SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED September 30, 2013

Commission file number   0-7818
 
INDEPENDENT BANK CORPORATION
(Exact name of registrant as specified in its charter)

Michigan
38-2032782
(State or jurisdiction of Incorporation or Organization)
(I.R.S. Employer Identification Number)
 
230 West Main Street, P.O. Box 491, Ionia, Michigan  48846
(Address of principal executive offices)

(616) 527-5820
(Registrant's telephone number, including area code)
 
NONE
Former name, address and fiscal year, if changed since last report.

     Indicate by check mark whether the registrant (1) has filed all documents and reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES x NO o

 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
YESx NO o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, non-accelerated filer or smaller reporting company.

Large accelerated filer o
Accelerated filer o
Non-accelerated filer o
Smaller reporting companyx

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
YES o NO x

     Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Common stock, no par value
22,813,593
Class
Outstanding at November 6, 2013
 


INDEPENDENT BANK CORPORATION AND SUBSIDIARIES

INDEX

 
 
Number(s)
PART I -
Financial Information
 
Item 1.
3
 
4
 
5
 
6
 
7
 
8-68
Item 2.
69-99
Item 3.
100
Item 4.
100
 
 
 
PART II -
Other Information
 
Item 1A
101
Item 2.
101
Item 6.
102

Discussions and statements in this report that are not statements of historical fact, including, without limitation, statements that include terms such as “will,” “may,” “should,” “believe,” “expect,” “forecast,” “anticipate,” “estimate,” “project,” “intend,” “likely,” “optimistic” and “plan,” and statements about future or projected financial and operating results, plans, projections, objectives, expectations, and intentions and other statements that are not historical facts, are forward-looking statements. Forward-looking statements include, but are not limited to, descriptions of plans and objectives for future operations, products or services; projections of our future revenue, earnings or other measures of economic performance; forecasts of credit losses and other asset quality trends; and predictions as to our Bank’s ability to maintain certain regulatory capital standards. These forward-looking statements express our current expectations, forecasts of future events, or long-term goals and, by their nature, are subject to assumptions, risks, and uncertainties.  Although we believe that the expectations, forecasts, and goals reflected in these forward-looking statements are reasonable, actual results could differ materially for a variety of reasons, including, among others:

· the failure of assumptions underlying the establishment of and provisions made to our allowance for loan losses;
· the timing and pace of an economic recovery in Michigan and the United States in general, including regional and local real estate markets;
· the ability of our Bank to remain well-capitalized;
· the failure of assumptions underlying our estimate of probable incurred losses from vehicle service contract payment plan counterparty contingencies, including our assumptions regarding future cancellations of vehicle service contracts, the value to us of collateral that may be available to recover funds due from our counterparties, and our ability to enforce the contractual obligations of our counterparties to pay amounts owing to us;
· the risk that sales of our common stock could trigger a reduction in the amount of net operating loss carryforwards that we may be able to utilize for income tax purposes;
· the continued services of our management team; and
1

· implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act or other new legislation, which may have significant effects on us and the financial services industry, the exact nature and extent of which cannot be determined at this time.

This list provides examples of factors that could affect the results described by forward-looking statements contained in this report, but the list is not intended to be all inclusive.  The risk factors disclosed in Part I – Item A of our Annual Report on Form 10-K for the year ended December 31, 2012, as updated by any new or modified risk factors disclosed in Part II – Item 1A of any subsequently filed Quarterly Report on Form 10-Q, include all known risks that our management believes could materially affect the results described by forward-looking statements in this report.  However, those risks may not be the only risks we face.  Our results of operations, cash flows, financial position, and prospects could also be materially and adversely affected by additional factors that are not presently known to us, that we currently consider to be immaterial, or that develop after the date of this report.  We cannot assure you that our future results will meet expectations. While we believe the forward-looking statements in this report are reasonable, you should not place undue reliance on any forward-looking statement. In addition, these statements speak only as of the date made. We do not undertake, and expressly disclaim, any obligation to update or alter any statements, whether as a result of new information, future events, or otherwise, except as required by applicable law.
2

Part I - Item 1.
INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Financial Condition
 
 
 
September 30,
2013
   
December 31,
2012
 
 
 
(unaudited)
 
Assets
 
(In thousands, except share amounts)
 
Cash and due from banks
 
$
56,179
   
$
55,487
 
Interest bearing deposits
   
74,766
     
124,295
 
Cash and Cash Equivalents
   
130,945
     
179,782
 
Interest bearing deposits - time
   
16,946
     
-
 
Trading securities
   
308
     
110
 
Securities available for sale
   
415,885
     
208,413
 
Federal Home Loan Bank and Federal Reserve Bank stock, at cost
   
21,496
     
20,838
 
Loans held for sale, carried at fair value
   
27,622
     
47,487
 
Loans held for sale, carried at lower of cost or fair value
   
-
     
3,292
 
Loans
               
Commercial
   
625,422
     
617,258
 
Mortgage
   
491,525
     
527,340
 
Installment
   
194,542
     
189,849
 
Payment plan receivables
   
68,494
     
84,692
 
Total Loans
   
1,379,983
     
1,419,139
 
Allowance for loan losses
   
(34,437
)
   
(44,275
)
Net Loans
   
1,345,546
     
1,374,864
 
Other real estate and repossessed assets
   
16,637
     
26,133
 
Property and equipment, net
   
47,884
     
47,016
 
Bank-owned life insurance
   
51,916
     
50,890
 
Deferred tax assets, net
   
58,807
     
-
 
Capitalized mortgage loan servicing rights
   
13,051
     
11,013
 
Vehicle service contract counterparty receivables, net
   
9,753
     
18,449
 
Other intangibles
   
3,366
     
3,975
 
Prepaid FDIC deposit insurance assessment
   
-
     
9,448
 
Accrued income and other assets
   
23,342
     
22,157
 
Total Assets
 
$
2,183,504
   
$
2,023,867
 
Liabilities and Shareholders' Equity
               
Deposits
               
Non-interest bearing
 
$
508,983
   
$
488,126
 
Savings and interest-bearing checking
   
908,599
     
871,238
 
Reciprocal
   
55,924
     
33,242
 
Retail time
   
362,585
     
372,340
 
Brokered time
   
13,227
     
14,591
 
Total Deposits
   
1,849,318
     
1,779,537
 
Other borrowings
   
17,282
     
17,625
 
Subordinated debentures
   
50,175
     
50,175
 
Vehicle service contract counterparty payables
   
5,499
     
7,725
 
Accrued expenses and other liabilities
   
34,629
     
33,830
 
Total Liabilities
   
1,956,903
     
1,888,892
 
Shareholders' Equity
               
 
               
Convertible preferred stock, no par value, 200,000 shares authorized; None issued and outstanding at September 30, 2013 and 74,426 shares issued and outstanding at December 31, 2012; liquidation preference: $85,150 at December 31, 2012
   
-
     
84,204
 
Common stock, no par value, 500,000,000 shares authorized; issued and outstanding:  22,808,839 shares at September 30, 2013 and 9,093,732 shares at December 31, 2012
   
350,926
     
251,237
 
Accumulated deficit
   
(115,155
)
   
(192,408
)
Accumulated other comprehensive loss
   
(9,170
)
   
(8,058
)
Total Shareholders' Equity
   
226,601
     
134,975
 
Total Liabilities and Shareholders' Equity
 
$
2,183,504
   
$
2,023,867
 
 
See notes to interim condensed consolidated financial statements (unaudited)
3

INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Operations
 
 
 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Interest Income
 
(unaudited – in thousands, except per share amounts)
 
Interest and fees on loans
 
$
20,083
   
$
23,385
   
$
61,096
   
$
71,427
 
Interest on securities
                               
Taxable
   
1,109
     
655
     
2,772
     
2,246
 
Tax-exempt
   
282
     
261
     
762
     
801
 
Other investments
   
310
     
432
     
966
     
1,210
 
Total Interest Income
   
21,784
     
24,733
     
65,596
     
75,684
 
Interest Expense
                               
Deposits
   
1,371
     
2,223
     
4,363
     
6,952
 
Other borrowings
   
884
     
1,059
     
2,625
     
3,351
 
Total Interest Expense
   
2,255
     
3,282
     
6,988
     
10,303
 
Net Interest Income
   
19,529
     
21,451
     
58,608
     
65,381
 
Provision for loan losses
   
(355
)
   
251
     
(3,153
)
   
6,438
 
Net Interest Income After Provision for Loan Losses
   
19,884
     
21,200
     
61,761
     
58,943
 
Non-interest Income
                               
Service charges on deposit accounts
   
3,614
     
4,739
     
10,603
     
13,492
 
Interchange income
   
1,852
     
2,324
     
5,542
     
7,053
 
Net gains (losses) on assets
                               
Mortgage loans
   
1,570
     
4,602
     
8,415
     
12,041
 
Securities
   
14
     
301
     
205
     
1,154
 
Other than temporary impairment loss on securities
                               
Total impairment loss
   
-
     
(70
)
   
(26
)
   
(332
)
Loss recognized in other comprehensive loss
   
-
     
-
     
-
     
-
 
Net impairment loss recognized in earnings
   
-
     
(70
)
   
(26
)
   
(332
)
Mortgage loan servicing
   
338
     
(364
)
   
2,614
     
(716
)
Title insurance fees
   
409
     
482
     
1,261
     
1,479
 
(Increase) decrease in fair value of U.S. Treasury warrant
   
-
     
(32
)
   
(1,025
)
   
(211
)
Other
   
2,040
     
2,560
     
6,327
     
8,208
 
Total Non-interest Income
   
9,837
     
14,542
     
33,916
     
42,168
 
Non-interest Expense
                               
Compensation and employee benefits
   
12,591
     
13,610
     
35,613
     
39,598
 
Occupancy, net
   
2,017
     
2,482
     
6,588
     
7,688
 
Data processing
   
2,090
     
2,024
     
6,048
     
5,960
 
Loan and collection
   
1,584
     
2,832
     
5,512
     
8,129
 
Vehicle service contract counterparty contingencies
   
149
     
281
     
3,403
     
1,078
 
Furniture, fixtures and equipment
   
1,051
     
1,083
     
3,171
     
3,490
 
Provision for loss reimbursement on sold loans
   
1,417
     
193
     
2,436
     
751
 
Communications
   
695
     
896
     
2,205
     
2,791
 
FDIC deposit insurance
   
685
     
816
     
2,026
     
2,489
 
Advertising
   
652
     
647
     
1,881
     
1,842
 
Legal and professional
   
487
     
952
     
1,843
     
3,117
 
Interchange expense
   
410
     
468
     
1,238
     
1,321
 
Net losses on other real estate and repossessed assets
   
119
     
291
     
1,091
     
1,911
 
Credit card and bank service fees
   
310
     
433
     
975
     
1,708
 
Write-down of property and equipment held for sale
   
-
     
860
     
-
     
860
 
Cost (recoveries) related to unfunded lending commitments
   
(86
)
   
(538
)
   
(57
)
   
(597
)
Other
   
1,763
     
1,966
     
5,176
     
4,692
 
Total Non-interest Expense
   
25,934
     
29,296
     
79,149
     
86,828
 
Income Before Income Tax
   
3,787
     
6,446
     
16,528
     
14,283
 
Income tax expense (benefit)
   
282
     
-
     
(56,172
)
   
-
 
Net Income
 
$
3,505
   
$
6,446
   
$
72,700
   
$
14,283
 
Preferred stock dividends and discount accretion
   
(749
)
   
(1,093
)
   
(3,001
)
   
(3,241
)
Preferred stock discount
   
7,554
     
-
     
7,554
     
-
 
Net Income Applicable to Common Stock
 
$
10,310
   
$
5,353
   
$
77,253
   
$
11,042
 
Net Income Per Common Share
                               
Basic
 
$
0.73
    $ 0.61    
$
7.03
   
$
1.28
 
Diluted
   
0.17
      0.16      
3.40
     
0.36
 
Dividends Per Common Share
                               
Declared
 
$
0.00
   
$
0.00
   
$
$0.00
    $ 0.00  
Paid
   
0.00
     
0.00
     
0.00
      0.00  
 
See notes to interim condensed consolidated financial statements (unaudited)
4

INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Comprehensive Income

 
 
Three months ended
   
Nine months ended
 
 
 
September 30,
   
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
 
 
(unaudited - in thousands)
 
Net income
 
$
3,505
   
$
6,446
   
$
72,700
   
$
14,283
 
Other comprehensive income (loss), before tax
Available for sale securities
Unrealized gain (loss) arising during period
   
(2,910
)
   
909
     
(4,399
)
   
