6,895 13,681 79,655 10,904 103,768 6,895 13,801 Commercial real estate Commercial, financial and agricultural Commercial construction One-to-four family residential real estate Consumer construction Consumer Total loans $ 5,534 $ 31,211 $ 148,171 $ 172,945 $ - $ 8,468 $ - $ 117,503 $ 483,832 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. There was no interest income recorded during impairment, and that which would have been recognized was $.130 million for the year ended December 31, 2014. For the year ended December 31, 2013, there was no interest recorded during impairment and that which would have been recognized was $.228 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 31 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) 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. Purchased loans acquired in a business combination are recorded at estimated fair value on their purchase date with no carryover of the related allowance for loan losses. In determining the estimated fair value of purchased loans, management considers a number of factors including the remaining life of the acquired loans, estimated prepayments, estimated loss ratios, estimated value of the underlying collateral, net present value of cash flows expected to be received, among others. Purchased loans are accounted for in accordance with guidance for certain loans acquired in a transfer (ASC 310-30), when the loans have evidence of credit deterioration since origination and it is probable at the date of acquisition that the acquirer will not collect all contractually required principal and interest payments. The difference between contractually required payments and the cash flows expected to be collected at acquisition is referred to as the non-accretable difference. Subsequent decreases to the expected cash flows will general result in a provision for loan losses. Subsequent increase in expected cash flows will results in a reversal of the provision for loan losses to the extent of prior charges and then an adjustment to accretable yield, which would have a positive impact on interest income. The ASC 310-30 mark on impaired loans totaled $2.978 million. The accretable yield in this impaired loans was estimated at $.744 million. The Corporation recorded no accretable yield of the loan mark in 2014. The following table reflects the contractually required payments receivable, cash flows expected to be collected, and fair value of the credit impaired Peninsula loans at acquisition date: $ $ 13,290 (2,234) 11,056 (744) 10,312 Contractually required payments including interest Less: nonaccretable difference Cash flows expected to be collected Less: accretable yield Fair value of credit impaired loans acquired 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, 2014 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, 2013 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 $ 632 74 - 1,844 274 - $ 227 774 - 114 - - $ 5,352 702 158 3,877 215 8 - $ - - - - - $ 532 685 11 656 15 1 - $ - - - - - - $ - - - - - 7 $ 27 - 25 - 1 $ 229 1,109 - 116 - - $ 227 484 - 9 - - $ 18 45 - 7 - - $ $ $ $ $ - $ - - - - - - $ - - - - - $ - 227 484 - 9 - - 720 859 848 - 1,958 274 - 3,939 5,352 702 158 3,877 215 8 10,312 761 1,794 11 772 15 1 3,354 $ $ $ $ $ $ 513 59 - 361 - - $ 59 752 - 250 - 30 572 811 - 611 - 30 2,024 - $ - - - - - - $ - - - - - - $ - - - - - $ - $ 3,045 505 626 625 - 2 - $ - - - - - - $ - - - - - $ 153 13 3 16 - - $ 71 834 - 261 - 30 $ 14 265 - 78 - 13 - $ - - - - - 5 $ 18 - 20 - - $ $ $ $ 3,116 1,339 626 886 - 32 5,999 14 265 - 78 - 13 370 - $ - - - - - $ - $ $ $ $ 25 72 - 32 - 1 130 158 31 3 36 - - 228 A summary of past due loans at December 31, is as follows (dollars in thousands): 30-89 days Past Due (accruing) 2014 90+ days Past Due/ Nonaccrual $ 1,857 104 - 1,412 38 88 $ 859 848 - 1,958 274 - Total $ 2,716 952 - 3,370 312 88 30-89 days Past Due (accruing) - $ 4 20 201 - 14 2013 90+ days Past Due/ Nonaccrual $ 572 811 - 611 - 30 Total $ 572 815 20 812 - 44 Commercial real estate Commercial, financial and agricultural Commercial construction One to four family residential real estate Consumer construction Consumer Total past due loans $ 3,499 $ 3,939 $ 7,438 $ 239 $ 2,024 $ 2,263 33 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) The Corporation acquired loans 30-89 days past due and nonaccrual loans with December 31, 2014 balance of $2.908 million and $2.281 million, respectively. A roll-forward of nonaccrual activity during the year ended December 31, 2014 (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 $ 572 $ 811 $ - $ 611 $ - $ 30 $ 2,024 Principal payments Charge-offs Advances Transfers to OREO Transfers to accruing Transfers from accruing Acquired impaired loans Other (104) (18) - (233) - - 632 10 (692) (435) - - (10) 1,167 - 7 - - - - - - - - (35) (206) - (357) (127) 685 1,375 12 - - - - - - 274 - (4) (32) - - - 6 - - (835) (691) - (590) (137) 1,858 2,281 29 Ending balance $ 859 $ 848 $ - $ 1,958 $ 274 $ - $ 3,939 A roll-forward of nonaccrual activity during the year ended December 31, 2013 (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 $ 3,071 $ 436 $ 675 $ 505 $ - $ - $ 4,687 Principal payments Charge-offs Advances Transfers to OREO Transfers to accruing Transfers from accruing Other (1,478) (1,304) - (208) - 443 48 (319) (616) - (37) - 1,346 1 (100) - - (580) - - 5 (88) (141) - (107) - 434 8 - - - - - - - (2) (4) - - - 36 - (1,987) (2,065) - (932) - 2,259 62 Ending balance $ 572 $ 811 $ - $ 611 $ - $ 30 $ 2,024 Loans accounted for under ASC 310-30 accrue interest as any nonpayment of contractual principal or interest is considered in the periodic re-estimation of expected cash flows and is included in the resulting recognition of current period loan loss provision or prospective yield adjustments. 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. 34 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) 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): 2014 2013 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 - - - - - - - - $ - - - - - $ - - 1 - - - - 1 - $ 528 - - - - $ 528 A roll-forward of troubled debt restructuring during the year ended December 31, 2014 (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 $ 3,520 $ 1,186 $ 858 $ 99 $ - $ 5,663 Principal payments Charge-offs Advances New restructured Transferred out of TDR Transfers to nonaccrual Ending Balance NONACCRUAL (2,513) - - - - - - - - - - - (6) - - - - - (4) (37) - - 91 (89) - - - - - - (2,523) (37) - - 91 (89) $ 1,007 $ 1,186 $ 852 $ 60 $ - $ 3,105 Beginning balance $ - $ 523 $ - $ 91 $ - $ 614 Principal payments Charge-offs Advances New restructured Transfers to foreclosed properties Transfers from accruing Ending Balance TOTALS - - - - - - (319) (204) - - - - - - - - - - - (37) - - (143) 89 - - - - - - (319) (241) - - (143) 89 $ - $ - $ - $ - $ - $ - Beginning balance $ 3,520 $ 1,709 $ 858 $ 190 $ - $ 6,277 Principal payments Charge-offs Advances New restructured Transfers out of TDRs Tansfers to nonaccrual Transfers to foreclosed properties Transfers from accruing (2,513) - - - - - - - (319) (204) - - - - - - (6) - - - - - - - (4) (74) - - 91 (89) (143) 89 - - - - - - - - (2,842) (278) - - 91 (89) (143) 89 Ending Balance $ 1,007 $ 1,186 $ 852 $ 60 $ - $ 3,105 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, 2013 (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 $ 3,611 $ 1,221 $ 858 $ 102 $ - $ 5,792 Principal payments Charge-offs Advances New restructured Transferred out of TDR Transfers to nonaccrual Ending Balance NONACCRUAL Beginning balance Principal payments Charge-offs Advances New restructured Transfers to foreclosed properties Transfers from accruing Ending Balance TOTALS (91) - - - - - (460) - - 953 - (528) (3) - - - - - - - - - - - (554) - - 953 - (528) $ 3,520 $ 1,186 $ 858 $ 99 $ - $ 5,663 $ 2,162 $ - (1,376) (793) - 7 - - (5) - - 528 - - - $ - - - - - - - $ 102 $ - $ 2,264 (15) - - 4 - - - - - - - - (1,396) (793) - 539 - - $ - $ 523 $ - $ 91 $ - $ 614 Beginning balance $ 5,773 $ 1,221 $ 858 $ 204 $ - $ 8,056 Principal payments Charge-offs Advances New restructured Transfers out of TDRs Tansfers to nonaccrual Transfers to foreclosed properties Transfers from accruing (1,467) (793) - 7 - - - - (465) - - 1,481 - (528) - - - - - - - - - - (18) - - 4 - - - - - - - - - - - - (1,950) (793) - 1,492 - (528) - - Ending Balance $ 3,520 $ 1,709 $ 858 $ 190 $ - $ 6,277 The above includes loans with revolving privileges which are scoped out of 310-30 and certain loans which the Corporation elected to treat under the cost recovery method of accounting. Loans were recorded at fair value in accordance with FASB ASC 805, Business Combinations. No allowance for loan losses related to the acquired loans is recorded on the acquisition date as the fair value of the loans acquired incorporates assumptions regarding credit. Loans acquired are recorded at fair value in accordance with the fair value methodology prescribed in FASB ASC 820. The fair value estimated associated with the loans include estimates related to expected prepayments and the amount and timing of undiscounted expected principal, interest and other cash flows. 36 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 4 – LOANS (CONTINUED) 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 2014 2013 $ 9,043 33 1,390 (1,677) $ 11,297 496 (266) (2,484) Loans outstanding, December 31 $ 8,789 $ 9,043 There were no loans to related-parties classified substandard as of December 31, 2014 and 2013. In addition to the outstanding balances above, there were unfunded commitments of $.372 million to related parties at December 31, 2014. 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 2014 2013 $ 1,812 15,069 7,892 87 24,860 12,202 $ 1,781 12,911 6,833 145 21,670 11,460 Net book value $ 12,658 $ 10,210 Depreciation of premises and equipment charged to operating expenses amounted to $1.337 million in 2014, $1.231 million in 2013, and $1.092 million in 2012. 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): Balance, January 1 Other real estate transferred from loans due to foreclosure Other real estate acquired, net of purchase accounting Other real estate sold Writedowns of other real estate held for sale Loss on sale of other real estate held for sale 2014 2013 $ 1,884 588 1,193 (375) (228) (52) $ 3,212 932 - (1,996) (231) (33) Balance, December 31 $ 3,010 $ 1,884 37 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES 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 2014 2013 $ 95,498 212,565 28,015 134,951 30,316 105,628 $ 72,936 149,123 13,039 140,495 23,159 67,547 $ 606,973 $ 466,299 The aggregate amount of deposits that meet or exceed the $250,000 FDIC insurance limit was $6.610 million and $5.056 million at December 31, 2014 and 2013, respectively. Maturities of non-brokered time deposits outstanding at December 31, 2014 are as follows (dollars in thousands): 2015 2016 2017 2018 2019 Thereafter Total $ 91,426 58,464 10,733 3,875 650 119 $ 165,267 NOTE 8 – GOODWILL AND OTHER INTANGIBLE ASSETS During the fourth quarter, the Corporation recorded $3.805 million of goodwill and $1.206 million of deposit based intangible assets associated with the acquisition of Peninsula. The excess of the cost of acquired entities over the fair value of identifiable assets acquired less liabilities assumed is recorded as goodwill. In accordance with FASB ASC 350 (SFAS No. 142, Goodwill and Other Intangible Assets), amortization of goodwill and indefinite-lived assets is not recorded. However, the recoverability of goodwill and other intangible assets are annually tested for impairment. Intangible assets, including core deposits and customer business relationships, are amortized primarily on an accelerated cash flow basis over their estimated useful lives. The Corporation is currently amortizing the deposit based intangible over a ten-year estimated life. The deposit based intangible is reported net of accumulated amortization at $1.196 million at December 31, 2014. Amortization expense in 2014 is $.010 million. Amortization expense for the next five years is expected to be at $.121 million per year. 38 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 9 – SERVICING RIGHTS Mortgage Loans Mortgage servicing rights (“MSRs”) are recorded when loans are sold in the secondary market with servicing retained. As of December 31, 2014, the Corporation had obligations to service $224 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 10.75% and a discount rate of 8.90% for December 31, 2014. The following summarizes the fair value of the mortgage servicing rights capitalized and amortized. There was no valuation allowance required (dollars in thousands): December 31, December 31, 2014 2013 Balance at beginning of period Additions from loans sold with servicing retained MSRs acquired in Peninsula transaction Amortization $ 1,129 636 539 (310) $ 638 675 - (184) Book value of MSRs at end of period $ 1,994 $ 1,129 Commercial Loans The Corporation also retains the servicing on commercial loans that have been sold. These loans were originated and underwritten under the SBA and USDA government guarantee programs, in which the guaranteed portion of the loan was sold to a third party with servicing retained. The balance of these sold loans with servicing retained at December 31, 2014 and December 31, 2013 was approximately $46 million and $59 million. The Corporation valued these servicing rights at $.198 million as of December 31, 2014 and $.200 million at December 31, 2013. This valuation was established in consideration of the discounted cash flow of expected servicing income over the life of the loans. NOTE 10 – BORROWINGS Borrowings consist of the following at December 31 (dollars in thousands): Federal Home Loan Bank fixed rate advances at December 31, 2014 with a weighted average $ 35,000 $ 35,000 2014 2013 rate of 1.68% maturing in 2016, 2018 and 2019 Correspondent bank line of credit - holding company Bank line of credit - wholly owned asset based lending subsidiary Correspondent bank term note, current floor rate of 4%, maturing December 28, 2017 USDA Rural Development, fixed-rate note payable, maturing August 24, 2024 interest payable at 1% 8,000 3,367 2,700 2,000 - - 779 852 $ 49,846 $ 37,852 The Federal Home Loan Bank borrowings are collateralized at December 31, 2014 by the following: a collateral agreement on the Corporation’s one to four family residential real estate loans with a book value of approximately $40.582 million; mortgage related and municipal securities with an amortized cost and estimated fair value of $3.983 million and $4.181 million, respectively; and Federal Home Loan Bank stock owned by the Bank totaling $2.973 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, 2014. 39 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 10 – BORROWINGS (CONTINUED) The USDA Rural Development borrowing is collateralized by loans totaling $.121 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 $.724 million, and guaranteed by the Corporation. The Corporation currently has two banking borrowing relationships. The first relationship consists of a non-revolving line of credit and a term note. The line of credit bears interest at 90-day LIBOR plus 2.75%, with a floor rate of 4.00% and has an initial term that expires on December 28, 2017. The term note bears the same interest and matures on March 22, 2017 and requires quarterly principal payments of $100,000 beginning June 30, 2014. This relationship is secured by all of the outstanding mBank stock. The second borrowing relationship consists of a $10 million revolving line of credit, which can be increased to $25 million upon request, used to support asset based lending activities at a wholly-owned subsidiary that currently bears interest at 90-day LIBOR plus 2.75% and has an initial term that expires on September 10, 2016. This line of credit it secured by an assignment of all collateral securing the outstanding loan balances of our asset based lending subsidiary. Maturities and principal payments of borrowings outstanding at December 31, 2014 are as follows (dollars in thousands): 2015 2016 2017 2018 2019 Thereafter Total $ 474 18,842 9,976 10,077 10,077 400 $ 49,846 NOTE 11 – 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) 2014 2013 2012 $ - - 1,129 $ - (2,250) 1,847 $ - (3,000) 2,078 Provision for (benefit of) income taxes $ 1,129 $ (403) $ (922) 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 Nondeductible transaction expenses Other 2014 2013 2012 $ 962 $ 1,882 $ 2,096 (25) - 176 16 (47) (2,250) - 12 (49) (3,000) - 31 Provision for (benefit of) income taxes, as reported $ 1,129 $ (403) $ (922) 40 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 11 – INCOME TAXES (CONTINUED) 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 Pension liability Stock compensation Depreciation Purchase accounting adjustments Other Total deferred tax assets Valuation allowance Deferred tax liabilities: Core deposit premium FHLB stock dividend Unrealized gain on securities Mortgage servicing rights Other Total deferred tax liabilities 2014 2013 $ 5,500 2,194 1,586 474 767 576 475 247 (88) 2,095 33 $ 6,737 1,585 1,463 138 672 152 - 267 157 - 188 13,859 11,359 $ (760) $ (760) (407) (103) (363) (658) (70) (1,601) - (103) (111) (452) - (666) Net deferred tax asset $ 11,498 $ 9,933 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, 2014 had a net operating loss and tax credit carryforwards for tax purposes of approximately $16.2 million, and $2.353 million, respectively. The Corporation will 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 and recognizes 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 $10.5 million, and the majority 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 expense of approximately $1.129 million for the year ended December 31, 2014 and a deferred tax benefit of $.403 million for the year ended December 31, 2013. The valuation allowance at December 31, 2014 was approximately $.760 million. The Corporation has reduced the valuation allowance as it was determined that it was “more likely than not” that these benefits would be realized. In December 2013, the Corporation reduced the valuation by $2.250 million and in June 2012 a reduction of $3.0 million was recorded. The Corporation made these determinations 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. The remaining valuation allowance pertains to the existing tax credit carryovers, which will only be utilized after all net operating loss carryforwards. Since a portion of these tax credits may expire before that occurs, a valuation allowance for these has been established. The Corporation will continue to evaluate the future benefits from these carryforwards in order to determine if any adjustment to the deferred tax asset is warranted. In connection with the Peninsula acquisition in December 2014, the Corporation acquired $.933 million of NOL carryforward and approximately $.217 million of various tax credits, which it expects to utilize prior to expiration. 41 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 12 – OPERATING LEASES The Corporation currently maintains seven 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 and again in 2014 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. The fourth operating lease was initiated in December 2013 as the Corporation consolidated its banking offices in Marquette. The original term of this lease is 15 years with options for two consecutive renewal terms of four years each. With the acquisition, the Corporation acquired three additional operating leases for office locations. The first, for an additional location in Marquette, was executed in February 2011 with a term of five years. The second, for the location in Negaunee was executed in September 2012 with an initial term of five years, with option to renew for one additional term of five years. The final, for a location in Ishpeming was executed in April 2008 for an initial term of five years. This lease was renewed in May 2013 for an additional five years. Future minimum payments for base rent, by year and in the aggregate, under the initial terms of the operating lease agreements, consist of the following (dollars in thousands): 2015 2016 2017 2018 2019 Thereafter Total $ 724 680 571 455 458 4,232 $ 7,120 Rent expense for all operating leases amounted to $.885 million in 2014, $.280 million in 2013, and $.269 million in 2012. NOTE 13 – 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 $214,000, $198,000, and $161,000 in 2014, 2013, and 2012, respectively. 42 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 14 – DEFINED BENEFIT PENSION PLAN The Corporation acquired the Peninsula Financial Corporation noncontributory defined benefit pension plan. Effective December 31, 2005, the plan was amended to freeze participation in the plan; therefore, no additional employees are eligible to become participants in the plan. The benefits are based on years of service and the employee’s compensation at the time of retirement. The Plan was amended effective December 31, 2010, to freeze benefit accrual for all participants. Expected contributions to the Plan in 2015 are $.114 million. The anticipated distributions over the next five years and thereafter are detailed in the table below (dollars in thousands): 2015 2016 2017 2018 2019 Thereafter Total $ 132,026 130,003 127,902 128,608 126,361 701,944 1,346,844 $ The following table sets forth the plan’s funded status and amounts recognized in the Corporation’s balance sheets and the activity from date of acquisition (dollars in thousands): 2014 $ 3,229 - 9 52 - 3,290 2,118 (11) - - 2,107 (1,183) - $ (1,183) Change in benefit obligation: Benefit obligation when acquired Service cost Interest cost Actuarial gain (loss) Benefits paid Benefit (asset) obligation at end of year Change in plan assets: Fair value of plan assets when acquired Actual return on plan assets Employer contributions Benefits paid Fair value of plan assets at end of year Funded status Unrecognized net actuarial loss Prepaid (accrued) pension expense, included with other assets or liabilities The accumulated benefit obligation at December 31, 2014 was $3.290 million. Net pension costs included in the Corporation’s results of operations was immaterial. 