2,543
 
Change in unrealized losses for which a portion of other than temporary impairment has been recognized in earnings
   
(108
)
   
770
     
183
     
1,103
 
Reclassification adjustment for other than temporary impairment included in earnings
   
-
     
70
     
26
     
332
 
Reclassification adjustments for (gains) losses included in earnings
   
-
     
(350
)
   
(8
)
   
(1,193
)
Unrealized gains (losses) recognized in other comprehensive income on available for sale securities
   
(3,018
)
   
1,399
     
(4,198
)
   
2,785
 
Income tax benefit
   
(1,056
)
   
-
     
(1,469
)
   
-
 
Unrealized gains (losses) recognized in other comprehensive income on available for sale securities, net of tax
   
(1,962
)
   
1,399
     
(2,729
)
   
2,785
 
Derivative instruments
                               
Unrealized loss arising during period
   
-
     
(54
)
   
(38
)
   
(129
)
Reclassification adjustment for expense recognized in earnings
   
-
     
92
     
208
     
397
 
Reclassification adjustment for accretion on settled derivatives
   
95
     
145
     
95
     
436
 
Unrealized gains recognized in other comprehensive income on derivative instruments
   
95
     
183
     
265
     
704
 
Income tax expense (benefit)
   
33
     
-
     
(1,352
)
   
-
 
Unrealized gains recognized in other comprehensive income on derivative instruments, net of tax
   
62
     
183
     
1,617
     
704
 
Other comprehensive income (loss)
   
(1,900
)
   
1,582
     
(1,112
)
   
3,489
 
Comprehensive income
 
$
1,605
   
$
8,028
   
$
71,588
   
$
17,772
 

 See notes to interim condensed consolidated financial statements (unaudited)
5

INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
 
 
 
Nine months ended September 30,
 
 
 
2013
   
2012
 
 
 
(unaudited - in thousands)
 
Net Income
 
$
72,700
   
$
14,283
 
Adjustments to Reconcile Net Income to Net Cash from Operating Activities
               
Proceeds from sales of loans held for sale
   
346,206
     
378,804
 
Disbursements for loans held for sale
   
(317,926
)
   
(363,931
)
Net decrease in loans held for sale relating to branch sale
   
-
     
900
 
Net decrease in deposits held for sale relating to branch sale
    -      
(11,671
)
Provision for loan losses
   
(3,153
)    
6,438
 
Deferred federal income tax benefit
   
(58,807
)
   
-
 
Deferred loan fees
   
(28
)
   
(501
)
Depreciation, amortization of intangible assets and premiums and accretion of discounts on securities and loans
   
(2,168
)
   
(3,532
)
Write-down of property and equipment held for sale
   
-
     
860
 
Net gains on mortgage loans
   
(8,415
)
   
(12,041
)
Net gains on securities
   
(205
)
   
(1,154
)
Securities impairment recognized in earnings
   
26
     
332
 
Net losses on other real estate and repossessed assets
   
1,091
     
1,911
 
Vehicle service contract counterparty contingencies
   
3,403
     
1,078
 
Share based compensation
   
1,002
     
572
 
(Increase) decrease in accrued income and other assets
   
8,572
     
(5,439
)
Increase (decrease) in accrued expenses and other liabilities
   
(947
)
   
3,957
 
Total Adjustments
   
(31,349
)    
(3,417
)
Net Cash from Operating Activities
   
41,351
     
10,866
 
Cash Flow used in Investing Activities
               
Proceeds from the sale of securities available for sale
   
2,940
     
37,176
 
Proceeds from the maturity of securities available for sale
   
25,975
     
66,868
 
Principal payments received on securities available for sale
   
28,766
     
18,214
 
Purchases of securities available for sale
   
(266,974
)
   
(192,382
)
Purchases of interest bearing deposits
   
(16,419
)    
-
 
Purchase of Federal Reserve Bank stock
   
(658
)
   
-
 
Redemption of Federal Reserve Bank stock
   
-
     
334
 
Net cash from branch sale
   
3,292
     
-
 
Net decrease in portfolio loans (loans originated, net of principal payments)
   
30,255
     
75,148
 
Net proceeds from the sale of watch, substandard and non-performing loans
   
6,721
     
-
 
Proceeds from the collection of vehicle service contract counterparty receivables
   
6,351
     
7,413
 
Proceeds from the sale of other real estate and repossessed assets
   
11,659
     
14,062
 
Proceeds from the sale of property and equipment, net
   
52
     
415
 
Capital expenditures
   
(5,992
)
   
(4,185
)
Net Cash from (used in) Investing Activities
   
(174,032
)
   
23,063
 
Cash Flow from Financing Activities
               
Net increase in total deposits
   
69,781
     
98,836
 
Net increase (decrease) in other borrowings
   
(2
)
   
3
 
Proceeds from Federal Home Loan Bank advances
   
100
     
12,000
 
Payments of Federal Home Loan Bank advances
   
(441
)
   
(27,670
)
Redemption of convertible preferred stock and common stock warrant
   
(81,000
)
   
-
 
Share based compensation withholding obligation
   
(513
)
   
-
 
Net increase (decrease) in vehicle service contract counterparty payables
   
(2,226
)
   
1,781
 
Proceeds from issuance of common stock
   
98,145
     
557
 
Net Cash from Financing Activities
   
83,844
     
85,507
 
Net Increase (Decrease) in Cash and Cash Equivalents
   
(48,837
)
   
119,436
 
Cash and Cash Equivalents at Beginning of Period
   
179,782
     
341,108
 
Cash and Cash Equivalents at End of Period
 
$
130,945
   
$
460,544
 
Cash paid during the period for
               
Interest
 
$
13,853
   
$
8,647
 
Income taxes
   
42
     
198
 
Transfers to other real estate and repossessed assets
   
3,254
     
9,110
 
Transfer of payment plan receivables to vehicle service contract counterparty receivables
   
995
     
1,225
 
Purchase of securities available for sale and interest bearing deposits - time not yet settled
   
3,816
     
-
 
Transfers to loans held for sale
   
-
     
54,127
 
Transfers to fixed assets held for sale
   
-
     
10,884
 
Transfers to deposits held for sale
   
-
     
420,261
 
 
See notes to interim condensed consolidated financial statements (unaudited)
6

INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Shareholders' Equity

 
 
 
Nine months ended
September 30,
 
 
 
2013
   
2012
 
 
 
(unaudited)
 
 
 
(In thousands)
 
Balance at beginning of period
 
$
134,975
   
$
102,627
 
  Net income
   
72,700
     
14,283
 
  Issuance of common stock
   
99,065
     
557
 
  Redemption of convertible preferred stock and common stock warrant
   
(81,000
)
   
-
 
  Common stock warrant
   
1,484
     
-
 
  Share based compensation
   
1,002
     
572
 
  Share based compensation withholding obligation
   
(513
)
   
-
 
Net change in accumulated other comprehensive loss, net of related tax effect
   
(1,112
)    
3,489
 
Balance at end of period
 
$
226,601
   
$
121,528
 
 
See notes to interim condensed consolidated financial statements (unaudited)
7

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1.
Preparation of Financial Statements

The condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to those rules and regulations, although we believe that the disclosures made are adequate to make the information not misleading.  The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes for the year ended December 31, 2012 included in our Annual Report on Form 10-K.

In our opinion, the accompanying unaudited condensed consolidated financial statements contain all the adjustments necessary to present fairly our consolidated financial condition as of September 30, 2013 and December 31, 2012, and the results of operations for the three and nine-month periods ended September 30, 2013 and 2012.  The results of operations for the three and nine-month periods ended September 30, 2013, are not necessarily indicative of the results to be expected for the full year.  Certain reclassifications have been made in the prior period financial statements to conform to the current period presentation.  Our critical accounting policies include the assessment for other than temporary impairment (“OTTI”) on investment securities,  the determination of the allowance for loan losses, the determination of vehicle service contract counterparty contingencies, the valuation of originated mortgage loan servicing rights and the valuation of deferred tax assets.  Refer to our 2012 Annual Report on Form 10-K for a disclosure of our accounting policies.

2.
New Accounting Standards

In February, 2013, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2013-02, “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income”. This ASU amended guidance on the reporting of reclassifications out of accumulated other comprehensive income.  The amendments in this guidance require an entity to report the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required under GAAP to be reclassified in its entirety to net income. For other amounts that are not required under GAAP to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under GAAP that provide additional detail about those amounts.  This amended guidance became effective for us at January 1, 2013 and was applied prospectively.  The effect of adopting this standard did not have a material impact on our consolidated operating results or financial condition, but the additional disclosures are included in note #16.
8

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

3.
Securities

Securities available for sale consist of the following:

 
 
Amortized
   
Unrealized
   
 
 
 
Cost
   
Gains
   
Losses
   
Fair Value
 
 
 
(In thousands)
 
September 30, 2013
 
   
   
   
 
U.S. agency
 
$
23,794
   
$
3
   
$
405
   
$
23,392
 
U.S. agency residential mortgage-backed
   
198,424
     
1,062
     
1,147
     
198,339
 
Private label residential mortgage-backed
   
7,615
     
57
     
779
     
6,893
 
Other asset backed
   
26,877
     
8
     
55
     
26,830
 
Obligations of states and political subdivisions
   
143,957
     
422
     
3,440
     
140,939
 
Corporate
   
17,031
     
22
     
37
     
17,016
 
Trust preferred
   
2,901
     
-
     
425
     
2,476
 
Total
 
$
420,599
   
$
1,574
   
$
6,288
   
$
415,885
 
 
                               
December 31, 2012
                               
U.S. agency
 
$
30,620
   
$
70
   
$
23
   
$
30,667
 
U.S. agency residential mortgage-backed
   
126,151
     
1,264
     
3
     
127,412
 
Private label residential mortgage-backed
   
9,070
     
-
     
876
     
8,194
 
Obligations of states and political subdivisions
   
38,384
     
736
     
69
     
39,051
 
Trust preferred
   
4,704
     
-
     
1,615
     
3,089
 
Total
 
$
208,929
   
$
2,070
   
$
2,586
   
$
208,413
 

Our investments’ gross unrealized losses and fair values aggregated by investment type and length of time that individual securities have been at a continuous unrealized loss position follows:

 
 
Less Than Twelve Months
   
Twelve Months or More
   
Total
 
 
 
   
Unrealized
   
   
Unrealized
   
   
Unrealized
 
 
 
Fair Value
   
Losses
   
Fair Value
   
Losses
   
Fair Value
   
Losses
 
 
 
(In thousands)
 
 
 
   
   
   
   
   
 
September 30, 2013
 
   
   
   
   
   
 
U.S. agency
 
$
18,090
   
$
405
   
$
-
   
$
-
   
$
18,090
   
$
405
 
U.S. agency residential mortgage-backed
   
84,132
     
1,147
     
-
     
-
     
84,132
     
1,147
 
Private label residential mortgage-backed
   
2,150
     
14
     
4,684
     
765
     
6,834
     
779
 
Other asset backed
   
17,364
     
55
     
-
     
-
     
17,364
     
55
 
Obligations of states and political subdivisions
   
100,584
     
3,210
     
4,940
     
230
     
105,524
     
3,440
 
Corporate
   
10,980
     
37
     
-
     
-
     
10,980
     
37
 
Trust preferred
   
-
     
-
     
2,476
     
425
     
2,476
     
425
 
Total
 
$
233,300
   
$
4,868
   
$
12,100
   
$
1,420
   
$
245,400
   
$
6,288
 
 
                                               
December 31, 2012
                                               
U.S. agency
 
$
8,097
   
$
23
   
$
-
   
$
-
   
$
8,097
   
$
23
 
U.S. agency residential mortgage-backed
   
-
     
-
     
457
     
3
     
457
     
3
 
Private label residential mortgage-backed
   
-
     
-
     
8,192
     
876
     
8,192
     
876
 
Obligations of states and political subdivisions
   
7,384
     
69
     
-
     
-
     
7,384
     
69
 
Trust preferred
   
-
     
-
     
3,089
     
1,615
     
3,089
     
1,615
 
Total
 
$
15,481
   
$
92
   
$
11,738
   
$
2,494
   
$
27,219
   
$
2,586
 

9

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Our portfolio of available-for-sale securities is reviewed quarterly for impairment in value. In performing this review management considers (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) the impact of changes in market interest rates on the market value of the security and (4) an assessment of whether we intend to sell, or it is more likely than not that we will be required to sell a security in an unrealized loss position before recovery of its amortized cost basis. For securities that do not meet the aforementioned recovery criteria, the amount of impairment recognized in earnings is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income or loss.