43 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 14 – DEFINED BENEFIT PENSION PLAN (CONTINUED) Assumptions in the actuarial valuation are: Weighted average discount rate Rate of increase in future compensation levels Expected long-term rate of return on plan assets 2014 3.98% N/A 8.00% The expected long-term rate of return on plan assets reflects management’s expectations of long-term average rates of return on funds invested to provide for benefits included in the projected benefit obligation. The expected return is based on the outlook for inflation, fixed income returns and equity returns, while also considering historical returns, asset allocation and investment strategy. The discount rate assumption is based on investment yields available on AA rated long- term corporate bonds. The primary investment objective is to maximize growth of the pension plan assets to meet the projected obligations to the beneficiaries over a long period of time, and to do so in a manner that is consistent with the Corporation’s risk tolerance. The intention of the plan sponsor is to invest the plan assets in mutual funds with the following asset allocation: Target Allocation Actual Allocation Equity securities Fixed income securities 50% to 70 % 30% to 50% 60% 40% NOTE 15 – 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, 2014 and 2013, for vested benefits under this plan, was $.362 million and $.447 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 $1.572 million and $1.506 million at December 31, 2014 and 2013, respectively. Deferred compensation expense for the plan was $16,000, $25,000, and $30,000 for 2014, 2013, and 2012, respectively. The Peninsula Financial Corporation, acquired by the Corporation in December 2014, also had a deferred compensation plan, which was similar in nature to the Corporation’s discontinued plan. The liability for this plan as of 2014 year end was $1.340 million and the bank owned life insurance policy as a cash surrender value of $1.666 million. This Plan was also discontinued by the Corporation and will not apply to future employees or directors of the Corporation. 44 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 16 – 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, 2014, the Corporation is well capitalized. Regulatory guidelines require bank holding companies to maintain a minimum ratio of qualifying total capital to risk- weighted assets of 8.0%, of which at least 4.0% must be in the form of Tier 1 Capital. Guidelines also mandate a minimum tangible Tier 1 leverage ratio of 3.0% for strong bank holding companies. For all other bank holding companies, the minimum tangible Tier 1 leverage ratio is 4.0%. In addition, regulatory guidelines continue to consider the tangible Tier 1 leverage ratio in evaluating proposals for expansion or new activities. Effective January 1, 2015, the Corporation will be subject to new capital requirements due to the Basel III regulation, including: (cid:2) A new minimum ratio of Common Equity Tier I Capital to risk-weighted assets of 4.5%; (cid:2) An increase in the minimum required amount of Additional Tier 1 Capital to 6% of risk-weighted assets; (cid:2) A continuation of the current minimum required amount of Total Capital (Tier 1 plus Tier 2) at 8% of risk- weighted assets; and (cid:2) A minimum leverage ratio of Tier I Capital to total assets equal to 4% in all circumstances. In order to be “well-capitalized” under the new guidelines, a depository institution must maintain a Common Equity Tier 1 Capital ratio of 6.5% or more; an Additional Tier 1 Capital ratio of 8% or more; a Total Capital ratio of 10% or more; and a leverage ratio of 5% or more. The Corporation’s and the Bank’s actual capital and ratios compared to generally applicable regulatory requirements as of December 31, 2014 are as follows (dollars in thousands): 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 Actual Amount Ratio Adequacy Purposes Amount Ratio Well-Capitalized Amount Ratio $ $ 67,427 70,320 11.1% > 11.8% > $ $ 48,717 47,611 > 8.0% > > 8.0% > $ $ 60,896 59,513 10.0% 10.0% $ $ 62,287 65,345 10.2% > 11.0% > $ $ 36,538 35,708 > 6.0% > > 6.0% > $ $ 36,538 35,708 6.0% 6.0% $ $ 62,287 65,355 8.6% > 9.1% > $ $ 29,065 28,680 > 4.0% > > 4.0% > $ $ 36,332 35,850 5.0% 5.0% 45 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 16 – REGULATORY MATTERS (CONTINUED) The Corporation’s and the Bank’s actual capital and ratios compared to generally applicable regulatory requirements as of December 31, 2013 are as follows (dollars in thousands): Actual Amount Ratio Adequacy Purposes Amount Ratio Action Provisions Amount Ratio 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 $ $ 62,581 60,537 12.8% 12.4% > > $ $ 39,153 38,944 > 8.0% > 8.0% N/A $ 48,680 > N/A 10.0% $ $ 57,920 55,947 11.8% 11.5% > > $ $ 19,576 19,472 > 4.0% > 4.0% N/A $ 29,208 > N/A 6.0% $ $ 57,920 55,947 10.3% 10.0% > > $ $ 22,469 22,352 > 4.0% > 4.0% N/A $ 27,940 > N/A 5.0% NOTE 17 – 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 575,000, which included 392,152 option shares outstanding at that time. Awards are made at the discretion of management. Compensation cost equal to the fair value of the award is recognized over the vesting period. Restricted Stock Awards The Corporation’s restricted stock awards require certain service-based or performance requirements and have a vesting period of four years. Compensation expense is recognized on a straight-line basis over the vesting period. Shares are subject to certain restrictions and risk of forfeiture by the participants. The Corporation, in August 2012 and March 2014, granted Restricted Stock Units (“RSUs”) to members of the Board of Directors and Management. In August 2012, 148,500 RSUs were granted at a market value of $7.91 and will vest equally over a four year term. In exchange for the grant of these RSUs various previously issued stock option awards were surrendered. In March 2014, 52,774 RSUs were granted at a market value of $12.95, also vesting equally over a four year term. The RSUs were awarded at no cost to the employee. Compensation cost to be recognized over the four –year vesting periods, is $1.175 million and $.683 million, respectively. On August 31, 2013 and 2014, the Corporation issued 37,125 shares and 37,125 shares of its common stock for vested RSUs, respectively. A summary of changes in our nonvested shares for the year follows: Number Outstanding Weighted Average Grant Date Fair Value Nonvested balance at January 1, 2014 Granted during the year Vested during the year Nonvested balance at December 31, 2014 111,375 52,774 (37,125) 127,024 46 $ $ 7.91 12.95 7.91 10.07 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 17 – STOCK COMPENSATION PLANS (CONTINUED) As of December 31, 2014, unrecognized compensation expense allotted to the Bank was $1.038 million. The Corporation also has outstanding stock options. 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 during the year 2014 2013 237,152 - (70,502) (146,650) 242,152 - - (5,000) Outstanding shares at end of year 20,000 237,152 Exercisable shares at end of year 4,000 124,861 Weighted average exercise price per share at end of year $ 11.33 $ 9.88 Shares available for grant at end of year - - Following is a summary of the options outstanding and exercisable at December 31, 2014: Exercise Price Outstanding Number Exercisable Unvested Options Weighted Average Remaining Contractual Life-Years $ $ 10.65 12.00 10,000 10,000 20,000 2,000 2,000 4,000 8,000 8,000 16,000 .54 .96 .75 NOTE 18 – SHAREHOLDERS’ EQUITY In December 2014, the Corporation consummated the previously announced acquisition of Peninsula Financial Corporation with a combination of cash and MFNC stock. Peninsula Financial Corporation was a bank holding company with The Peninsula Bank as its wholly-owned subsidiary. Peninsula was headquartered in Ishpeming, Michigan with six branch locations. The purchase price of the acquisition was $12.420 million with a combination of cash and MFNC common stock. MFNC issued 695,361 shares of its common stock and an increase shareholder equity of $7.804 million in recording this transaction, after the reduction for issuance costs of $.130 million. The Corporation recorded assets with a fair value of $112.766 million, including loans of $67.139 million, as well as $100.950 million of deposits. The Corporation currently has a share repurchase program. The program is conducted under authorizations from time to time by the Board of Directors. The Corporation repurchased 13,700 shares in 2014 and 55,594 shares in 2013. The share repurchases were conducted under Board authorizations made and publically announced of $600,000 on February 27, 2013 and an additional $600,000 on December 17, 2013. Neither of these authorizations has an expiration date. In 2014, MFNC paid cash dividends of $.225 per share which decreased equity by $1.308 million. 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. During 2013, the Corporation redeemed all of the outstanding Series A Preferred Shares. 47 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 19 - COMMITMENTS, CONTINGENCIES, AND CREDIT RISK Financial Instruments with Off-Balance-Sheet Risk The Corporation is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets. The Corporation’s exposure to credit loss, in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit, is represented by the contractual amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on- balance-sheet instruments. These commitments 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 2014 2013 $ 44,134 24,191 6,072 3,267 $ 36,039 15,070 5,077 3,152 $ 77,664 $ 59,338 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, 2014, 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, 2014 represents $107.835 million, or 26.47%, compared to $100.333 million, or 27.92%, of the commercial loan portfolio on December 31, 2013. 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. 48 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 20 - 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. 49 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 20 - 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, 2014 December 31, 2013 Carrying Amount Estimated Fair Value Level 1 Level 2 Level 2 Level 2 Level 3 Level 3 Level 2 Level 2 Level 3 $ 21,947 5,797 65,832 2,973 595,795 1,680 $ 21,947 5,797 65,832 2,973 596,429 1,680 $ 18,219 10 44,388 3,060 479,171 1,351 $ 18,219 10 44,388 3,060 479,538 1,351 $ 694,024 $ 694,658 $ 546,199 $ 546,566 $ 606,973 49,846 205 $ 606,534 50,280 205 $ 466,299 37,852 182 $ 465,431 37,487 182 $ 657,024 $ 657,019 $ 504,333 $ 503,100 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, 2014 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, 2014 and December 31, 2013 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, 2014 or December 31, 2013. 