U.S. agency and U.S. agency residential mortgage-backed securities — at September 30, 2013 we had six U.S. Agency and 13 U.S. Agency residential mortgage-backed securities whose fair market value is less than amortized cost. The unrealized losses are largely attributed to rises in term interest rates and widening spreads to Treasury bonds. As management does not intend to liquidate these securities and it is more likely than not that we will not be required to sell these securities prior to recovery of these unrealized losses, no declines are deemed to be other than temporary.

Private label residential mortgage backed securities — at September 30, 2013 we had seven of this type of securities whose fair value is less than amortized cost. Two of the issues are rated by a major rating agency as investment grade while three are below investment grade and two are split rated. Three of these bonds have impairment in excess of 10% and four of these holdings have been impaired for more than 12 months.

The unrealized losses are largely attributable to credit spread widening on these securities since their acquisition.  The underlying loans within these securities include Jumbo (70%) and Alt A (30%) at September 30, 2013.

 
 
September 30, 2013
   
December 31, 2012
 
 
 
   
Net
   
   
Net
 
 
 
Fair
   
Unrealized
   
Fair
   
Unrealized
 
 
 
Value
   
Gain (Loss)
   
Value
   
Gain (Loss)
 
 
 
(In thousands)
 
 
 
   
   
   
 
Private label residential mortgage-backed
 
   
   
   
 
Jumbo
 
$
4,820
   
$
(566
)
 
$
6,041
   
$
(594
)
Alt-A
   
2,073
     
(156
)
   
2,153
     
(282
)

All of these securities are receiving some principal and interest payments. Most of these transactions are passthrough structures, receiving pro rata principal and interest payments from a dedicated collateral pool for loans that are performing. The nonreceipt of interest cash flows is not expected and thus not presently considered in our discounted cash flow methodology discussed below.
10

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

All private label residential mortgage-backed securities are reviewed for OTTI utilizing a cash flow projection. The cash flow analysis forecasts cash flow from the underlying loans in each transaction and then applies these cash flows to the bonds in the securitization. The cash flows from the underlying loans consider contractual payment terms (scheduled amortization), prepayments, defaults and severity of loss given default. The analysis uses dynamic assumptions for prepayments, defaults and loss severity. Near term prepayment assumptions are based on recently observed prepayment rates. More weight is given to longer term historic performance (12 months). In some cases, recently observed prepayment rates are lower than historic norms due to a minimal amount of new jumbo loan issuances. This loan market is heavily dependent upon securitization for funding, and new securitization transactions have been minimal. Our model projections anticipate that prepayment rates gradually revert to historical levels. For seasoned ARM transactions, normalized prepayment rates range from 12% to 16% CPR. For fixed rate collateral (one transaction), the prepayment speeds are projected to remain stable.

Default assumptions are largely based on the volume of existing real estate owned, pending foreclosures and severe delinquencies. Other considerations include the quality of loan underwriting, recent default experience, realized loss performance and the volume of less severe delinquencies. Default levels generally are projected to remain elevated or increase for a period of time sufficient to address the level of distressed loans in the transaction. Our projections expect defaults to then decline, generally beginning in year three. Current loss severity assumptions are based on recent observations when meaningful data is available. Loss severity is expected to remain elevated for the next 18 months. Severity is expected to decline after this period due to improving overall economic conditions, improving real estate prices and a reduced inventory of foreclosed properties on the market. Except for three securities discussed in further detail below (all three are currently below investment grade), our cash flow analysis forecasts complete recovery of our cost basis for each reviewed security.

At September 30, 2013 three below investment grade private label residential mortgage-backed securities had credit related OTTI and are summarized as follows:

 
 
   
Super
   
Senior
   
 
 
 
Senior
   
Senior
   
Support
   
 
 
 
Security
   
Security
   
Security
   
Total
 
 
 
(In thousands)
 
 
 
   
   
   
 
As of September 30, 2013
 
   
   
   
 
Fair value
 
$
2,584
   
$
1,717
   
$
57
   
$
4,358
 
Amortized cost
   
2,978
     
1,722
     
-
     
4,700
 
Non-credit unrealized loss
   
394
     
5
     
-
     
399
 
Unrealized gain
   
-
     
-
     
57
     
57
 
Cumulative credit related OTTI
   
748
     
457
     
380
     
1,585
 
 
                               
Credit related OTTI recognized in our Condensed Consolidated Statements of Operations
                               
For the three months ended September 30,
                               
2013
 
$
-
   
$
-
   
$
-
   
$
-
 
2012
   
70
     
-
     
-
     
70
 
For the nine months ended September 30,
                               
2013
   
26
     
-
     
-
     
26
 
2012
   
240
     
32
     
60
     
332
 

11

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Each of these securities is receiving principal and interest payments similar to principal reductions in the underlying collateral.  One of these securities has an unrealized gain and two have unrealized losses at September 30, 2013.  Prior to the second quarter of 2013 all three of these securities had an unrealized loss.  The original amortized cost for each of these securities has been permanently adjusted downward for previously recorded credit related OTTI.  The unrealized loss (based on original amortized cost) for one of these securities is now less than previously recorded credit related OTTI amounts.  The remaining non-credit related unrealized loss in the senior and super senior securities is attributed to other factors and is reflected in other comprehensive income during those same periods.

As management does not intend to liquidate these securities and it is more likely than not that we will not be required to sell these securities prior to recovery of these unrealized losses, no other declines discussed above are deemed to be other than temporary.

Other asset backed — at September 30, 2013 we had five other asset backed securities whose fair value is less than amortized cost. The unrealized losses are primarily due to increases in interest rates.  As management does not intend to liquidate these securities and it is more likely than not that we will not be required to sell these securities prior to recovery of these unrealized losses, no declines are deemed to be other than temporary.

Obligations of states and political subdivisions — at September 30, 2013 we had 137 municipal securities whose fair value is less than amortized cost. The increase in unrealized losses during 2013 is primarily due to increases in interest rates.  As management does not intend to liquidate these securities and it is more likely than not that we will not be required to sell these securities prior to recovery of these unrealized losses, no declines are deemed to be other than temporary.

Corporate — at September 30, 2013 we had nine corporate securities whose fair value is less than amortized cost. The unrealized losses are primarily due to credit spread widening.  As management does not intend to liquidate these securities and it is more likely than not that we will not be required to sell these securities prior to recovery of these unrealized losses, no declines are deemed to be other than temporary.

Trust preferred securities — at September 30, 2013 we had three trust preferred securities whose fair value is less than amortized cost. All of our trust preferred securities are single issue securities issued by a trust subsidiary of a bank holding company. The pricing of trust preferred securities over the past several years has suffered from credit spread widening fueled by uncertainty regarding potential losses of financial companies and repricing of risk related to these hybrid capital securities.

One of the three securities is rated by two major rating agencies as investment grade, while one (a Bank of America issuance) is rated below investment grade by two major rating agencies and the other one is non-rated. The non-rated issue is a relatively small bank and was never rated. The issuer of this non-rated trust preferred security, which had a total amortized cost of $1.0 million and total fair value of $0.9 million as of September 30, 2013, continues to have satisfactory credit metrics and make interest payments.
12

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The following table breaks out our trust preferred securities in further detail as of September 30, 2013 and December 31, 2012:

 
 
September 30, 2013
   
December 31, 2012
 
 
 
   
Net
   
   
Net
 
 
 
Fair
   
Unrealized
   
Fair
   
Unrealized
 
 
 
Value
   
Loss
   
Value
   
Loss
 
 
 
(In thousands)
 
 
 
   
   
   
 
Trust preferred securities
 
   
   
   
 
Rated issues
 
$
1,620
   
$
(281
)
 
$
1,581
   
$
(316
)
Unrated issues
   
856
     
(144
)
   
1,508
     
(1,299
)

As management does not intend to liquidate these securities and it is more likely than not that we will not be required to sell these securities prior to recovery of these unrealized losses, no declines are deemed to be other than temporary.

We recorded credit related OTTI charges in earnings on securities available for sale of zero and $0.070 million during the three month periods ended September 30, 2013 and 2012, respectively and $0.026 million and $0.332 million during the nine month periods ended September 30, 2013 and 2012, respectively (see discussion above).

A roll forward of credit losses recognized in earnings on securities available for sale for the three and nine month periods ending September 30, follows:

 
 
Three months ended
   
Nine months ended
 
 
 
September 30,
   
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
 
 
(In thousands)
 
Balance at beginning of period
 
$
1,835
   
$
1,732
   
$
1,809
   
$
1,470
 
Additions to credit losses on securities for which no previous OTTI was recognized
   
-
     
-
     
-
     
-
 
Increases to credit losses on securities for which OTTI was previously recognized
   
-
     
70
     
26
     
332
 
Balance at end of period
 
$
1,835
   
$
1,802
   
$
1,835
   
$
1,802
 

The amortized cost and fair value of securities available for sale at September 30, 2013, by contractual maturity, follow. The actual maturity may differ from the contractual maturity because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 
 
Amortized
   
Fair
 
 
 
Cost
   
Value
 
 
 
(In thousands)
 
Maturing within one year
 
$
12,322
   
$
12,325
 
Maturing after one year but within five years
   
70,216
     
70,165
 
Maturing after five years but within ten years
   
29,982
     
29,545
 
Maturing after ten years
   
75,163
     
71,788
 
 
   
187,683
     
183,823
 
U.S. agency residential mortgage-backed
   
198,424
     
198,339
 
Private label residential mortgage-backed
   
7,615
     
6,893
 
Other asset backed
   
26,877
     
26,830
 
Total
 
$
420,599
   
$
415,885
 

13

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Gains and losses realized on the sale of securities available for sale are determined using the specific identification method and are recognized on a trade-date basis.  A summary of proceeds from the sale of securities available for sale and gains and losses for the nine month periods ending September 30, follows:

 
 
   
Realized
   
 
 
 
Proceeds
   
Gains
   
Losses(1)
 
 
 
(In thousands)
 
2013
 
$
2,940
   
$
15
   
$
7
 
2012
   
37,176
     
1,193
     
-
 
 

(1)
Losses in 2013 and 2012 exclude $0.026 million and $0.332 million, respectively of credit related OTTI recognized in earnings.

During 2013 and 2012 our trading securities consisted of various preferred stocks.  During the first nine months of 2013 and 2012 we recognized gains (losses) on trading securities of $0.20 million and ($0.04) million, respectively, that are included in net gains (losses) on securities in the Condensed Consolidated Statements of Operations.  Both of these amounts, relate to gains (losses) recognized on trading securities still held at each respective period end.

4.
Loans

Our assessment of the allowance for loan losses is based on an evaluation of the loan portfolio, recent loss experience, current economic conditions and other pertinent factors.

An analysis of the allowance for loan losses by portfolio segment for the three months ended September 30, follows:

 
 
   
   
   
Payment
   
   
 
 
 
   
   
   
Plan
   
   
 
 
 
Commercial
   
Mortgage
   
Installment
   
Receivables
   
Unallocated
   
Total
 
 
 
(In thousands)
 
2013
 
   
   
   
   
   
 
Balance at beginning of period
 
$
8,236
   
$
18,659
   
$
2,996
   
$
125
   
$
6,770
   
$
36,786
 
Additions (deductions)
Provision for loan losses
   
(709
)
   
712
     
105
     
(37
)
   
(426
)
   
(355
)
Recoveries credited to allowance
   
878
     
343
     
244
     
19
     
-
     
1,484
 
Loans charged against the allowance
   
(1,450
)
   
(1,497
)
   
(534
)
   
3
     
-
     
(3,478
)
Balance at end of period
 
$
6,955
   
$
18,217
   
$
2,811
   
$
110
   
$
6,344
   
$
34,437
 
 
                                               
2012
                                               
Balance at beginning of period
 
$
15,476
   
$
21,271
   
$
4,981
   
$
195
   
$
9,423
   
$
51,346
 
Additions (deductions)
Provision for loan losses
   
18
     
1,839
     
(849
)
   
(17
)
   
(740
)
   
251
 
Recoveries credited to allowance
   
782
     
303
     
287
     
-
     
-
     
1,372
 
Loans charged against the allowance
   
(2,619
)
   
(1,720
)
   
(793
)
   
13
     
-
     
(5,119
)
Reclassification to loans held for sale
   
16
     
136
     
133
     
-
     
(114
)
   
171
 
Balance at end of period
 
$
13,673
   
$
21,829
   
$
3,759
   
$
191
   
$
8,569
   
$
48,021
 

14

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

An analysis of the allowance for loan losses by portfolio segment for the nine months ended September 30, follows:

 
 
   
   
   
Payment
   
   
 
 
 
   
   
   
Plan
   
   
 
 
 
Commercial
   
Mortgage
   
Installment
   
Receivables
   
Unallocated
   
Total
 
 
 
(In thousands)
 
2013
 
   
   
   
   
   
 
Balance at beginning of period
 
$
11,402
   
$
21,447
   
$
3,378
   
$
144
   
$
7,904
   
$
44,275
 
Additions (deductions)
Provision for loan losses
   
(2,385
)
   
224
     
621
     
(53
)
   
(1,560
)
   
(3,153
)
Recoveries credited to allowance
   
4,595
     
1,415
     
836
     
47
     
-
     
6,893
 
Loans charged against the allowance
   
(6,657
)
   
(4,869
)
   
(2,024
)
   
(28
)
   
-
     
(13,578
)
Balance at end of period
 
$
6,955
   
$
18,217
   
$
2,811
   
$
110
   
$
6,344
   
$
34,437
 
 
                                               
2012
                                               
Balance at beginning of period
 
$
18,183
   
$
22,885
   
$
6,146
   
$
197
   
$
11,473
   
$
58,884
 
Additions (deductions)
Provision for loan losses
   
2,708
     
6,644
     
(331
)
   
6
     
(2,589
)
   
6,438
 
Recoveries credited to allowance
   
2,178
     
1,423
     
1,002
     
-
     
-
     
4,603
 
Loans charged against the allowance
   
(9,242
)
   
(9,067
)
   
(2,973
)
   
(12
)
   
-
     
(21,294
)
Reclassification to loans held for sale
   
(154
)
   
(56
)
   
(85
)
   
-
     
(315
)
   
(610
)
Balance at end of period
 
$
13,673
   
$
21,829
   
$
3,759
   
$
191
   
$
8,569
   
$
48,021
 

15

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Allowance for loan losses and recorded investment in loans by portfolio segment follows:

 
 
   
   
   
Payment
   
   
 
 
 
   
   
   
Plan
   
   
 
 
 
Commercial
   
Mortgage
   
Installment
   
Receivables
   
Unallocated
   
Total
 
 
 
(In thousands)
 
September 30, 2013
 
   
   
   
   
   
 
Allowance for loan losses:
 
   
   
   
   
   
 
Individually evaluated for impairment
 
$
3,500
   
$
11,318
   
$
1,365
   
$
-
   
$
-
   
$
16,183
 
Collectively evaluated for impairment
   
3,455
     
6,899
     
1,446
     
110
     
6,344
     
18,254
 
Total ending allowance balance
 
$
6,955
   
$
18,217
   
$
2,811
   
$
110
   
$
6,344
   
$
34,437
 
 
                                               
Loans
                                               
Individually evaluated for impairment
 
$
44,789
   
$
79,511
   
$
7,097
   
$
-
           
$
131,397
 
Collectively evaluated for impairment
   
582,213
     
414,311
     
188,104
     
68,494
             
1,253,122
 
Total loans recorded investment
   
627,002
     
493,822
     
195,201
     
68,494
             
1,384,519
 
Accrued interest included in recorded investment
   
1,580
     
2,297
     
659
     
-
             
4,536
 
Total loans
 
$
625,422
   
$
491,525
   
$
194,542
   
$
68,494
           
$
1,379,983
 
 
                                               
December 31, 2012
                                               
Allowance for loan losses:
                                               
Individually evaluated for impairment
 
$
6,558
   
$
12,869
   
$
1,582
   
$
-
   
$
-
   
$
21,009
 
Collectively evaluated for impairment
   
4,844
     
8,578
     
1,796
     
144
     
7,904
     
23,266
 
Total ending allowance balance
 
$
11,402
   
$
21,447
   
$
3,378
   
$
144
   
$
7,904
   
$
44,275
 
 
                                               
Loans
                                               
Individually evaluated for impairment
 
$
55,634
   
$
88,028
   
$
7,505
   
$
-
           
$
151,167
 
Collectively evaluated for impairment
   
563,316
     
441,703
     
183,090
     
84,692
             
1,272,801
 
Total loans recorded investment
   
618,950
     
529,731
     
190,595
     
84,692
             
1,423,968
 
Accrued interest included in recorded investment
   
1,692
     
2,391
     
746
     
-
             
4,829
 
Total loans
 
$
617,258
   
$
527,340
   
$
189,849
   
$
84,692
           
$
1,419,139
 

16

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Loans on non-accrual status and past due more than 90 days (“Non-performing Loans”) follow:

 
 
90+ and
   
   
Total Non-
 
 
 
Still
   
Non-
   
Performing
 
 
 
Accruing
   
Accrual
   
Loans
 
 
 
(In thousands)
 
September 30, 2013
 
   
   
 
Commercial
 
   
   
 
Income producing - real estate
 
$
153
   
$
4,666
   
$
4,819
 
Land, land development and construction - real estate
   
-
     
1,291
     
1,291
 
Commercial and industrial
   
212
     
372
     
584
 
Mortgage
                       
1-4 family
   
-
     
7,520
     
7,520
 
Resort lending
   
-
     
3,039
     
3,039
 
Home equity line of credit - 1st lien
   
-
     
378
     
378
 
Home equity line of credit - 2nd lien
   
-
     
609
     
609
 
Installment
                       
Home equity installment - 1st lien
   
-
     
1,181
     
1,181
 
Home equity installment - 2nd lien
   
-
     
479
     
479
 
Loans not secured by real estate
   
-
     
448
     
448
 
Other
   
-
     
-
     
-
 
Payment plan receivables
                       
Full refund
   
-
     
25
     
25
 
Partial refund
   
-
     
6
     
6
 
Other
   
-
     
-
     
-
 
Total recorded investment
 
$
365
   
$
20,014
   
$
20,379
 
Accrued interest included in recorded investment
 
$
9
   
$
-
   
$
9
 
December 31, 2012
                       
Commercial
                       
Income producing - real estate
 
$
-
   
$
5,611
   
$
5,611
 
Land, land development and construction - real estate
   
-
     
4,062
     
4,062
 
Commercial and industrial
   
-
     
5,080
     
5,080
 
Mortgage
                       
1-4 family
   
7
     
9,654
     
9,661
 
Resort lending
   
-
     
4,861
     
4,861
 
Home equity line of credit - 1st lien
   
-
     
529
     
529
 
Home equity line of credit - 2nd lien
   
-
     
685
     
685
 
Installment
                       
Home equity installment - 1st lien
   
-
     
1,278
     
1,278
 
Home equity installment - 2nd lien
   
-
     
675
     
675
 
Loans not secured by real estate
   
-
     
390
     
390
 
Other
   
-
     
-
     
-
 
Payment plan receivables
                       
Full refund
   
-
     
57
     
57
 
Partial refund
   
-
     
38
     
38
 
Other
   
-
     
9
     
9
 
Total recorded investment
 
$
7
   
$
32,929
   
$
32,936
 
Accrued interest included in recorded investment
 
$
-
   
$
-
   
$
-
 

17

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

An aging analysis of loans by class follows:
 
 
 
Loans Past Due
   
Loans not
   
Total
 
 
 
30-59 days
   
60-89 days
   
90+ days
   
Total
   
Past Due
   
Loans
 
 
 
(In thousands)
 
September 30, 2013
 
   
   
   
   
   
 
Commercial
 
   
   
   
   
   
 
Income producing - real estate
 
$
136
   
$
297
   
$
4,495
   
$
4,928
   
$
235,617
   
$
240,545
 
Land, land development and construction - real estate
   
44
     
-
     
296
     
340
     
45,597
     
45,937
 
Commercial and industrial
   
1,700
     
369
     
261
     
2,330
     
338,190
     
340,520
 
Mortgage
                                               
1-4 family
   
2,519
     
910
     
7,520
     
10,949
     
268,098
     
279,047
 
Resort lending
   
646
     
-
     
3,039
     
3,685
     
148,609
     
152,294
 
Home equity line of credit - 1st lien
   
50
     
28
     
378
     
456
     
18,440
     
18,896
 
Home equity line of credit - 2nd lien
   
253
     
257
     
609
     
1,119
     
42,466
     
43,585
 
Installment
                                               
Home equity installment - 1st lien
   
625
     
417
     
1,181
     
2,223
     
26,341
     
28,564
 
Home equity installment - 2nd lien
   
393
     
180
     
479
     
1,052
     
37,188
     
38,240
 
Loans not secured by real estate
   
919
     
188
     
448
     
1,555
     
124,225
     
125,780
 
Other
   
18
     
4
     
-
     
22
     
2,595
     
2,617
 
Payment plan receivables
                                               
Full refund
   
1,511
     
361
     
25
     
1,897
     
61,832
     
63,729
 
Partial refund
   
182
     
57
     
6
     
245
     
4,498
     
4,743
 
Other
   
4
     
-
     
-
     
4
     
18
     
22
 
Total recorded investment
 
$
9,000
   
$
3,068
   
$
18,737
   
$
30,805
   
$
1,353,714
   
$
1,384,519
 
Accrued interest included in recorded investment
 
$
80
   
$
42
   
$
9
   
$
131
   
$
4,405
   
$
4,536
 
 
                                               
December 31, 2012
                                               
Commercial
                                               
Income producing - real estate
 
$
3,734
   
$
609
   
$
2,826
   
$
7,169
   
$
215,623
   
$
222,792
 
Land, land development and construction - real estate
   
336
     
-
     
1,176
     
1,512
     
41,750
     
43,262
 
Commercial and industrial
   
2,522
     
654
     
1,913
     
5,089
     
347,807
     
352,896
 
Mortgage
                                               
1-4 family
   
4,429
     
1,115
     
9,661
     
15,205
     
279,132
     
294,337
 
Resort lending
   
748
     
370
     
4,861
     
5,979
     
164,414
     
170,393
 
Home equity line of credit - 1st lien
   
453
     
51
     
529
     
1,033
     
18,003
     
19,036
 
Home equity line of credit - 2nd lien
   
442
     
32
     
685
     
1,159
     
44,806
     
45,965
 
Installment
                                               
Home equity installment - 1st lien
   
599
     
140
     
1,278
     
2,017
     
30,368
     
32,385
 
Home equity installment - 2nd lien
   
430
     
125
     
675
     
1,230
     
38,956
     
40,186
 
Loans not secured by real estate
   
899
     
259
     
390
     
1,548
     
113,751
     
115,299
 
Other
   
24
     
12
     
-
     
36
     
2,689
     
2,725
 
Payment plan receivables
                                               
Full refund
   
2,249
     
552
     
57
     
2,858
     
77,335
     
80,193
 
Partial refund
   
112
     
46
     
38
     
196
     
4,119
     
4,315
 
Other
   
3
     
6
     
9
     
18
     
166
     
184
 
Total recorded investment
 
$
16,980
   
$
3,971
   
$
24,098
   
$
45,049
   
$
1,378,919
   
$
1,423,968
 
Accrued interest included in recorded investment
 
$
146
   
$
43
   
$
-
   
$
189
   
$
4,640
   
$
4,829
 

18

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

During the second quarter of 2013 we sold certain commercial watch, substandard and non-performing loans as follows:

 
 
(In thousands)
 
Income producing - real estate
 
$
4,570
 
Land, land development and construction - real estate
   
401
 
Commercial and industrial
   
3,630
 
Total
 
$
8,601
 

Impaired loans are as follows :

 
 
September 30,
   
December 31,
 
 
 
2013
   
2012
 
Impaired loans with no allocated allowance
 
(In thousands)
 
TDR
 
$
20,753
   
$
14,435
 
Non - TDR
   
-
     
418
 
Impaired loans with an allocated allowance
               
TDR - allowance based on collateral
   
8,069
     
16,231
 
TDR - allowance based on present value cash flow
   
101,075
     
112,997
 
Non - TDR - allowance based on collateral
   
1,029
     
6,580
 
Non - TDR - allowance based on present value cash flow
   
-
     
-
 
Total impaired loans
 
$
130,926
   
$
150,661
 
 
               
Amount of allowance for loan losses allocated
               
TDR - allowance based on collateral
 
$
2,812
   
$
5,060
 
TDR - allowance based on present value cash flow
   
13,104
     
14,462
 
Non - TDR - allowance based on collateral
   
267
     
1,487
 
Non - TDR - allowance based on present value cash flow
   
-
     
-
 
Total amount of allowance for loan losses allocated
 
$
16,183
   
$
21,009
 

19

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Impaired loans by class  are as follows (1):

 
 
September 30, 2013
   
December 31, 2012
 
 
 
   
Unpaid
   
   
   
Unpaid
   
 
 
 
Recorded
   
Principal
   
Related
   
Recorded
   
Principal
   
Related
 
 
 