50 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 20 - 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, 2014 Balance at December 31, 2014 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, 2014 (dollars in thousands) Assets Impaired loans Other real estate held for sale $ 1,658 3,010 - $ - - $ - $ 1,658 3,010 $ 857 280 $ 1,137 Assets Measured at Fair Value on a Nonrecurring Basis at December 31, 2013 Balance at December 31, 2013 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, 2013 (dollars in thousands) Assets Impaired loans Other real estate held for sale $ 2,024 1,884 - $ - - $ - $ 2,024 1,884 $ 2,075 265 $ 2,340 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). NOTE 21 – BUSINESS COMBINATIONS The Corporation completed its acquisition of Peninsula Financial Corporation (“PFC”) and its wholly owned subsidiary, The Peninsula Bank. PFC had six branch offices and $126 million in assets of December 5, 2014. The results of operations due to the merger have been included in the Corporation’s results since the acquisition date. The merger was effected by a combination of cash and the issuance of shares of the Corporation’s common stock to PFC shareholders. Each share of PFC’s 288,000 shares of common stock was converted into the right to receive 3.64 shares of the Corporation’s common stock, with cash paid in lieu of fractional shares. PFC shareholders also had the option to receive cash at $46.13 per share of common stock. The conversion of PFC’s shares resulted in the issuance of 695,361 shares of the Corporation’s common stock and $4.484 million in total for all shares exchanged for cash. 51 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 21 – BUSINESS COMBINATIONS (CONTINUED) The table below highlights the allocation of the purchase price: Purchase Price: Peninsula shares outstanding at December 5, 2014 Price per share /Cash Price Aggregate value of Mackinac stock issued, 695,361 shares, at a market value of $11.41 in exch for 190,800 shares Cash consideration $46.13 for 97,200 shares Cash for partial shares Total purchase price Net assets acquired: Cash and cash equivalents Securities available for sale Federal Home Loan Bank stock Loans Premises and equipment Other real estate owned Deposit based intangible Other assets Total assets Non-interest bearing deposits Interest bearing deposits Total deposits Other liabilities Total liabilities Net assets acquired Goodwill 288,000 46.13 $ $ 7,934 4,484 2 $ 6,295 27,768 394 67,139 2,918 1,011 1,206 6,035 112,766 10,250 90,700 100,950 3,201 104,151 $ 12,420 8,615 $ 3,805 The results of operations for the twelve months ended December 31, 2014, include the operating results of the acquired assets and assumed liabilities for the 26 days subsequent to the acquisition date. PFC’s results of operations prior to the acquisition date are not included in the Corporation’s consolidated statement of comprehensive income. The Corporation recorded merger related expenses of $1.622 million after tax during the twelve months ended December 31, 2014. These expenses were for professional services such as legal, accounting and contractual arrangements for consulting services and data processing termination fees. The following table provides the unaudited pro forma information for the results of operations for the twelve months ended December 31, 2014, as if the acquisition had occurred on January 1. These adjustments reflect the impact of certain purchase accounting fair value measurements, primarily on the loan and deposit portfolios of PFC. In addition, the merger- related costs noted above are excluded from the 2014 results of operations, for comparative purposes. Further operating cost savings are expected along with additional business synergies as a result of the merger which are not presented in the pro forma amounts. These unaudited pro forma results are presented for illustrative purposes only and are not intended to represent or be indicative of the actual results of operations of the combined banking organization that would have been achieved had the merger occurred at the beginning of the period presented, nor are they intended to represent or be indicative of future results of the Corporation. 2014 2013 $ $ 27,952 4,647 7,740 1.22 $ $ 26,387 4,733 6,706 1.06 Net interest income Noninterest income Net income Net income per diluted share 52 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 21 – BUSINESS COMBINATIONS (CONTINUED) In most instances, determining the fair value of the acquired assets and assumed liabilities required the Corporation to estimate the cash flows expected to result from those assets and liabilities and to discount those cash flows at appropriate rates of interest. The most significant of those determinations is related to the valuation of acquired loans. For such loans, the excess cash flows expected at merger over the estimated fair value is recognized as interest income over the remaining lives of the loans. The difference between contractually required payments at merger and the cash flows expected to be collected at merger reflects the impact of estimated credit losses and other factors, such as prepayments. In accordance with the applicable accounting guidance for business combinations, there was no carry-over of PFC’s previously established allowance for loan losses. The acquired loans were divided into loans with evidence of credit quality deterioration, which are accounted for under ASC 310-30 (“acquired impaired”) and loans that do not meet the criteria, which are accounted for under ASC 310-20 (“acquired non-impaired”). In addition, the loans are further categorized into different pools based primarily on the type and purpose of the loan. 53 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 22 - PARENT COMPANY ONLY FINANCIAL STATEMENTS BALANCE SHEETS December 31, 2014 and 2013 (Dollars in Thousands) ASSETS Cash and cash equivalents Investment in subsidiaries Other assets TOTAL ASSETS LIABILITIES AND SHAREHOLDERS' EQUITY Line of Credit Other borrowing 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 - 6,266,756 and 5,541,390 shares respectively Retained earnings Accumulated other comprehensive income Total shareholders' equity 2014 2013 $ 1,693 83,226 5,884 $ 1,301 65,881 567 $ 90,803 $ 67,749 $ 8,000 2,700 6,107 16,807 $ 2,000 - 500 2,500 - - 61,679 11,804 513 73,996 53,621 11,412 216 65,249 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 90,803 $ 67,749 54 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 22 - PARENT COMPANY ONLY FINANCIAL STATEMENTS (CONTINUED) STATEMENTS OF OPERATIONS Years Ended December 31, 2014, 2013, and 2012 (Dollars in Thousands) INCOME: Interest income Total income EXPENSES: Interest expense on borrowings Salaries and benefits Professional service fees Nonrecurring transaction related expenses Other Total expenses Loss before income taxes and equity in undistributed net income of subsidiaries (Benefit of) income taxes 2014 2013 2012 $ - $ 1 $ 3 $ - $ 1 $ 3 210 609 247 1,284 304 2,654 - 482 208 - 520 - 280 562 - 340 1,210 1,182 (2,654) (1,209) (1,179) (726) (411) (393) Loss before equity in undistributed net income of subsidiaries (1,928) (798) (786) Equity in undistributed net income of subsidiaries Net income Preferred dividend and accretion of discount 3,628 1,700 - 6,735 5,937 308 7,873 7,087 629 NET INCOME AVAILABLE TO COMMON SHAREHOLDERS $ 1,700 $ 5,629 $ 6,458 55 Notes to the Consolidated Financial Statements MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES NOTE 22 - PARENT COMPANY ONLY FINANCIAL STATEMENTS (CONTINUED) STATEMENTS OF CASH FLOWS Years Ended December 31, 2014, 2013, and 2012 (Dollars in Thousands) Cash Flows from Operating Activities: Net income 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 provided by (used in) operating activities Cash Flows from Investing Activities: Investments in subsidiaries Net cash paid for acquisition of Peninsula Net cash (used in) investing activities Cash Flows from Financing Activities: Increase on term borrowing Principal payments on borrowings Net activity on line of credit Proceeds from issuance of common stock Repurchase of common stock Purchase of common stock warrants Dividend on common stock Dividend on preferred stock Redemption of Series A Preferred Stock Net cash provided by (used in) financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period 2014 2013 2012 $ 1,700 $ 5,937 $ 7,087 (3,628) 429 (5,664) 8,603 1,440 (4,000) (4,484) (8,484) 3,000 (300) 6,000 - (143) - (1,121) - - 7,436 392 1,301 (6,735) 333 2,587 (3) 2,119 (3,000) - (3,000) - - 2,000 - (509) - (944) (308) (11,000) (10,761) (11,642) 12,943 (7,873) 66 92 (163) (791) - - - - - - 11,506 - (1,300) (223) (550) - 9,433 8,642 4,301 Cash and cash equivalents at end of period $ 1,693 $ 1,301 $ 12,943 56 Selected Financial Data MACKINAC FINANCIAL CORPORATION AND SUBSIDIARIES SELECTED FINANCIAL DATA (Unaudited) (Dollars in Thousands, Except Per Share Data) SELECTED FINANCIAL CONDITION DATA: Total assets Loans Securities Deposits Borrowings Common shareholders' equity Total shareholders' equity 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 ASSET QUALITY RATIOS: Nonperforming loans to total loans Nonperforming assets to total assets Allowance for loan losses to total loans Allowance for loan losses to nonperforming loans Net charge-offs to average loans Texas ratio Years Ended December 31 2014 2013 2012 2011 2010 $ 743,785 600,935 65,832 606,973 49,846 73,996 73,996 $ 572,800 483,832 44,388 466,299 37,852 65,249 65,249 $ 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 $ $ $ $ $ 27,669 4,142 23,527 1,200 54 3,058 (22,610) 2,829 1,129 1,700 - 1,700 25,523 4,124 21,399 1,675 73 3,865 (18,128) 5,534 (403) 5,937 308 5,629 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) $ $ $ $ $ $ .30 .30 .225 11.81 11.85 $ 1.01 1.00 0.170 11.77 9.90 $ 1.51 1.46 0.040 11.05 7.09 $ .42 .41 - 12.97 5.42 $ (.34) (.34) - 12.63 4.58 % 2.57 2.57 .28 75.00 10.94 74.43 4.19 % .66 .93 .86 130.49 .14 9.37 % % 9.07 8.26 1.01 16.83 12.28 67.46 4.17 .42 .58 .96 230.29 .48 5.59 % % 12.43 10.26 1.23 2.65 11.95 67.95 4.17 1.04 1.45 1.16 111.33 .23 10.25 % % 3.30 2.66 .30 N/A 11.15 68.43 4.06 1.99 2.24 1.18 65.69 .94 18.56 % (2.64) (2.06) (.23) N/A 11.17 72.57 3.66 % 2.76 3.37 1.73 62.61 1.33 26.66 57 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 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 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 2014 FOR THE QUARTER ENDED 2013 12/31 9/30 6/30 3/31 12/31 9/30 6/30 3/31 $ 600,935 (5,140) 595,795 743,785 471,029 135,944 606,973 49,846 73,996 73,996 68,995 6,266,756 5,770,104 $ 518,373 (5,279) 513,094 613,943 403,950 87,256 491,206 52,409 67,132 67,132 67,132 5,564,815 5,540,200 $ 502,940 (5,097) 497,843 595,869 380,772 103,244 484,016 42,087 66,477 66,477 66,477 5,527,690 5,527,690 $ 485,862 (4,883) 480,979 583,592 384,846 90,864 475,710 38,852 65,730 65,730 65,730 5,527,690 5,530,908 $ 483,832 (4,661) 479,171 572,800 375,593 90,706 466,299 37,852 65,249 65,249 65,249 5,541,390 5,555,952 $ 472,495 (4,959) 467,536 567,917 375,166 86,522 461,688 35,852 63,045 67,045 67,045 5,581,339 5,562,835 $ 455,555 (5,177) 450,378 553,501 357,935 89,972 447,907 35,925 62,520 66,520 66,520 5,554,459 5,556,133 $ 454,051 (5,037) 449,014 541,896 362,911 62,325 425,236 40,925 62,039 73,039 73,039 5,557,859 5,559,859 $ 549,411 (5,674) 543,737 651,935 414,459 107,696 522,155 55,487 67,397 $ 509,618 (5,084) 504,534 607,840 400,202 95,512 495,714 35,685 66,558 $ 492,923 (4,858) 488,065 581,150 374,935 96,010 470,945 37,901 66,553 $ 486,354 (4,776) 481,578 580,717 384,951 90,762 475,713 35,000 65,462 $ 479,321 (4,872) 474,449 569,443 375,455 86,175 461,630 37,573 66,906 $ 464,324 (5,094) 459,230 560,089 372,375 83,816 456,191 36,449 66,134 $ 456,937 (5,180) 451,757 548,455 361,721 78,059 439,780 40,656 67,483 $ 449,065 (5,127) 443,938 541,279 366,838 62,336 429,174 36,681 72,238 .66 .93 .86 130.49 .57 9.37 8.57 10.23 11.07 10.34 9.25 .52 0.74 1.02 195.88 N/M 6.27 10.23 11.68 12.68 10.95 10.93 .53 0.77 1.01 192.19 N/M 6.43 10.50 11.86 12.87 11.28 11.16 % .31 0.63 1.01 327.50 N/M 5.18 % 10.25 11.79 12.79 11.27 11.26 % .42 .68 .96 230.29 .93 5.59 % 10.31 11.83 12.79 11.75 11.75 % .91 1.21 1.09 114.98 .50 9.56 % 10.90 12.45 13.47 11.81 11.81 % .87 1.17 1.14 129.98 (.04) 9.02 % 11.01 12.74 13.85 12.30 12.30 % .84 1.41 1.11 131.41 .50 9.81 % 12.23 13.98 15.06 13.35 13.35 (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 58 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 2014 FOR THE QUARTER ENDED 2013 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 $ 6,389 $ 5,886 $ 5,659 $ 5,593 $ 5,626 $ 5,348 $ 5,269 $ 5,156 639 5,750 1,003 7,479 (726) (74) (652) 187 5,699 768 5,126 1,341 455 886 191 5,468 650 4,898 1,220 414 806 183 5,410 691 5,107 994 334 660 825 4,801 1,191 4,935 1,057 (1,911) 2,968 375 4,973 738 4,359 1,352 456 896 100 5,169 1,251 4,523 1,897 637 1,260 375 4,781 758 4,311 1,228 415 813 Preferred dividend and accretion of discount Net income available to common shareholders - (652) $ - 886 $ - 806 $ - 660 $ 58 2,910 $ 50 846 $ 63 1,197 $ 137 676 $ 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 $ (.13) $ .16 $ .15 $ .12 $ .52 $ .15 $ .22 $ .12 (.13) 11.81 11.85 .16 12.06 11.30 .15 12.03 12.90 .12 11.89 12.54 .51 11.77 9.90 .15 11.30 9.10 .22 11.26 8.88 .12 11.16 9.21 (.40) % .58 % .56 % .46 % 2.03 % .60 % .88 % .51 % (3.84) (3.84) 4.19 70.27 105.22 5.28 5.28 4.20 73.83 103.03 4.94 4.93 4.18 77.55 104.94 4.09 4.09 4.25 80.57 102.62 18.34 17.26 4.24 66.94 103.83 5.40 5.08 4.12 70.64 101.78 7.69 7.12 4.16 68.02 103.90 4.47 3.79 4.18 72.65 104.63 59 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, 2013 through December 31, 2014, as reported by NASDAQ. 