Investment
   
Balance
   
Allowance
   
Investment
   
Balance
   
Allowance
 
With no related allowance recorded:
 
(In thousands)
   
 
Commercial
 
   
   
   
   
   
 
Income producing - real estate
 
$
8,020
   
$
9,433
   
$
-
   
$
4,050
   
$
4,672
   
$
-
 
Land, land development & construction-real estate
   
3,549
     
4,554
     
-
     
3,304
     
3,294
     
-
 
Commercial and industrial
   
4,380
     
4,361
     
-
     
2,611
     
2,592
     
-
 
Mortgage
                                               
1-4 family
   
8
     
8
     
-
     
-
     
-
     
-
 
Resort lending
   
35
     
163
     
-
     
-
     
-
     
-
 
Home equity line of credit - 1st lien
   
-
     
4
     
-
     
-
     
-
     
-
 
Home equity line of credit - 2nd lien
   
-
     
-
     
-
     
-
     
-
     
-
 
Installment
                                               
Home equity installment - 1st lien
   
1,952
     
2,077
     
-
     
2,027
     
2,219
     
-
 
Home equity installment - 2nd lien
   
2,299
     
2,292
     
-
     
2,278
     
2,278
     
-
 
Loans not secured by real estate
   
544
     
668
     
-
     
610
     
681
     
-
 
Other
   
17
     
17
     
-
     
20
     
20
     
-
 
 
   
20,804
     
23,577
     
-
     
14,900
     
15,756
     
-
 
With an allowance recorded:
                                               
Commercial
                                               
Income producing - real estate
   
14,166
     
16,356
     
1,068
     
20,628
     
24,250
     
1,822
 
Land, land development & construction-real estate
   
5,085
     
5,833
     
792
     
8,808
     
11,971
     
1,986
 
Commercial and industrial
   
9,589
     
9,723
     
1,640
     
16,233
     
18,564
     
2,750
 
Mortgage
                                               
1-4 family
   
58,497
     
61,557
     
7,881
     
64,160
     
68,418
     
8,518
 
Resort lending
   
20,776
     
21,383
     
3,352
     
23,763
     
24,160
     
4,321
 
Home equity line of credit - 1st lien
   
153
     
165
     
81
     
62
     
77
     
30
 
Home equity line of credit - 2nd lien
   
42
     
118
     
4
     
43
     
118
     
-
 
Installment
                                               
Home equity installment - 1st lien
   
1,023
     
1,068
     
494
     
1,215
     
1,240
     
610
 
Home equity installment - 2nd lien
   
1,067
     
1,078
     
818
     
1,161
     
1,174
     
930
 
Loans not secured by real estate
   
195
     
194
     
53
     
194
     
194
     
42
 
Other
   
-
     
-
     
-
     
-
     
-
     
-
 
 
   
110,593
     
117,475
     
16,183
     
136,267
     
150,166
     
21,009
 
Total
                                               
Commercial
                                               
Income producing - real estate
   
22,186
     
25,789
     
1,068
     
24,678
     
28,922
     
1,822
 
Land, land development & construction-real estate
   
8,634
     
10,387
     
792
     
12,112
     
15,265
     
1,986
 
Commercial and industrial
   
13,969
     
14,084
     
1,640
     
18,844
     
21,156
     
2,750
 
Mortgage
                                               
1-4 family
   
58,505
     
61,565
     
7,881
     
64,160
     
68,418
     
8,518
 
Resort lending
   
20,811
     
21,546
     
3,352
     
23,763
     
24,160
     
4,321
 
Home equity line of credit - 1st lien
   
153
     
169
     
81
     
62
     
77
     
30
 
Home equity line of credit - 2nd lien
   
42
     
118
     
4
     
43
     
118
     
-
 
Installment
                                               
Home equity installment - 1st lien
   
2,975
     
3,145
     
494
     
3,242
     
3,459
     
610
 
Home equity installment - 2nd lien
   
3,366
     
3,370
     
818
     
3,439
     
3,452
     
930
 
Loans not secured by real estate
   
739
     
862
     
53
     
804
     
875
     
42
 
Other
   
17
     
17
     
-
     
20
     
20
     
-
 
Total
 
$
131,397
   
$
141,052
   
$
16,183
   
$
151,167
   
$
165,922
   
$
21,009
 
 
                                               
Accrued interest included in recorded investment
 
$
471
                   
$
506
                 

(1) There were no impaired payment plan receivables at September 30, 2013 or December 31, 2012.
20

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Average recorded investment in and interest income earned on impaired loans by class for the  three month periods ending September 30, follows (1):

 
 
2013
   
2012
 
 
 
Average
   
Interest
   
Average
   
Interest
 
 
 
Recorded
   
Income
   
Recorded
   
Income
 
 
 
Investment
   
Recognized
   
Investment
   
Recognized
 
With no related allowance recorded:
 
(In thousands)
 
Commercial
 
   
   
   
 
Income producing - real estate
 
$
6,417
   
$
202
   
$
1,827
   
$
15
 
Land, land development & construction-real estate
   
3,512
     
58
     
3,131
     
61
 
Commercial and industrial
   
4,255
     
85
     
3,483
     
58
 
Mortgage
                               
1-4 family
   
8
     
13
     
-
     
-
 
Resort lending
   
35
     
-
     
704
     
-
 
Home equity line of credit - 1st lien
   
-
     
-
     
-
     
-
 
Home equity line of credit - 2nd lien
   
-
     
-
     
-
     
-
 
Installment
                               
Home equity installment - 1st lien
   
1,951
     
31
     
2,063
     
20
 
Home equity installment - 2nd lien
   
2,305
     
34
     
2,233
     
29
 
Loans not secured by real estate
   
568
     
8
     
540
     
8
 
Other
   
18
     
-
     
22
     
1
 
 
   
19,069
     
431
     
14,003
     
192
 
With an allowance recorded:
                               
Commercial
                               
Income producing - real estate
   
16,788
     
100
     
26,233
     
207
 
Land, land development & construction-real estate
   
5,443
     
40
     
9,785
     
31
 
Commercial and industrial
   
9,761
     
102
     
20,749
     
136
 
Mortgage
                               
1-4 family
   
59,723
     
593
     
66,593
     
706
 
Resort lending
   
21,213
     
212
     
23,630
     
264
 
Home equity line of credit - 1st lien
   
154
     
1
     
66
     
1
 
Home equity line of credit - 2nd lien
   
42
     
-
     
45
     
-
 
Installment
                               
Home equity installment - 1st lien
   
1,050
     
15
     
1,348
     
11
 
Home equity installment - 2nd lien
   
1,039
     
15
     
1,130
     
13
 
Loans not secured by real estate
   
212
     
2
     
277
     
2
 
Other
   
-
     
-
     
-
     
-
 
 
   
115,425
     
1,080
     
149,856
     
1,371
 
Total
                               
Commercial
                               
Income producing - real estate
   
23,205
     
302
     
28,060
     
222
 
Land, land development & construction-real estate
   
8,955
     
98
     
12,916
     
92
 
Commercial and industrial
   
14,016
     
187
     
24,232
     
194
 
Mortgage
                               
1-4 family
   
59,731
     
606
     
66,593
     
706
 
Resort lending
   
21,248
     
212
     
24,334
     
264
 
Home equity line of credit - 1st lien
   
154
     
1
     
66
     
1
 
Home equity line of credit - 2nd lien
   
42
     
-
     
45
     
-
 
Installment
                               
Home equity installment - 1st lien
   
3,001
     
46
     
3,411
     
31
 
Home equity installment - 2nd lien
   
3,344
     
49
     
3,363
     
42
 
Loans not secured by real estate
   
780
     
10
     
817
     
10
 
Other
   
18
     
-
     
22
     
1
 
Total
 
$
134,494
   
$
1,511
   
$
163,859
   
$
1,563
 

(1) There were no impaired payment plan receivables during the three month periods ended September 30, 2013 and 2012, respectively.
21

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Average recorded investment in and interest income earned on impaired loans by class for the  nine month periods ending September 30, follows (1):
 
 
 
2013
   
2012
 
 
 
Average
   
Interest
   
Average
   
Interest
 
 
 
Recorded
   
Income
   
Recorded
   
Income
 
 
 
Investment
   
Recognized
   
Investment
   
Recognized
 
With no related allowance recorded:
 
(In thousands)
 
Commercial
 
   
   
   
 
Income producing - real estate
 
$
5,446
   
$
307
   
$
2,713
   
$
45
 
Land, land development & construction-real estate
   
3,319
     
142
     
2,360
     
97
 
Commercial and industrial
   
3,948
     
199
     
3,755
     
104
 
Mortgage
                               
1-4 family
   
4
     
13
     
-
     
-
 
Resort lending
   
26
     
-
     
641
     
-
 
Home equity line of credit - 1st lien
   
-
     
-
     
-
     
-
 
Home equity line of credit - 2nd lien
   
-
     
-
     
-
     
-
 
Installment
                               
Home equity installment - 1st lien
   
2,005
     
83
     
1,945
     
72
 
Home equity installment - 2nd lien
   
2,301
     
96
     
2,047
     
80
 
Loans not secured by real estate
   
588
     
23
     
533
     
21
 
Other
   
19
     
1
     
23
     
2
 
 
   
17,656
     
864
     
14,017
     
421
 
With an allowance recorded:
                               
Commercial
                               
Income producing - real estate
   
19,071
     
413
     
24,228
     
474
 
Land, land development & construction-real estate
   
6,892
     
151
     
10,680
     
136
 
Commercial and industrial
   
12,398
     
330
     
18,227
     
406
 
Mortgage
                               
1-4 family
   
61,670
     
1,981
     
67,067
     
2,155
 
Resort lending
   
22,093
     
653
     
24,053
     
760
 
Home equity line of credit - 1st lien
   
132
     
2
     
66
     
2
 
Home equity line of credit - 2nd lien
   
42
     
1
     
91
     
2
 
Installment
                               
Home equity installment - 1st lien
   
1,071
     
35
     
1,487
     
41
 
Home equity installment - 2nd lien
   
1,094
     
40
     
1,367
     
38
 
Loans not secured by real estate
   
208
     
8
     
227
     
7
 
Other
   
-
     
-
     
-
     
-
 
 
   
124,671
     
3,614
     
147,493
     
4,021
 
Total
                               
Commercial
                               
Income producing - real estate
   
24,517
     
720
     
26,941
     
519
 
Land, land development & construction-real estate
   
10,211
     
293
     
13,040
     
233
 
Commercial and industrial
   
16,346
     
529
     
21,982
     
510
 
Mortgage
                               
1-4 family
   
61,674
     
1,994
     
67,067
     
2,155
 
Resort lending
   
22,119
     
653
     
24,694
     
760
 
Home equity line of credit - 1st lien
   
132
     
2
     
66
     
2
 
Home equity line of credit - 2nd lien
   
42
     
1
     
91
     
2
 
Installment
                               
Home equity installment - 1st lien
   
3,076
     
118
     
3,432
     
113
 
Home equity installment - 2nd lien
   
3,395
     
136
     
3,414
     
118
 
Loans not secured by real estate
   
796
     
31
     
760
     
28
 
Other
   
19
     
1
     
23
     
2
 
Total
 
$
142,327
   
$
4,478
   
$
161,510
   
$
4,442
 

(1) There were no impaired payment plan receivables during the nine month periods ended September 30, 2013 and 2012, respectively.
22

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Our average investment in impaired loans was approximately $134.5 million and $163.9 million for the three-month periods ended September 30, 2013 and 2012, respectively and $142.3 million and $161.5 million for the nine-month periods ended September 30, 2013 and 2012, respectively.  Cash receipts on impaired loans on non-accrual status are generally applied to the principal balance.  Interest income recognized on impaired loans during the three months ending September 30, 2013 and 2012 was approximately $1.5 million and $1.6 million, respectively and was approximately $4.5 million and $4.4 million during the nine months ending September 30, 2013 and 2012, respectively.

Troubled debt restructurings follow:
 
 
 
September 30, 2013
 
 
 
Commercial
   
Retail
   
Total
 
 
 
(In thousands)
 
Performing TDR's
 
$
38,299
   
$
80,630
   
$
118,929
 
Non-performing TDR's(1)
   
5,338
     
5,630
(2) 
   
10,968
 
Total
 
$
43,637
   
$
86,260
   
$
129,897
 
 
 
 
December 31, 2012
 
 
 
Commercial
   
Retail
   
Total
 
 
 
(In thousands)
 
Performing TDR's
 
$
40,753
   
$
85,977
   
$
126,730
 
Non-performing TDR's(1)
   
7,756
     
9,177
(2) 
   
16,933
 
Total
 
$
48,509
   
$
95,154
   
$
143,663
 
 
(1)
Included in non-performing loans table above.
(2)
Also includes loans on non-accrual at the time of modification until six payments are received on a timely basis.