2014 High Low Close Dividends delcared per share Book value 2013 High Low Close Dividends delcared per share Book value For the Quarter Ended March 31 June 30 $ 15.06 9.86 12.54 .050 11.89 $ 14.19 11.35 12.90 .050 12.03 September 30 13.70 $ 10.28 11.30 .050 12.06 December 31 12.10 $ 9.95 11.85 .075 11.81 $ 9.25 7.09 9.04 .04 11.16 $ 9.25 8.25 8.88 .04 11.26 $ 10.09 8.61 9.05 .04 11.30 $ 10.14 8.38 9.90 .05 11.77 The Corporation had approximately 1,600 shareholders of record as of March 30, 2015. 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. The Bank paid a $3.0 million dividend in 2013 and 2014. The Corporation declared a $.075 dividend per share on its common stock in the fourth quarter of 2014. There were no sales of unregistered securities in 2014. In 2013, the Corporation approved a stock buyback program. In 2014, the Corporation repurchased 13,700 shares of its common stock at a total purchase price of $143,298. During 2013, the Corporation repurchased 55,594 shares of its common stock at a total purchase price of $509,334. 60 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, 2014. The following information is based on an investment of $100, on December 31, 2009 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. 61 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) As a community banking organization, the Corporation’s success depends upon local and regional economic conditions and has different lending risks than larger banks. We manage our credit exposure through careful monitoring of loan applicants and loan concentrations in particular industries and through loan approval and review procedures. We have established an evaluation process designed to determine the adequacy of our allowance for loan losses. While this evaluation process uses historical and other objective information, the classification of loans and the establishment of loan losses is an estimated based on experience, judgment and expectations regarding borrowers and economic conditions, as well as regulator judgments. We can make no assurance that our loan loss reserves will be sufficient to absorb future loan losses of prevent a material adverse effect on its business, profitability or financial condition. (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, 2014, net deferred tax assets are approximately $11.498 million. If 62 Forward Looking Statements/Risk Factors 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. 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. 63 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, 2014 and 2013 and the results of operations for 2012 through 2014. This discussion also covers asset quality, liquidity, interest rate sensitivity, and capital resources for the years 2013 and 2014. 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 2014 results of operations and financial condition. A more detailed analysis of the results of operations and financial condition follows this summary. The Corporation reported net income of $1.700 million or $.30 per share, for the year ended December 31, 2014, compared to net income of $5.629 million, or $1.01 per share, for 2013 and $6.458 million, or $1.51 per share, in 2012. The 2014 results include nonrecurring transaction related expenses of $2.475 million. The 2013 and 2012 consolidated and bank results include a deferred tax valuation adjustment of $2.250 million, or $.40 per share and $3.000 million, $.70 per share, respectively. Total assets of the Corporation at December 31, 2014, were $743.785 million, an increase of $170.985 million, or 29.85% from total assets of $572.800 million reported at December 31, 2013. At December 31, 2014, the Corporation’s loans stood at $600.935 million, an increase of $117.103 million, or 24.20%, from 2013 year-end balances of $483.832 million. Acquired loans, net of purchase accounting adjustments had a balance of $64.123 million at December 31, 2014. Total loan production in 2014 amounted to $183.403 million, which included $29.871 million of secondary market mortgage loans sold. The Corporation also sold $7.075 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 $3.939 million, or .66% of total loans at December 31, 2014. Nonperforming assets at December 31, 2014, were $6.949 million, .93% of total assets, compared to $3.908 million or .68% of total assets at December 31, 2013. Total deposits increased from $466.299 million at December 31, 2013, to $606.973 million at December 31, 2014, an increase of 30.17%. The increase in deposits in 2014 was comprised of an increase in wholesale deposits of $45.238 million and an increase in core deposits of $95.436 million, largely a result of the Peninsula transaction. In 2014, the Corporation utilized wholesale deposits in order to better manage interest rate risk in funding fixed rate loans. Shareholders’ equity totaled $73.996 million at December 31, 2014, compared to $65.249 million at the end of 2013, an increase of $8.747 million. This change reflects the net income available to common shareholders of $1.700 million, other comprehensive income of $.297 million, an increase related to stock compensation expense of $.429 million, the impact acquisition of Peninsula of $7.804 million, the exercise of stock options of $.032 million, the repurchase of common stock of $.143 million and dividends declared on common stock of $1.308 million. The book value per common share at December 31, 2014, amounted to $11.81 compared to $11.87 at the end of 2013. 64 Management’s Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS (dollars in thousands, except per share data) 2014 2013 2012 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 Preferred dividend expense $ 23,575 (48) $ 21,471 (72) $ 19,898 (74) 23,527 1,200 3,112 22,610 2,829 1,129 21,399 1,675 3,938 18,128 5,534 (403) 19,824 945 4,043 16,757 6,165 (922) $ 1,700 - $ 5,937 308 $ 7,087 629 Net income available to common shareholders $ 1,700 $ 5,629 $ 6,458 Earnings per common share Basic Diluted Return on average assets Return on average common equity Return on average equity $ $ .30 .30 $ $ 1.01 1.00 $ $ 1.51 1.51 % .28 2.57 2.57 % 1.01 9.07 8.26 % 1.23 12.43 10.26 Summary The Corporation reported net income available to common shareholders of $1.700 million in 2014, compared to $5.629 million in 2013 and $6.458 million in 2012. The 2014 results include a provision for loan loss of $1.200 million and nonrecurring transaction related expense of $2.475 million. The 2013 results include a deferred tax valuation adjustment of $2.250 million, and reduced nonperforming costs. The 2012 results include significantly reduced credit related expenses and a decreased loan loss provision. 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 88% of total revenue in 2014. 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 $2.104 million from $21.471 million in 2013 to $23.575 million in 2014. In 2014, interest rates were stable with the prime rate at 3.25% for the entire year. The Corporation experienced a decrease, five basis points, in the overall rates on earnings assets from 4.99% in 2013 to 4.94% in 2014. Interest bearing funding sources declined by nine basis points, from .99% in 2013 to .90% in 2014. The combination of these effective rate changes resulted in a slight increase in net interest margin from 4.19% in 2013 to 4.20 in 2014. In 2013, 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. 65 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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 2014 Mix 2013 Mix 2012 Mix $ 26,491 - 962 64 152 27,669 404 15 1,680 304 815 924 4,142 95.74 - 3.48 .23 .55 100.00 9.75 .35 40.56 7.34 19.68 22.31 100.00 % % % % $ 24,400 - 961 34 128 25,523 388 13 2,033 380 654 656 4,124 95.60 - 3.77 .13 .50 100.00 9.41 .32 49.29 9.21 15.86 15.91 100.00 % % % % $ 23,313 18 948 27 121 24,427 548 16 2,429 433 520 657 4,603 95.44 0.07 3.88 0.11 .50 100.00 11.91 0.35 52.77 9.41 11.30 14.27 100.00 % % % % Net interest income $ 23,527 $ 21,399 $ 19,824 Average Rates Earning assets Interest-bearing funds Interest rate spread % 4.93 .90 4.03 % 4.98 .99 3.99 % 5.14 1.15 3.99 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 $333.009 million of variable rate loans that predominantly reprice with changes in the prime rate and $267.926 million of fixed rate loans. A large portion of the variable rate loans, 44%, or $148.120 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 $104.337 million of these loans with floors, while the majority of 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 rate sensitivity of earning assets and interest bearing liabilities to minimize the risk of movements in interest rates. 66 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 2014 Interest Average Rate Average Balance $ 509,749 45,172 2,062 78 3,810 560,871 (5,187) 23,124 10,174 2,088 14,542 44,741 $ 26,506 962 97 - 152 27,717 % 5.20 2.13 4.70 - 3.99 4.94 $ 462,500 46,294 1,002 3 3,070 512,869 (5,045) 20,535 10,632 2,800 13,361 42,283 2013 Interest $ 24,454 961 51 - 128 25,594 Average Rate Average Balance % 5.29 2.08 5.09 - 4.17 4.99 $ 422,440 38,094 850 11,127 3,070 475,581 (5,232) 28,561 10,254 3,392 14,184 51,159 2012 Interest $ 23,373 948 41 18 121 24,501 Average Rate % 5.53 2.49 4.82 .16 3.94 5.15 TOTAL ASSETS $ 605,612 $ 555,152 $ 526,740 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 $ 309 95 15 1,680 304 815 924 4,142 $ 114,313 45,158 15,717 144,061 24,288 69,833 45,451 458,821 76,880 3,662 66,249 146,791 % .27 .21 .10 1.17 1.25 1.17 2.03 .90 % $ 289 99 13 2,032 380 654 656 4,123 $ 120,401 35,242 13,052 133,082 24,243 53,435 37,838 417,293 67,596 2,091 68,172 137,859 % .24 .28 .10 1.53 1.57 1.22 1.73 .99 $ 119,053 31,837 13,682 138,767 25,128 36,569 35,973 401,009 59,730 3,062 62,939 125,731 $ 406 142 16 2,429 433 520 657 4,603 % .34 .45 .12 1.75 1.72 1.42 1.83 1.15 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 605,612 $ 555,152 $ 526,740 Rate spread Net interest margin/revenue, tax equivalent basis $ 23,575 4.04 4.20 % $ 21,471 4.00 4.19 % % $ 19,898 4.00 4.18 % % (1) For purposes of these computations, non-accruing loans are included in the daily average loan amounts outstanding. (2) The amount of interest income on nontaxable securities and loans has been adjusted to a tax equivalent basis, using a 34% tax rate. (3) Interest income on loans includes loan fees. 67 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. 