We allocated $15.9 million and $19.5 million of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of September 30, 2013 and December 31, 2012, respectively.

During the three and nine months ended September 30, 2013 and 2012, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans generally included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a permanent reduction of the recorded investment in the loan.

Modifications involving a reduction of the stated interest rate of the loan have generally been for periods ranging from 9 months to 60 months but have extended to as much as 480 months in certain circumstances. Modifications involving an extension of the maturity date have generally been for periods ranging from 1 month to 60 months but have extended to as much as 193 months in certain circumstances.
23

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Loans that have been classified as troubled debt restructurings during the three-month periods ended September 30 follow:

 
 
   
Pre-modification
   
Post-modification
 
 
 
Number of
   
Recorded
   
Recorded
 
 
 
Contracts
   
Balance
   
Balance
 
 
 
(Dollars in thousands)
 
2013
 
   
   
 
Commercial
 
   
   
 
Income producing - real estate
   
-
   
$
-
   
$
-
 
Land, land development & construction-real estate
   
-
     
-
     
-
 
Commercial and industrial
   
4
     
1,141
     
1,113
 
Mortgage
                       
1-4 family
   
-
     
-
     
-
 
Resort lending
   
1
     
207
     
206
 
Home equity line of credit - 1st lien
   
-
     
-
     
-
 
Home equity line of credit - 2nd lien
   
-
     
-
     
-
 
Installment
                       
Home equity installment - 1st lien
   
4
     
177
     
178
 
Home equity installment - 2nd lien
   
4
     
220
     
218
 
Loans not secured by real estate
   
-
     
-
     
-
 
Other
   
-
     
-
     
-
 
Total
   
13
   
$
1,745
   
$
1,715
 
 
                       
2012
                       
Commercial
                       
Income producing - real estate
   
4
   
$
626
   
$
545
 
Land, land development & construction-real estate
   
2
     
460
     
523
 
Commercial and industrial
   
10
     
631
     
558
 
Mortgage
                       
1-4 family
   
10
     
1,870
     
1,656
 
Resort lending
   
7
     
1,575
     
1,562
 
Home equity line of credit - 1st lien
   
-
     
-
     
-
 
Home equity line of credit - 2nd lien
   
-
     
-
     
-
 
Installment
                       
Home equity installment - 1st lien
   
4
     
137
     
98
 
Home equity installment - 2nd lien
   
2
     
59
     
56
 
Loans not secured by real estate
   
2
     
22
     
21
 
Other
   
-
     
-
     
-
 
Total
   
41
   
$
5,380
   
$
5,019
 

24

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Loans that have been classified as troubled debt restructurings during the nine-month periods ended September 30 follow:

 
 
   
Pre-modification
   
Post-modification
 
 
 
Number of
   
Recorded
   
Recorded
 
 
 
Contracts
   
Balance
   
Balance
 
 
 
(Dollars in thousands)
 
2013
 
   
   
 
Commercial
 
   
   
 
Income producing - real estate
   
5
   
$
4,478
   
$
3,869
 
Land, land development & construction-real estate
   
1
     
16
     
-
 
Commercial and industrial
   
19
     
2,053
     
1,901
 
Mortgage
                       
1-4 family
   
13
     
1,273
     
1,237
 
Resort lending
   
5
     
1,240
     
1,231
 
Home equity line of credit - 1st lien
   
1
     
95
     
97
 
Home equity line of credit - 2nd lien
   
-
     
-
     
-
 
Installment
                       
Home equity installment - 1st lien
   
17
     
503
     
498
 
Home equity installment - 2nd lien
   
14
     
432
     
432
 
Loans not secured by real estate
   
3
     
84
     
55
 
Other
   
-
     
-
     
-
 
Total
   
78
   
$
10,174
   
$
9,320
 
 
                       
2012
                       
Commercial
                       
Income producing - real estate
   
18
   
$
8,894
   
$
8,736
 
Land, land development & construction-real estate
   
5
     
3,347
     
3,436
 
Commercial and industrial
   
43
     
8,827
     
8,453
 
Mortgage
                       
1-4 family
   
58
     
7,738
     
7,330
 
Resort lending
   
29
     
7,529
     
7,356
 
Home equity line of credit - 1st lien
   
1
     
15
     
-
 
Home equity line of credit - 2nd lien
   
-
     
-
     
-
 
Installment
                       
Home equity installment - 1st lien
   
14
     
561
     
521
 
Home equity installment - 2nd lien
   
16
     
604
     
590
 
Loans not secured by real estate
   
12
     
299
     
278
 
Other
   
-
     
-
     
-
 
Total
   
196
   
$
37,814
   
$
36,700
 

The troubled debt restructurings described above for 2013 increased the allowance for loan losses by $0.03 million and resulted in zero charge offs during the three months ended September 30, 2013 and decreased the allowance by $0.2 million and resulted in $0.5 million of charge offs during the nine months ended September 30, 2013.

The troubled debt restructurings described above for 2012 increased the allowance for loan losses by $0.4 million and resulted in zero charge offs during the three months ending September 30, 2012 and increased the allowance by $1.5 million and resulted in $0.4 million of charge offs during the nine months ending September 30, 2012.
25

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Loans that have been classified as troubled debt restructurings during the past twelve months and that have subsequently defaulted during the three-month periods ended September 30 follow:

 
 
Number of
   
Recorded
 
 
 
Contracts
   
Balance
 
 
 
(Dollars in thousands)
 
2013
 
   
 
Commercial
 
   
 
Income producing - real estate
   
-
   
$
-
 
Land, land development & construction-real estate
   
-
     
-
 
Commercial and industrial
   
-
     
-
 
Mortgage
               
1-4 family
   
-
     
-
 
Resort lending
   
-
     
-
 
Home equity line of credit - 1st lien
   
-
     
-
 
Home equity line of credit - 2nd lien
   
-
     
-
 
Installment
               
Home equity installment - 1st lien
   
2
     
32
 
Home equity installment - 2nd lien
   
-
     
-
 
Loans not secured by real estate
   
-
     
-
 
Other
   
-
     
-
 
 
   
2
   
$
32
 
 
               
2012
               
Commercial
               
Income producing - real estate
   
2
   
$
827
 
Land, land development & construction-real estate
   
-
     
-
 
Commercial and industrial
   
-
     
-
 
Mortgage
               
1-4 family
   
-
     
-
 
Resort lending
   
2
     
468
 
Home equity line of credit - 1st lien
   
-
     
-
 
Home equity line of credit - 2nd lien
   
-
     
-
 
Installment
               
Home equity installment - 1st lien
   
-
     
-
 
Home equity installment - 2nd lien
   
-
     
-
 
Loans not secured by real estate
   
-
     
-
 
Other
   
-
     
-
 
 
   
4
   
$
1,295
 

26

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Loans that have been classified as troubled debt restructurings during the past twelve months and that have subsequently defaulted during the nine-month periods ended September 30 follow:

 
 
Number of
   
Recorded
 
 
 
Contracts
   
Balance
 
 
 
(Dollars in thousands)
 
2013
 
   
 
Commercial
 
   
 
Income producing - real estate
   
-
   
$
-
 
Land, land development & construction-real estate
   
-
     
-
 
Commercial and industrial
   
-
     
-
 
Mortgage
               
1-4 family
   
1
     
106
 
Resort lending
   
1
     
156
 
Home equity line of credit - 1st lien
   
-
     
-
 
Home equity line of credit - 2nd lien
   
-
     
-
 
Installment
               
Home equity installment - 1st lien
   
2
     
32
 
Home equity installment - 2nd lien
   
1
     
22
 
Loans not secured by real estate
   
-
     
-
 
Other
   
-
     
-
 
 
   
5
   
$
316
 
 
               
2012
               
Commercial
               
Income producing - real estate
   
2
   
$
827
 
Land, land development & construction-real estate
   
1
     
136
 
Commercial and industrial
   
7
     
520
 
Mortgage
               
1-4 family
   
2
     
148
 
Resort lending
   
3
     
584
 
Home equity line of credit - 1st lien
   
-
     
-
 
Home equity line of credit - 2nd lien
   
-
     
-
 
Installment
               
Home equity installment - 1st lien
   
1
     
26
 
Home equity installment - 2nd lien
   
1
     
20
 
Loans not secured by real estate
   
-
     
-
 
Other
   
-
     
-
 
 
   
17
   
$
2,261
 

A loan is considered to be in payment default generally once it is 90 days contractually past due under the modified terms.

The troubled debt restructurings that subsequently defaulted described above for 2013 had no impact on the allowance for loan losses and resulted in no charge offs during the three months ended September 30, 2013 and decreased the allowance for loan losses by $0.1 million and resulted in charge offs of $0.2 million during the nine months ended September 30, 2013.

The troubled debt restructurings that subsequently defaulted described above for 2012 increased the allowance for loan losses by $0.7 million and resulted in zero charge offs during the three months ending September 30, 2012 and increased the allowance for loan losses by $0.7 million and resulted in charge offs of $0.4 million during the nine months ending September 30, 2012.
27

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The terms of certain other loans were modified during the three and nine months ended September 30, 2013 and 2012 that did not meet the definition of a troubled debt restructuring.  The modification of these loans could have included modification of the terms of a loan to borrowers who were not experiencing financial difficulties or a delay in a payment that was considered to be insignificant.

In order to determine whether a borrower is experiencing financial difficulty, we perform an evaluation of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under our internal underwriting policy.

Credit Quality Indicators – As part of our on on-going monitoring of the credit quality of our loan portfolios, we track certain credit quality indicators including (a) weighted-average risk grade of commercial loans, (b) the level of classified commercial loans (c) credit scores of mortgage and installment loan borrowers (d) investment grade of certain counterparties for payment plan receivables and (e) delinquency history and non-performing loans.

For commercial loans we use a loan rating system that is similar to those employed by state and federal banking regulators. Loans are graded on a scale of 1 to 12. A description of the general characteristics of the ratings follows:

Rating 1 through 6: These loans are generally referred to as our “non-watch” commercial credits that include very high or exceptional credit fundamentals through acceptable credit fundamentals.

Rating 7 and 8: These loans are generally referred to as our “watch” commercial credits. This rating includes loans to borrowers that exhibit potential credit weakness or downward trends. If not checked or cured these trends could weaken our asset or credit position. While potentially weak, no loss of principal or interest is envisioned with these ratings.

Rating 9: These loans are generally referred to as our “substandard accruing” commercial credits. This rating includes loans to borrowers that exhibit a well-defined weakness where payment default is probable and loss is possible if deficiencies are not corrected. Generally, loans with this rating are considered collectible as to both principal and interest primarily due to collateral coverage.

Rating 10 and 11: These loans are generally referred to as our “substandard - non-accrual” and “doubtful” commercial credits. This rating includes loans to borrowers with weaknesses that make collection of debt in full, on the basis of current facts, conditions and values at best questionable and at worst improbable. All of these loans are placed in non-accrual.