2014 vs. 2013 2013 vs. 2012 Years ended December 31, Increase (Decrease) Due to Increase (Decrease) Due to Volume Rate $ 2,498 (23) 54 - 31 $ (405) 25 (4) - (6) Volume and Rate $ (41) (1) (4) - (1) Total Increase (Decrease) Volume Rate Volume and Rate Total Increase (Decrease) $ 2,052 1 46 - 24 $ 2,216 204 7 (18) - $ (1,037) (157) 2 (18) 7 $ (98) (34) 1 18 - $ 1,081 13 10 (18) 7 Interest earning assets: Loans Taxable securities Nontaxable securities Federal funds sold Other interest earning assets Total interest earning assets $ 2,560 $ (390) $ (47) $ 2,123 $ 2,409 $ (1,203) $ (113) $ 1,093 Interest bearing obligations: NOW and money market deposits Interest checking Savings deposits CDs <$100,000 CDs >$100,000 Brokered deposits Borrowings $ (15) 28 3 168 1 200 132 $ 37 (25) (1) (480) (77) (30) 113 $ (2) (7) - (40) - (9) 23 $ 20 (4) 2 (352) (76) 161 268 5 $ 15 (1) (100) (15) 240 34 $ (120) (53) (2) (310) (39) (72) (33) $ (2) (5) - 13 1 (34) (2) $ (117) (43) (3) (397) (53) 134 (1) Total interest bearing obligations $ 517 $ (463) $ (35) $ 19 $ 178 $ (629) $ (29) $ (480) Net interest income, tax equivalent basis $ 2,104 $ 1,573 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 2014, the Corporation recorded a provision for loan loss of $1.200 million, compared to a provision of $1.675 million in 2013 and $.945 million in 2012. Noninterest Income Noninterest income was $3.112 million, $3.938 million, and $4.043 million in 2014, 2013, and 2012, respectively. The principal recurring sources of noninterest income are the gains on the sale of SBA/USDA guaranteed loans and secondary market loans. In 2014, revenues from these two business lines totaled $1.394 million compared to $1.979 million in 2013 and $2.566 million in 2012. The Corporation, in recent years, expanded its efforts to generate increased income from secondary market loans by adding additional staff and centralizing processing activities. The Corporation also retains the servicing for the majority of mortgage loans sold to the secondary market. In 2014, income from servicing mortgages amounted to $.675 million, compared to $.790 million in 2013 and $.417 million in 2012. Deposit related income totaled $.701 million in 2014 compared to $.667 million in 2013 and $.699 million in 2012. 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. 68 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 2014 2013 2012 2014-2013 2013-2012 $ 150 $ 109 $ 110 37.61 % (.91) % % Increase (Decrease) 551 493 144 757 675 288 3,058 54 558 794 234 951 790 429 3,865 73 589 1,077 313 1,176 417 361 4,043 - (1.25) (37.91) (38.46) (20.40) (14.56) (32.87) (20.88) (26.03) (5.26) (26.28) (25.24) (19.13) 89.45 18.84 (4.40) 100.00 Total noninterest income $ 3,112 $ 3,938 $ 4,043 (20.98) % (2.60) % Noninterest Expense Noninterest expense was $22.610 million in 2014, compared to $18.128 million and $16.757 million in 2013 and 2012, respectively. In 2014, the increase in noninterest expense totaled $4.481 million, or 24.72%. This increase was higher than normal due in large part to nonrecurring transaction related expenses of $2.475 million, along with other costs related to strategic initiatives. Salaries and benefits, at $10.303 million, increased by $.952 million, 10.18%, from the 2013 expenses of $9.351 million and compared to $8.288 million in 2012. Expense increases on salaries and benefits in 2013 were largely due to increased staffing (due to the additions at our asset based lending subsidiary), combined with increased employee benefits costs relative to health insurance premium increases and stock compensation expenses related to the issuance of restricted stock. 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 Writedowns and losses on OREO held for sale FDIC insurance assessment Telephone Advertising Nonrecurring transaction related expenses Other operating expenses Total noninterest expense Federal Income Taxes 2014 $ 10,303 2,129 1,268 1,150 2013 $ 9,351 1,481 1,102 1,071 2012 $ 8,288 1,372 885 991 375 205 583 1,163 699 280 362 327 449 2,475 2,005 22,610 $ 362 264 443 1,069 617 265 385 303 436 - 2,048 18,128 $ 368 396 432 1,196 877 489 459 233 376 - 1,591 16,757 $ % Increase (Decrease) 2014 - 2013 % 10.18 43.75 15.06 7.38 3.59 (22.35) 31.60 8.79 13.29 5.66 (5.97) 7.92 2.98 100.00 (2.10) 24.72 % % 2013 - 2012 12.83 7.94 24.52 8.07 (1.63) (33.33) 2.55 (10.62) (29.65) (45.81) (16.12) 30.04 15.96 - 28.72 8.18 % 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 69 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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 asset will not be realized. The Corporation, as of December 31, 2014 had a net operating loss and tax credit carryforwards for tax purposes of approximately $16.2 million, and $2.353 million, respectively. The Corporation will 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 and recognizes 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 $10.5 million, and the majority 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. Current Federal Tax Provision The Corporation recognized a deferred tax expense of approximately $1.129 million for the year ended December 31, 2014 and a deferred tax benefit of $.403 million for the year ended December 31, 2013. The valuation allowance at December 31, 2014 was approximately $.760 million. The Corporation has reduced the valuation allowance as it was determined that it was “more likely than not” that these benefits would be realized. In December 2013, the Corporation reduced the valuation by $2.250 million and in June 2012 a reduction of $3.0 million was recorded. The Corporation made these determinations 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. The remaining valuation allowance pertains to the existing tax credit carryovers, which will only be utilized after all net operating loss carryforwards. Since a portion of these tax credits may expire before that occurs, a valuation allowance for these has been established. The Corporation will continue to evaluate the future benefits from these carryforwards in order to determine if any adjustment to the deferred tax asset is warranted. In connection with the Peninsula acquisition in December 2014, the Corporation acquired $.933 million of NOL carryforward and approximately $.217 million of various tax credits, which it expects to utilize prior to expiration. 70 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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 Pension liability Stock compensation Depreciation Purchase accounting adjustments Other Total deferred tax assets Valuation allowance Deferred tax liabilities: Core deposit premium FHLB stock dividend Unrealized gain on securities Mortgage servicing rights Other Total deferred tax liabilities 2014 2013 $ 5,500 2,194 1,586 474 767 576 475 247 (88) 2,095 33 $ 6,737 1,585 1,463 138 672 152 - 267 157 - 188 13,859 11,359 $ (760) $ (760) (407) (103) (363) (658) (70) (1,601) - (103) (111) (452) - (666) Net deferred tax asset $ 11,498 $ 9,933 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 $.760 million valuation adjustment as of December 31, 2014. The remaining valuation allowance pertains to the existing tax credit carryovers, which will only be utilized after all net operating loss carryforwards. Since a portion of these tax credits may expire before that occurs, a valuation allowance for those credits that may expire has been established. The Corporation will continue to evaluate the future benefits from these carryforwards in order to determine if any adjustment to the deferred tax asset is warranted. 71 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) 2014 December 31, 2013 2012 Sources of funds: Deposits: Non-interest bearing transactional deposits Interest-bearing transactional deposits 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 $ 95,498 240,580 134,951 471,029 30,316 105,628 135,944 49,846 12,970 73,996 % 12.84 32.35 18.14 63.33 4.08 14.20 18.28 6.70 1.74 9.95 $ 72,936 162,162 140,495 375,593 23,159 67,547 90,706 37,852 3,400 65,249 % 12.73 28.31 24.53 65.57 4.04 11.79 15.84 6.61 .59 11.39 $ 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 Total $ 743,785 100.00 % $ 572,800 100.00 % $ 545,980 100.00 % 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 $ 595,795 65,832 - 2,973 5,797 21,947 51,441 % 80.11 8.85 - .40 .78 2.95 6.92 $ 479,171 44,388 3 3,060 10 18,216 27,952 % 83.66 7.75 .00 .53 .00 3.18 4.88 $ 443,959 43,799 3 3,060 10 26,958 28,191 % 81.32 8.02 .00 .56 .00 4.94 5.16 Total $ 743,785 100.00 % $ 572,800 100.00 % $ 545,980 100.00 % 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 $21.444 million in 2014, from $44.388 million at December 31, 2013 to $65.832 million at December 31, 2014. Acquired securities, net of purchase accounting adjustments, totaled $22.144 million at year-end. The carrying value of the Corporation’s securities is as follows at December 31 (dollars in thousands): US Agencies US Agencies - MBS Corporate Obligations of states and political subdivisions US Treasury Total securities 2014 2013 $ 22,717 13,688 12,674 11,473 5,280 $ 14,855 7,359 16,079 6,095 - $ 65,832 $ 44,388 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, 2014, investment securities with an estimated fair market value of $4.181 million were pledged. 72 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 72% of total loans outstanding at December 31, 2014. The Corporation continued to experience strong loan demand in 2014 with approximately $183.403 million of new loan production, including $29.871 million of mortgage loans sold in the secondary market. At 2014 year-end, the Corporation’s loans stood at $600.935 million, an increase from the 2013 year-end balances of $483.832 million. In 2014, the secondary mortgage loans that were produced and sold totaled $29.871 million while the SBA/USDA loan sales amounted to $7.075 million. The production of loans was distributed among the regions, with the Upper Peninsula at $104.601 million, $40.133 million in the Northern Lower Peninsula and $38.669 million in Southeast Michigan. The December 2014 acquisition of loans added $72.289 million to our consolidated loan portfolio. These acquired loans consisted of approximately $30 million commercial loans and $34 million consumer loans. These acquired loans did not results in any concentration risk. 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 2013 and 2014(dollars in thousands): Loan balances as of December 31, 2012 Total production Secondary market sales SBA loan sales Loans transferred to OREO Loans charged off, net of recoveries Normal amortization/paydowns and payoffs 449,177 190,918 (54,736) (8,393) (932) (2,232) (89,970) Loan balances as of December 31, 2013 $ 483,832 Total production Total loans acquired Secondary market sales SBA loan sales Loans transferred to OREO Loans charged off, net of recoveries Normal amortization/paydowns and payoffs 183,403 72,289 (29,871) (7,075) (588) (721) (100,334) Loan balances as of December 31, 2014 $ 600,935 Following is a table that illustrates the balance changes in the loan portfolio from 2012 through 2014 year end (dollars in thousands): 2014 2013 2012 2014-2013 2013-2012 Percent Change Commercial real estate Commercial, financial, and agricultural $ 315,387 101,895 $ 268,809 79,655 $ 244,966 80,646 17.33 % 9.73 % 27.92 (1.23) One-to-four family residential real estate Construction: Consumer Commercial Consumer 139,553 103,768 87,948 34.49 17.99 9,431 16,284 18,385 6,895 10,904 13,801 7,465 17,229 10,923 36.78 49.34 33.21 (7.64) (36.71) 26.35 Total $ 600,935 $ 483,832 $ 449,177 24.20 % 7.72 % 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 improved in 2014, and we expect this trend to 73 Management’s Discussion and Analysis of Financial Condition and Results of Operations continue. 