Rating 12: These loans are generally referred to as our “loss” commercial credits. This rating includes loans to borrowers that are deemed incapable of repayment and are charged-off.
28

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The following table summarizes loan ratings by loan class for our commercial loan segment:

 
 
Commercial
 
 
 
   
   
Substandard
   
Non-
   
 
 
 
Non-watch
   
Watch
   
Accrual
   
Accrual
   
 
 
  1-6     7-8     9     10-11    
Total
 
 
                 
(In thousands)
           
 
September 30, 2013
                                 
 
Income producing - real estate
 
$
208,317
   
$
22,984
   
$
4,578
   
$
4,666
   
$
240,545
 
Land, land development and construction - real estate
   
39,129
     
4,868
     
649
     
1,291
     
45,937
 
Commercial and industrial
   
302,210
     
29,230
     
8,708
     
372
     
340,520
 
Total
 
$
549,656
   
$
57,082
   
$
13,935
   
$
6,329
   
$
627,002
 
Accrued interest included in total
 
$
1,359
   
$
162
   
$
59
   
$
-
   
$
1,580
 
 
                                       
December 31, 2012
                                       
Income producing - real estate
 
$
183,530
   
$
27,096
   
$
6,555
   
$
5,611
   
$
222,792
 
Land, land development and construction - real estate
   
32,784
     
3,457
     
2,959
     
4,062
     
43,262
 
Commercial and industrial
   
307,566
     
26,954
     
13,296
     
5,080
     
352,896
 
Total
 
$
523,880
   
$
57,507
   
$
22,810
   
$
14,753
   
$
618,950
 
Accrued interest included in total
 
$
1,417
   
$
163
   
$
112
   
$
-
   
$
1,692
 

For each of our mortgage and installment segment classes we generally monitor credit quality based on the credit scores of the borrowers. These credit scores are generally updated at least annually.
29

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The following table summarizes credit scores by loan class for our mortgage and installment loan segments:

   
Mortgage (1)
 
   
   
   
Home
   
Home
   
 
   
   
Resort
   
Equity
   
Equity
   
 
   
1-4 Family
   
Lending
   
1st Lien
   
2nd Lien
   
Total
 
   
(In thousands)
 
September 30, 2013
   
   
   
   
   
 
800 and above
   
$
21,129
   
$
14,301
   
$
3,517
   
$
5,990
   
$
44,937
 
750-799
     
59,317
     
56,533
     
5,117
     
11,570
     
132,537
 
700-749
     
58,316
     
40,155
     
3,024
     
8,695
     
110,190
 
650-699
     
50,911
     
19,944
     
2,973
     
7,417
     
81,245
 
600-649
     
32,340
     
9,136
     
2,246
     
4,680
     
48,402
 
550-599
     
24,646
     
4,352
     
965
     
2,773
     
32,736
 
500-549
     
16,998
     
1,944
     
409
     
1,724
     
21,075
 
Under 500
     
8,060
     
1,178
     
413
     
574
     
10,225
 
Unknown
     
7,330
     
4,751
     
232
     
162
     
12,475
 
Total
   
$
279,047
   
$
152,294
   
$
18,896
   
$
43,585
   
$
493,822
 
Accrued interest included in total
   
$
1,309
   
$
673
   
$
93
   
$
222
   
$
2,297
 
                                            
December 31, 2012
                                         
800 and above
   
$
19,638
   
$
15,430
   
$
3,031
   
$
5,515
   
$
43,614
 
750-799
     
62,419
     
67,094
     
4,758
     
12,783
     
147,054
 
700-749
     
59,594
     
41,860
     
3,293
     
9,177
     
113,924
 
650-699
     
57,584
     
17,685
     
2,309
     
7,987
     
85,565
 
600-649
     
31,465
     
12,317
     
3,311
     
4,775
     
51,868
 
550-599
     
27,739
     
7,887
     
964
     
2,754
     
39,344
 
500-549
     
20,243
     
1,212
     
656
     
1,997
     
24,108
 
Under 500
     
9,470
     
1,637
     
456
     
789
     
12,352
 
Unknown
     
6,185
     
5,271
     
258
     
188
     
11,902
 
Total
   
$
294,337
   
$
170,393
   
$
19,036
   
$
45,965
   
$
529,731
 
Accrued interest included in total
   
$
1,319
   
$
750
   
$
91
   
$
231
   
$
2,391
 

(1)
Credit scores have been updated within the last twelve months.
30

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

   
Installment(1)
 
   
Home
   
Home
   
Loans not
   
   
 
   
Equity
   
Equity
   
Secured by
   
   
 
   
1st Lien
   
2nd Lien
   
Real Estate
   
Other
   
Total
 
   
(In thousands)
 
September 30, 2013
   
   
   
   
   
 
800 and above
   
$
2,861
   
$
3,260
   
$
21,650
   
$
69
   
$
27,840
 
750-799
     
7,279
     
11,296
     
50,021
     
515
     
69,111
 
700-749
     
5,012
     
8,901
     
26,490
     
754
     
41,157
 
650-699
     
4,729
     
7,366
     
15,363
     
622
     
28,080
 
600-649
     
3,606
     
3,183
     
5,522
     
259
     
12,570
 
550-599
     
2,234
     
1,808
     
2,386
     
228
     
6,656
 
500-549
     
2,201
     
1,597
     
1,762
     
121
     
5,681
 
Under 500
     
483
     
740
     
608
     
31
     
1,862
 
Unknown
     
159
     
89
     
1,978
     
18
     
2,244
 
Total
   
$
28,564
   
$
38,240
   
$
125,780
   
$
2,617
   
$
195,201
 
Accrued interest included in total
   
$
114
   
$
138
   
$
385
   
$
22
   
$
659
 
                                            
December 31, 2012
                                         
800 and above
   
$
3,909
   
$
3,265
   
$
19,293
   
$
38
   
$
26,505
 
750-799
     
7,394
     
11,300
     
43,740
     
462
     
62,896
 
700-749
     
4,884
     
8,826
     
24,267
     
786
     
38,763
 
650-699
     
5,925
     
7,164
     
13,758
     
710
     
27,557
 
600-649
     
4,360
     
4,214
     
6,442
     
367
     
15,383
 
550-599
     
3,226
     
2,716
     
3,428
     
188
     
9,558
 
500-549
     
1,722
     
1,403
     
2,154
     
114
     
5,393
 
Under 500
     
760
     
1,195
     
895
     
42
     
2,892
 
Unknown
     
205
     
103
     
1,322
     
18
     
1,648
 
Total
   
$
32,385
   
$
40,186
   
$
115,299
   
$
2,725
   
$
190,595
 
Accrued interest included in total
   
$
137
   
$
157
   
$
429
   
$
23
   
$
746
 
 
(1)
Credit scores have been updated within the last twelve months.

Mepco Finance Corporation (“Mepco”) is a wholly-owned subsidiary of our Bank that operates a vehicle service contract payment plan business throughout the United States. See Note #14 for more information about Mepco’s business. As of September 30, 2013, approximately 93.0% of Mepco’s outstanding payment plan receivables relate to programs in which a third party insurer or risk retention group is obligated to pay Mepco the full refund owing upon cancellation of the related service contract (including with respect to both the portion funded to the service contract seller and the portion funded to the administrator). These receivables are shown as “Full Refund” in the table below. Another approximately 6.9% of Mepco’s outstanding payment plan receivables as of September 30, 2013, relate to programs in which a third party insurer or risk retention group is obligated to pay Mepco the refund owing upon cancellation only with respect to the unearned portion previously funded by Mepco to the administrator (but not to the service contract seller). These receivables are shown as “Partial Refund” in the table below. The balance of Mepco’s outstanding payment plan receivables relate to programs in which there is no insurer or risk retention group that has any contractual liability to Mepco for any portion of the refund amount. These receivables are shown as “Other” in the table below. For each class of our payment plan receivables we monitor credit ratings of the counterparties as we evaluate the credit quality of this portfolio.
31

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The following table summarizes credit ratings of insurer or risk retention group counterparties by class of payment plan receivable:

   
Payment Plan Receivables
 
   
Full
   
Partial
   
   
 
   
Refund
   
Refund
   
Other
   
Total
 
   
(In thousands)
 
September 30, 2013
   
   
   
   
 
AM Best rating
   
   
   
   
 
A+
 
$
-
   
$
-
   
$
-
   
$
-
 
A
   
23,303
     
3,969
     
-
     
27,272
 
A-
     
11,626
     
774
     
-
     
12,400
 
B+
   
2
     
-
     
-
     
2
 
B
   
-
     
-
     
-
     
-
 
Not rated
     
28,798
     
-
     
22
     
28,820
 
Total
   
$
63,729
   
$
4,743
   
$
22
   
$
68,494
 
                                   
December 31, 2012
                                 
AM Best rating
                                 
A+
 
$
-
   
$
-
   
$
110
   
$
110
 
A
   
24,825
     
3,916
     
-
     
28,741
 
A-
     
19,310
     
399
     
-
     
19,709
 
B+
   
56
     
-
     
-
     
56
 
B
   
-
     
-
     
-
     
-
 
Not rated
     
36,002
     
-
     
74
     
36,076
 
Total
   
$
80,193
   
$
4,315
   
$
184
   
$
84,692
 

Although Mepco has contractual recourse against various counterparties for refunds owing upon cancellation of vehicle service contracts, see Note #14 below regarding certain risks and difficulties associated with collecting these refunds.

5. Segments

Our reportable segments are based upon legal entities.  We currently have two reportable segments:  Independent Bank (“IB” or “Bank”) and Mepco.  These business segments are also differentiated based on the products and services provided.  We evaluate performance based principally on net income (loss) of the respective reportable segments.

In the normal course of business, our IB segment provides funding to our Mepco segment through an intercompany line of credit priced at the prime rate of interest as published in the Wall Street Journal. Our IB segment also provides certain administrative services to our Mepco segment which are reimbursed at an agreed upon rate. These intercompany transactions are eliminated upon consolidation. The only other material intersegment balances and transactions are investments in subsidiaries at the parent entities and cash balances on deposit at our IB segment.
32

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

A summary of selected financial information for our reportable segments follows:

 
 
IB(1)
   
Mepco
   
Other(1)(2)
   
Elimination(3)
   
Total
 
 
 
(In thousands)
 
Total assets
 
   
   
   
   
 
September 30, 2013
 
$
2,067,493
   
$
104,945
   
$
276,574
   
$
(265,508
)
 
$
2,183,504
 
December 31, 2012
   
1,885,807
     
135,447
     
192,343
     
(189,730
)
   
2,023,867
 
 
                                       
For the three months ended September 30,
                                 
2013
                                       
Interest income
 
$
19,114
   
$
2,670
   
$
-
   
$
-
   
$
21,784
 
Net interest income
   
18,033
     
2,094
     
(598
)
   
-
     
19,529
 
Provision for loan losses
   
(317
)
   
(38
)
   
-
     
-
     
(355
)
Income (loss) before income tax
   
4,278
     
261
     
(728
)
   
(24
)
   
3,787
 
Net income (loss)
   
3,831
     
172
     
(474
)
   
(24
)
   
3,505
 
 
                                       
2012
                                       
Interest income
 
$
21,057
   
$
3,676
   
$
-
   
$
-
   
$
24,733
 
Net interest income
   
19,380
     
2,806
     
(735
)
   
-
     
21,451
 
Provision for loan losses
   
270
     
(19
)
   
-
     
-
     
251
 
Income (loss) before income tax
   
6,988
     
405
     
(923
)
   
(24
)
   
6,446
 
Net income (loss)
   
7,125
     
268
     
(923
)
   
(24
)
   
6,446
 
 
                                       
For the nine months ended September 30,
                                 
2013
                                       
Interest income
 
$
56,829
   
$
8,767
   
$
-
   
$
-
   
$
65,596
 
Net interest income
   
53,456
     
6,921
     
(1,769
)
   
-
     
58,608
 
Provision for loan losses
   
(3,097
)
   
(56
)
   
-
     
-
     
(3,153
)
Income (loss) before income tax
   
21,734
     
(1,889
)
   
(3,246
)
   
(71
)
   
16,528
 
Net income (loss)
   
68,337
     
(1,124
)
   
5,558
     
(71
)
   
72,700
 
 
                                       
2012
                                       
Interest income
 
$
64,452
   
$
11,232
   
$
-
   
$
-
   
$
75,684
 
Net interest income
   
59,085
     
8,487
     
(2,191
)
   
-
     
65,381
 
Provision for loan losses
   
6,436
     
2
     
-
     
-
     
6,438
 
Income (loss) before income tax
   
14,945
     
2,298
     
(2,889
)
   
(71
)
   
14,283
 
Net income (loss)
   
15,726
     
1,517
     
(2,889
)
   
(71
)
   
14,283
 


(1) During the the three month period ending September 30, 2013 IB includes $0.6 million income tax expense and Other (parent company) includes $0.3 million income tax benefit related to the reversal of the valuation allowance on our net deferred tax assets.  During the nine month periods ending September 30, 2013 IB and Other (parent company) include $48.6 million and $8.7 million, respectively of income tax benefit related to the reversal of the valuation allowance on our net deferred tax assets (see note #10).
(2) Includes amounts relating to our parent company and certain insignificant operations.
(3) Includes parent company's investment in subsidiaries and cash balances maintained at subsidiary.
33

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

6.
Earnings Per Common Share

 
 
Three Months Ended
   
Nine Months Ended
 
 
 
September 30,
   
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
 
 
(in thousands, except per share amounts)
 
 
 
   
 
Net income applicable to common stock
 
$
10,310
   
$
5,353
   
$
77,253
   
$
11,042
 
Convertible preferred stock dividends
   
749
     
1,093
     
3,001
     
3,241
 
Preferred stock discount
   
(7,554
)
   
-
     
(7,554
)
   
-
 
Net income applicable to common stock for calculation of diluted earnings per share
 
$
3,505
   
$
6,446
   
$
72,700
   
$
14,283
 
 
                               
Weighted average shares outstanding (1)
   
14,167
     
8,779
     
10,989
     
8,637
 
Effect of convertible preferred stock
   
6,380
     
30,523
     
9,779
     
30,523
 
Restricted stock units
   
398
     
221
     
383
     
167
 
Stock units for deferred compensation plan for non-employee directors
   
128
     
81
     
122
     
54
 
Effect of stock options
   
97
     
9
     
84
     
-
 
Weighted average shares outstanding for calculation of diluted earnings per share
   
21,170
     
39,613
     
21,357
     
39,381
 
 
                               
Net income per common share
                               
Basic (1)
 
$
0.73
   
$
0.61
   
$
7.03
   
$
1.28
 
Diluted
 
$
0.17
   
$
0.16
   
$
3.40
   
$
0.36
 

(1)Basic net income per common share includes weighted average common shares outstanding during the period and participating share awards.
 