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 Lessors of residential buildings Commercial construction Gasoline stations and convenience stores Real estate agents and managers Other Balance $ 106,644 46,211 19,776 16,284 13,841 9,454 221,356 2014 % of Loans % of Capital % 24.60 10.66 4.56 3.76 3.19 2.18 51.05 % 144.12 62.45 26.73 22.01 18.71 12.78 299.15 Balance $ 100,333 45,360 14,191 10,904 11,534 10,922 166,124 2013 % of Loans % 27.92 12.62 3.95 3.03 3.21 3.04 46.23 % of Capital 153.77 69.52 21.75 16.71 17.68 16.74 254.60 Total commercial loans $ 433,566 100.00 % $ 359,368 100.00 % 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 2014 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, 2014, our residential loan portfolio totaled $148.984 million, or 25% 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 $1.526 million at the end of 2013 to $.858 million at 2014 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. 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. 74 Management’s Discussion and Analysis of Financial Condition and Results of Operations The Corporation, at December 31, 2014, had performing loans of $3.105 million and no nonperforming loans for which repayment terms were modified to the extent that they were deemed to be “restructured” loans. The total restructured loans of $3.105 million is comprised of six performing loans, the largest of which had a December 31, 2014 balance of $1.186 million. Credit Quality The table below shows balances of nonperforming assets for the three years ended December 31 (dollars in thousands): December 31, 2014 (Unaudited) December 31, 2013 (Unaudited) December 31, 2012 (Unaudited) 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 $ $ $ 3,939 - - 3,939 3,010 6,949 1,410 - 614 2,024 1,884 3,908 4,687 - - 4,687 3,212 7,899 $ $ $ .66 .93 % % .42 .68 % % 1.04 1.45 $ 5,140 1.01 130.49 130.49 9.37 % % % % $ 4,661 .96 230.29 330.57 5.59 $ 5,218 1.24 111.33 111.33 10.17 % % % % Charge-off Information (year to date): Average loans Net charge-offs Charge-offs as a % of average loans, annualized $ $ 509,749 721 $ $ 462,500 2,232 $ $ 442,440 978 .14 % .48 % .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 2014 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 2015. 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 2014 2013 2012 $ 130 $ 228 $ 313 - - 54 Net interest lost $ 130 $ 228 $ 259 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 2014 amounted to $.721 million, or .14% of average loans outstanding, compared to $2.232 million, or .48% of loans outstanding in 2012. The current reserve balance is representative of the relevant risk inherent within the Corporation’s loan portfolio. Additions or reductions to the reserve in 75 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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 2014 2013 2012 Balance at beginning of period Loans charged off: Commercial One-to-four family residential real estate Consumer Total loans charged off Recoveries of loans previously charged off: Commercial One-to-four family residential real estate Consumer Total recoveries of loans previously charged off Net loans charged off Provision for loan losses $ 4,661 $ 5,218 $ 5,251 682 290 74 1,046 259 22 44 325 721 1,200 2,171 141 120 2,432 150 26 24 200 2,232 1,675 775 399 82 1,256 253 7 18 278 978 945 Balance at end of period $ 5,140 $ 4,661 $ 5,218 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 $ 600,935 509,749 .86 % .14 15.47 $ 483,832 462,500 .96 .48 42.78 % $ 449,177 422,440 1.16 .23 18.63 % 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 2014, the allowance for loan losses represented .86% of total loans. The allowance for loan losses at the end of 2014 as a percentage of nonperforming assets was 110.11% compared to 119.27% at 2013 year end. 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. This position is further illustrated with the ratio of the allowance as a percent of nonperforming loans, which stood at 310.00% at December 31, 2014, compared to 230.29% at 2013 year end. The Corporation completed the acquisition of Peninsula Financial Corporation on December 5, 2014. The acquired loans were divided into loans with evidence of credit quality deterioration, which are accounted for under ASC 310-30 (“acquired impaired”) and loans that do not meet that criteria, which are accounted for under ASC 310-20 (“acquired nonimpaired”). The acquired impaired loans totaled $10.321 million. The Corporation recorded these loans at fair value taking into account a number of factors, including remaining life, estimated loss, estimated value of the underlying collateral and net present values of cash flows. For the period of December 5, 2014 to December 31, 2014, recorded interest compared to accretable interest on acquired impaired loans was immaterial and no significant payments of principal were recorded. 76 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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. The following table represents the activity in other real estate held for sale (dollars in thousands): Balance at December 31, 2012 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 3,212 932 (1,996) (231) (33) Balance at December 31, 2013 $ 1,884 Other real estate transferred from loans due to foreclosure Other real estate acquired, net of purchase accounting Other real estate sold Writedowns on other real estate held for sales Loss on other real estate held for sale 588 1,193 (375) (228) (52) Balance at December 31, 2014 $ 3,010 During 2014, the Corporation received real estate in lieu of loan payments of $.588 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, 2014 were $606.973 million, an increase of $140.674 million, or 30.17% from December 31, 2013 deposits of $466.299 million. Deposits acquired totaled $102.482 million at 2014 year end. The table below shows the deposit mix for the periods indicated (dollars in thousands): 2014 Mix 2013 Mix 2012 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 $ 95,498 212,565 28,015 134,951 471,029 30,316 105,628 135,944 15.73 35.02 4.62 22.23 77.60 4.99 17.40 22.40 % $ 72,936 149,123 13,039 140,495 375,593 23,159 67,547 90,706 15.64 31.98 2.80 30.13 80.55 4.97 14.48 19.45 % $ 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 Total deposits $ 606,973 100.00 % $ 466,299 100.00 % $ 434,557 100.00 % The increase in deposits, as illustrated above, is composed of an increase in noncore deposits of $45.238 million, while core deposits increased by $95.436 million. Through the acquisition of Peninsula, the Corporation has enhanced its core deposit portfolio with additional stable deposit relationships from Peninsula’s long term customer base. 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 78% 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 2014 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 77 Management’s Discussion and Analysis of Financial Condition and Results of Operations FHLB borrowings had a weighted average maturity of 2.6 years, with a weighted average rate of 1.68% at December 31, 2014. Shareholders’ Equity Changes in shareholders’ equity are discussed in detail in the “Capital and Regulatory” section of this report. 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, 2014 the Bank had $65.832 million of securities, with a weighted average maturity of 73.9 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 78 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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. The following are the Corporation’s repricing opportunities at December 31, 2014 (dollars in thousands): Interest-earning assets: Loans Securities Other (1) 1-90 Days 91-365 Days >1-5 Years Over 5 Years Total $ 209,577 5,137 4,470 $ 168,091 9,430 $ 220,494 29,175 $ 2,773 22,090 $ 600,935 65,832 908 3,392 - 8,770 Total interest-earning assets 219,184 178,429 253,061 24,863 675,537 Interest-bearing obligations: NOW, money market, savings and interest checking Time deposits Brokered CDs Borrowings 240,580 23,720 20,831 11,767 - 67,910 24,404 374 - 73,518 60,393 37,305 Total interest-bearing obligations 296,898 92,688 171,216 - 119 - 400 519 240,580 165,267 105,628 49,846 561,321 Gap Cumulative gap $ (77,714) $ 85,741 $ 81,845 $ 24,344 $ 114,216 $ (77,714) $ 8,027 $ 89,872 $ 114,216 (1) includes Federal Home Loan Bank stock The above analysis indicates that at December 31, 2014, the Corporation had a cumulative asset sensitivity gap position of $8.027 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, 2014, the Corporation had $333.009 million of variable rate loans that reprice primarily with the prime rate index. Approximately $148.120 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, $104.337 million of these floor- rate loans would reprice with a 100 basis point prime rate increase, with $41.336 million repricing with an additional 100 basis point prime rate increase. At December 31, 2013, the Corporation had a cumulative asset sensitive gap position of $24.272 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 79 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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. 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, 2014 (dollars in thousands). Nonaccrual loans of $3.939 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 Fixed interest rate loans Average interest rate Principal/Notional Amount Maturing/Repricing In: 2015 2016 2017 2018 2019 Thereafter Total Fair Value 12/31/2013 $ 8,880 1.59 $ 5,055 2.27 $ 2,203 1.60 $ 11,986 1.51 $ 12,541 2.12 $ 25,167 3.01 $ 65,832 2.27 % $ 65,832 17,807 4.97 27,265 5.60 58,265 5.13 86,314 4.71 55,622 4.79 22,653 4.92 267,926 4.94 268,209 Variable interest rate loans Average interest rate 333,009 4.67 - - - - - - - - - - 333,009 4.67 333,360 Other assets Average interest rate 5,372 2.38 924 .86 1,729 1.78 498 1.33 247 2.04 - - 8,770 2.11 8,770 Total rate sensitive assets Average interest rate $ 365,068 4.58 % $ 33,244 $ 62,197 $ 98,798 $ 68,410 $ 47,820 $ 675,537 $ 676,171 4.96 % 4.91 % 4.30 % 4.30% % 3.53 % 4.23 % Rate Sensitive Liabilities Interest-bearing savings, NOW, MMAs, checking Average interest rate Time deposits Average interest rate Variable interest rate borrowings Average interest rate Fixed interest rate borrowings Average interest rate Total rate sensitive liabilities Average interest rate $ 240,580 .16 $ - - $ - - $ - 0 $ - - $ - - % .16 % 240,580 $ 240,580 136,660 1.10 94,797 1.41 29,794 1.49 14,067 3.82 - - - - 8,875 1.70 - - 650 2.28 119 2.29 270,895 1.28 270,456 - - - - 14,067 3.82 14,067 - - 15,000 2.03 - - 10,000 1.11 10,000 1.72 779 1.00 35,779 1.66 36,213 $ 377,240 .62 % $ 109,797 $ 29,794 $ 18,875 $ 10,650 $ 898 $ 547,254 $ 547,249 1.49 % 1.49 % 1.39 % 1.75 % 1.17 % .88 % 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, 2014, the Corporation had excess Canadian assets of $.091 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. 80 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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. 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 19 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 2014, the Corporation increased cash and cash equivalents by $3.728 million. As shown on the Corporation’s consolidated statement of cash flows, liquidity was primarily impacted by cash used in investing activities and cash provided by financing activities. The net change in investing activities included a net increase in loans of $50.969 million and a net increase in securities available for sale of $1.132 million. The net increases in assets were offset by a similar increase in deposit liabilities of $39.724 million. This increase in deposits was composed of an increase in non-core deposits of $45.238 million combined with an increase in core deposits of $95.436 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, 2014, $61.651 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 2015, 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. In December 2013 and 2014, the Bank paid a $3.0 million dividend. Bank capital, after payment of this dividend, was strong and above the “well capitalized” regulatory level. The Corporation, has a $12.0 million line of credit with a correspondent bank, which also serves as a source of liquidity. As of December 31, 2014, $4.0 million was available under this line. The Corporation will continue to explore 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, 2014, the Bank’s core deposits in relation to total funding were 71.71% compared to 74.50% in 2013. These ratios indicated at December 31, 2013, that the Bank has increased 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 81 Management’s Discussion and Analysis of Financial Condition and Results of Operations 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, 2014, 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 2014 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. 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, 2014, the aggregate contractual obligations and commitments are (dollars in thousands): Contractual Obligations Less than 1 Year 1 to 3 Years 4 to 5 Years Payments Due by Period Total deposits Federal Home Loan Bank borrowings Other borrowings Directors' deferred compensation Annual rental / purchase commitments under noncancelable leases / contracts TOTAL Other Commitments $ 472,943 - 474 287 $ 124,386 15,000 13,818 491 $ 9,525 20,000 154 441 After 5 Years $ 119 - 400 1,022 Total $ 606,973 35,000 14,846 2,241 724 1,251 913 4,232 7,120 $ 474,428 $ 154,946 $ 31,033 $ 5,773 $ 666,180 Letters of credit Commitments to extend credit Credit card commitments $ 6,072 68,325 3,267 $ - - - $ - - - $ - - - $ 6,072 68,325 3,267 TOTAL $ 77,664 $ - $ - $ - $ 77,664 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, 2014, the Corporation and the Bank were well capitalized. The Corporation and Bank capital is 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. 82 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): 2014 2013 2012 Capital Structure Common shareholders' equity Preferred stock Total shareholders' equity Total capitalization Tangible capital Intangible Assets Subsidiaries: Core deposit premium Goodwill Other identifiable intangibles Total intangibles Risk-Based Capital Tier 1 capital: Total shareholders' equity Accumulated other comprehensive income 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 $ $ $ 73,996 - 73,996 73,996 68,800 $ $ $ $ 65,249 - 65,249 65,249 65,249 61,448 11,000 72,448 72,448 72,448 $ $ $ $ 1,196 3,805 195 5,196 - $ - 1,129 1,129 $ - $ - 688 688 $ $ 73,996 $ 65,249 $ 72,448 (513) (6,000) (5,196) 62,287 $ (216) (7,000) (113) 57,920 $ (924) (7,100) (69) 64,355 $ $ $ $ 5,140 - 5,140 67,427 608,961 $ $ 4,661 - 4,661 62,581 489,407 $ $ 5,218 - 5,218 69,573 466,039 $ $ 8.57% 10.23% 11.07% 10.31% 11.83% 12.79% 11.98% 13.81% 14.93% 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. The Corporation’s and the Bank’s actual capital and ratios compared to generally applicable regulatory requirements as of December 31, 2014 are as follows (dollars in thousands): 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 Actual Amount Ratio Adequacy Purposes Amount Ratio Well-Capitalized Amount Ratio $ $ 67,427 70,320 11.1% > 11.8% > $ $ 48,717 47,611 > 8.0% > > 8.0% > $ $ 60,896 59,513 10.0% 10.0% $ $ 62,287 65,355 10.2% > 11.0% > $ $ 36,538 35,708 > 6.0% > > 6.0% > $ $ 36,538 35,708 6.0% 6.0% $ $ 62,287 65,355 9.6% > 9.1% > $ $ 29,065 28,680 > 4.0% > > 4.0% > $ $ 36,332 35,850 5.0% 5.0% 83 Management’s Discussion and Analysis of Financial Condition and Results of Operations The Corporation’s and the Bank’s actual capital and ratios compared to generally applicable regulatory requirements as of December 31, 2013 are as follows (dollars in thousands): Actual Amount Ratio Adequacy Purposes Amount Ratio Action Provisions Amount Ratio 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 $ $ 62,581 60,537 12.8% 12.4% > > $ $ 39,153 38,944 > 8.0% > 8.0% N/A $ 48,680 > N/A 10.0% $ $ 57,920 55,947 11.8% 11.5% > > $ $ 19,576 19,472 > 4.0% > 4.0% N/A $ 29,208 > N/A 6.0% $ $ 57,920 55,947 10.3% 10.0% > > $ $ 22,469 22,352 > 4.0% > 4.0% N/A $ 27,940 > N/A 5.0% 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. 84 Corporate Information 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 Robert H. Orley Founding Partner O2 Investment Partners, LLC Director Since: 2004 L. Brooks Patterson County Executive Oakland County Director Since: 2006 Joseph D. Garea Managing Director Hancock Securities and related entities Director Since: 2007 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 OFFICERS Mackinac Financial Corporation Paul D. Tobias Chairman and Chief Executive Officer Birmingham, MI Kelly W. George President Manistique, MI Ernie R. Krueger Executive Vice President/Chief Financial Officer Manistique, MI Mackinac Commercial Credit, LLC Officers Board of Managers Paul D. Tobias Chairman and Manager Paul A. Barr Credit Manager Edward P. Lewan EVP/Chief Lending Officer Michael J. Gallagher Regional Vice President Darlene Goy Controller Paul D. Tobias Chairman and CEO Mackinac Financial Corporation Don Barr, Jr. President Baywood Holdings, LLC Kelly W. George President and CEO mBank Ernie R. Krueger EVP - Chief Financial Officer mBank 85 Tamara R. McDowell EVP - Managing Director Credit Administration/Operations Walter J. Aspatore Chairman Methode Electronics Corp Robert H. Orley Founding Partner O2 Investment Partners, LLC Frank N. Sheckell Managing Director Oakland Capital Partners, LLC Directors and Officers Bernadette C. Beaudre Assistant Vice President Deposit Compliance/BSA Officer Manistique Linda K. Bolda Senior Vice President Human Resources Director Manistique Catherine M. Bolm Vice President Mortgage Loan Officer Marquette Julie L. Bosanic Assistant Vice President Underwriting Supervisor Manistique Angela E. Buckingham Assistant Vice President District Branch Supervisor Newberry Michael A. Caruso Vice President Senior Commercial Banking Officer Traverse City Jesse A. Deering Senior Vice President Managing Director of Retail Branch Banking/Marketing Birmingham Richard B. Demers Vice President Commercial Banking Officer Manistique Trisha L. DeMars Assistant Vice President Senior Deposit Operations Specialist Manistique George J. Demou Vice President Senior Commercial Banking Officer Birmingham Elena C. Dritsas Assistant Vice President Branch Administrator Birmingham Jeremy W. Flodin Vice President Senior Credit Administrator/ Credit Risk Analyst Manistique Daniel P. Galbraith Assistant Vice President District Branch Supervisor Traverse City mBank Officers Laura L. Garvin Vice President Commercial Portfolio Manager Birmingham Kelly W. George President and Chief Executive Officer Manistique, Marquette Clarice A. Ghiardi Vice President Mortgage Loan Officer Marquette Joseph T. Havican Vice President Commercial Banking Officer Marquette Michael J. Hoar Senior Vice President Information Technology/ Communications Manager Manistique Ernie R. Krueger Executive Vice President Chief Financial Officer Manistique David W. Leslie Senior Vice President Southeast Michigan/Gaylord Commercial Lending Manager Birmingham Magan L. MacArthur Assistant Vice President Mortgage Loan Officer Manistique Boris Martysz Senior Vice President Marquette Regional Executive Marquette Tamara R. McDowell Executive Vice President Managing Director, Credit Administration/ Operations/Information Technology Manistique, Marquette Joan M. Pitera-Powell Vice President Commercial Banking Officer Birmingham Scott A. Ravet Vice President Commercial Banking Officer Escanaba Jason J. Rolling Vice President Premier Client Services Marquette Andrew P. Sabatine Regional President Northern Lower Peninsula Traverse City Teresa M. Same Assistant Vice President District Branch Supervisor Marquette Gregory D. Schuetter Senior Vice President Upper Peninsula Commercial Lending Manager Manistique, Marquette Joanna B. Slaght Senior Vice President Compliance/Risk Manager Manistique Michael A. Slaght Vice President Commercial Banking Officer Newberry Jennifer A. Stempki Vice President Controller Manistique Daniel L. Stoudt Assistant Vice President Mortgage Loan Officer Traverse City Jacquelyn R. Menhennick Senior Vice President Mortgage and Consumer Lending Manager Marquette David R. Thomas Vice President Commercial Banking Officer Sault Ste. Marie Barbara A. Parrett Assistant Vice President District Branch Supervisor Stephenson Clay V. Peterson Senior Vice President Delta County Regional Executive Escanaba Paul D. Tobias Chairman Birmingham Nicole A. Tryan Assistant Vice President Senior Loan Operations Officer Manistique Janet M. Willbee Vice President Mortgage Loan Officer Gaylord Terry L. Garceau Senior Vice President Ishpeming/Negaunee Market Executive Ishpeming Debra L. Peterson Vice President Mortgage Loan Officer Escanaba 86 (THIS PAGE INTENTIONALLY LEFT BLANK) 87 (THIS PAGE INTENTIONALLY LEFT BLANK) 88 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 Computershare 480 Washington Blvd., 29th Floor Jersey City, NJ 07310 (800) 368-5948 WEBSITE www.bankmbank.com INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Plante Moran, PLLC Auburn Hills, 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 2015 Annual Meeting of the Shareholders of Mackinac Financial Corporation will be held on May 27, 2015. Visit our website, www.bankmbank.com, for updated news releases, financial reports, SEC filings, corporate governance and other investor information. 2 6 0 E a s t B r o w n S t . , S u i t e 3 0 0 , B i r i m n g h a m 2 2 2 4 N . L i n c o l n R d . , P . O . B o x 4 5 8 , E s c a n a b a 3 0 1 0 , G a yl o r d 1 9 5 5 S . O t s e g o A v e , P . O . B o x 100 S. M ain St., Ishpe ming 900 US 41 West, Ishpeming U S 4 1 W e s t & 1 7 0 N . D a i s y S t . , I s h p e m i n g a v a le e ., K v si A k 1 4 o 4 2 9 W u 130 S. Cedar St., P.O. Box 369, Manistique k a h e S 5 E. L 3 7 e u a nistiq ore Dr., M e City ers v ntry Dr., Tra orth C 0 N u o 3 5 3 S216 Menominee St., Stephenson e S t., S g a rie u lt S t e . M a 3 1 8 R i d 4 1 4 N e w b e r r y A v e . , N e w b e r r y 440 US 41 East, Negaunee 1414 W. Fair Ave., Ste. #140, M c C 1 7 5 S . M arquette 8 5 7 W . W a s h i n g t o n l e ll a n A v e ., M a r q u e t t e S t r e e t , M a r q u e t t e 130 S. Cedar St., Manistique, MI 49854-1438 906.341.8401 | bankmbank.com 

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