Weighted average stock options outstanding that were not considered in computing diluted net income per share because they were anti-dilutive totaled 0.1 million and 0.1 million for the three-month periods ended September 30, 2013 and 2012, respectively and totaled 0.1 million and 0.2 million for the nine-month periods ended September 30, 2013 and 2012, respectively.  The warrant to purchase 346,154 shares of our common stock (see note #15) was not considered in computing diluted net income per share in all periods in 2013 and 2012 as it was anti-dilutive.
 
7.
Derivative Financial Instruments
 
We are required to record derivatives on our Condensed Consolidated Statements of Financial Condition as assets and liabilities measured at their fair value.  The accounting for increases and decreases in the value of derivatives depends upon the use of derivatives and whether the derivatives qualify for hedge accounting.
34

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
 
Our derivative financial instruments according to the type of hedge in which they are designated follows:

 
  September 30, 2013  
 
 
   
Average
   
 
 
 
Notional
   
Maturity
   
Fair
 
 
 
Amount
   
(years)
   
Value
 
 
 
   
(Dollars in thousands)
   
 
No hedge designation
 
   
   
 
Mandatory commitments to sell mortgage loans
 
$
47,947
     
0.1
   
$
(658
)
Rate-lock mortgage loan commitments
   
19,255
     
0.1
     
692
 
Total
 
$
67,202
     
0.1
   
$
34
 

We have established management objectives and strategies that include interest-rate risk parameters for maximum fluctuations in net interest income and market value of portfolio equity. We monitor our interest rate risk position via simulation modeling reports. The goal of our asset/liability management efforts is to maintain profitable financial leverage within established risk parameters.

We use variable-rate and short-term fixed-rate (less than 12 months) debt obligations to fund a portion of our balance sheet, which exposes us to variability in interest rates. To meet our objectives, we may periodically enter into derivative financial instruments to mitigate exposure to fluctuations in cash flows resulting from changes in interest rates (“Cash Flow Hedges”).  Cash Flow Hedges during 2013 and 2012 included certain pay-fixed interest-rate swaps which converted the variable-rate cash flows on debt obligations to fixed-rates.  During the second quarter of 2013 we terminated our last pay-fixed interest rate swap and paid a termination fee of $0.6 million.

We recorded the fair value of Cash Flow Hedges in accrued income and other assets and accrued expenses and other liabilities.  The related gains or losses were reported in other comprehensive income or loss and were subsequently reclassified into earnings as a yield adjustment in the same period in which the related interest on the hedged items (primarily variable-rate debt obligations) affected earnings.  To the extent that the Cash Flow Hedges were not effective, the ineffective portion of the Cash Flow Hedges were immediately recognized as interest expense.  The remaining unrealized loss on the terminated pay-fixed interest-rate swap which was equal to the termination fee discussed above is included in accumulated other comprehensive income and is being amortized into earnings over the remaining original life of the pay-fixed interest-rate swap.

Certain financial derivative instruments have not been designated as hedges. The fair value of these derivative financial instruments has been recorded on our Condensed Consolidated Statements of Financial Condition and is adjusted on an ongoing basis to reflect their then current fair value. The changes in fair value of derivative financial instruments not designated as hedges are recognized in earnings.
35

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

In the ordinary course of business, we enter into rate-lock mortgage loan commitments with customers (“Rate Lock Commitments”).  These commitments expose us to interest rate risk.  We also enter into mandatory commitments to sell mortgage loans (“Mandatory Commitments”) to reduce the impact of price fluctuations of mortgage loans held for sale and Rate Lock Commitments.  Mandatory Commitments help protect our loan sale profit margin from fluctuations in interest rates. The changes in the fair value of Rate Lock Commitments and Mandatory Commitments are recognized currently as part of net gains on mortgage loans.  We obtain market prices on Mandatory Commitments and Rate Lock Commitments.  Net gains on mortgage loans, as well as net income may be more volatile as a result of these derivative instruments, which are not designated as hedges.

During 2010, we entered into an amended and restated warrant with the U.S. Department of the Treasury (“UST”) that would allow them to purchase our common stock at a fixed price (see Note #15). Because of certain anti-dilution features included in the Amended Warrant (as defined in Note #15), it was not considered to have been indexed to our common stock and was therefore accounted for as a derivative instrument and recorded as a liability. Any change in value of the Amended Warrant while it was accounted for as a derivative was recorded in other income in our Condensed Consolidated Statements of Operations.  However, the anti-dilution features in the Amended Warrant which caused it to be accounted for as a derivative and included in accrued expenses and other liabilities expired on April 16, 2013.  As a result, the Amended Warrant was reclassified into shareholders’ equity on that date at its then fair value which totaled $1.5 million.  During the third quarter of 2013 we repurchased the Amended Warrant from the UST (see Note #15).
36

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The following tables illustrate the impact that the derivative financial instruments discussed above have on individual line items in the Condensed Consolidated Statements of Financial Condition for the periods presented:

Fair Values of Derivative Instruments
 
 
Asset Derivatives
 
Liability Derivatives
 
 
September 30,
2013
 
December 31,
2012
 
September 30,
2013
 
December 31,
2012
 
 
Balance
Sheet
Location
Fair
Value
Balance
Sheet
Location
Fair
Value
Balance
Sheet
Location
Fair
Value
Balance
Sheet
Location
Fair
Value
 
(In thousands)
 
Derivatives designated as hedging instruments
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Pay-fixed interest rate swap agreements
 
 
 
 
 
 
Other liabilities
 
$
-
 
Other liabilities
 
$
739
 
Total
 
 
 
 
 
 
 
   
-
 
 
   
739
 
 
 
 
 
 
 
 
 
       
 
       
Derivatives not designated as hedging instruments
 
 
 
 
 
 
 
       
 
       
Rate-lock mortgage loan commitments
Other assets
 
$
692
 
   Other assets
   
1,368
 
 
       
 
       
Mandatory commitments to sell mortgage loans
Other assets
   
-
 
  Other assets
   
-
 
Other liabilities
   
658
 
Other liabilities
   
122
 
Amended Warrant
Other assets
   
-
 
  Other assets
   
-
 
Other liabilities
   
-
 
Other liabilities
   
459
 
Total
 
   
692
 
 
   
1,368
 
 
   
658
 
 
   
581
 
Total derivatives
 
 
$
692
 
 
 
$
1,368
 
 
 
$
658
 
 
 
$
1,320
 

37

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The effect of derivative financial instruments on the Condensed Consolidated Statements of Operations follows:
 
Three Month Periods Ended September 30,
 
 
 
 
 Location of
 
 
 
 
 
 
 
 
 Gain (Loss)
 
 
 
 
 
 
 
 
 Reclassified
 
 
 
 
 
 
 
 
   from
 
 
 
 
 
 
 
Gain (Loss)
 
 Accumulated
 
Gain (Loss)
 
 
 
 
 
 
Recognized in
 
 Other
 
Reclassified from
 
 
 
 
 
 
Other
 
 Comprehensive
 
Accumulated Other
 
 
 
 
 
 
Comprehensive
 
 Loss into
 
Comprehensive
 
 Location of
 
Gain (Loss)
 
 
 
Income (Loss)
 
 Income
 
Loss into Income
 
 Gain (Loss)
 
Recognized
 
 
 
(Effective Portion)
 
 (Effective
 
(Effective Portion)
 
 Recognized
 
in Income (1)
 
 
 
2013
   
2012
 
 Portion)
 
2013
   
2012
 
 in Income (1)
 
2013
   
2012
 
 
 
(In thousands)
 
Cash Flow Hedges
 
   
 
 
 
   
 
 
 
   
 
Pay-fixed interest rate swap agreements
 
$
-
   
$
(54
)
Interest expense
 
$
(95
)
 
$
(237
)
 
 
$
-
   
$
-
 
Total
 
$
-
   
$
(54
)
 
 
$
(95
)
 
$
(237
)
 
 
$
-
   
$
-
 
 
               
 
               
 
               
No hedge designation Rate-lock mortgage loan commitments
               
 
               
Net mortgage loan gains
 
$
316
   
$
804
 
Mandatory commitments to sell mortgage loans
               
 
               
Net mortgage loan gains
   
(2,657
)
   
(779
)
Amended warrant
               
 
               
Increase in fair value of U.S. Treasury warrant
   
-
     
(32
)
Total
               
 
               
      
 
$
(2,341
)
 
$
(7
)

(1)
For cash flow hedges, this location and amount refers to the ineffective portion.
38

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)
 
Nine Month Periods Ended September 30,
 
 
 
 
 Location of
 
 
 
 
 
 
 
 
 Gain (Loss)
 
 
 
 
 
 
 
 
 Reclassified
 
 
 
 
 
 
 
 
   from
 
 
 
 
 
 
 
Gain (Loss)
 
 Accumulated
 
Gain (Loss)
 
 
 
 
 
 
Recognized in
 
 Other
 
Reclassified from
 
 
 
 
 
 
Other
 
 Comprehensive
 
Accumulated Other
 
 
 
 
 
 
Comprehensive
 
 Loss into
 
Comprehensive
 
 Location of
 
Gain (Loss)
 
 
 
Income (Loss)
 
 Income
 
Loss into Income
 
 Gain (Loss)
 
Recognized
 
 
 
(Effective Portion)
 
 (Effective
 
(Effective Portion)
 
 Recognized
 
in Income (1)
 
 
 
2013
   
2012
 
 Portion)
 
2013
   
2012
 
 in Income (1)
 
2013
   
2012
 
 
 
(In thousands)
 
 
 
   
 
 
 
   
 
 
 
   
 
Cash Flow Hedges
Pay-fixed interest rate swap agreements
 
$
(38
)
 
$
(129
)
Interest expense
 
$
(303
)
 
$
(833
)
 
 
$
-
   
$
-
 
Total
 
$
(38
)
 
$
(129
)
 
 
$
(303
)
 
$
(833
)
 
 
$
-
   
$
-
 
 
               
 
               
 
               
No hedge designation
               
 
               
 
               
Rate-lock mortgage loan  commitments
Net mortgage loan gains
$
(676
)
$
1,930
Mandatorycommitments to sell mortgage loans
               
 
               
Net mortgage loan gains
   
(536
)
   
(869
)
 
               
 
               
 
               
Amended warrant
               
 
               
Increase in fair value of U.S. Treasury warrant
   
(1,025
)
   
(211
)
Total
               
 
               
      
 
$
(2,237
)
 
$
850
 
 
(1)
For cash flow hedges, this location and amount refers to the ineffective portion.

8.
Intangible Assets

The following table summarizes intangible assets, net of amortization:
 
 
 
September 30, 2013
December 31, 2012
 
Gross
Carrying
Amount
Accumulated
Amortization
Gross
Carrying
Amount
Accumulated
Amortization
 
(In thousands)
 
 
   
   
   
 
Amortized intangible assets - core deposits
 
$
23,703
   
$
20,337
   
$
23,703
   
$
19,728
 
 
39

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Amortization of other intangibles has been estimated through 2018 and thereafter in the following table.

 
 
(In thousands)
 
 
 
 
 
 
 
Three months ending December 31, 2013
 
$
204
 
2014
   
536
 
2015
   
347
 
2016
   
347
 
2017
   
346
 
2018 and thereafter
   
1,586
 
Total
 
$
3,366
 

9. Share Based Compensation

We maintain share based payment plans that include a non-employee director stock purchase plan and a long-term incentive plan that permits the issuance of share based compensation, including stock options and non-vested share awards. The long-term incentive plan, which is shareholder approved, permits the grant of additional share based awards for up to 0.5 million shares of common stock as of September 30, 2013.  The non-employee director stock purchase plan permits the issuance of additional share based payments for up to 0.3 million shares of common stock as of September 30, 2013. Share based awards and payments are measured at fair value at the date of grant and are expensed over the requisite service period. Common shares issued upon exercise of stock options come from currently authorized but unissued shares.

A portion of our president’s annual salary is paid in the form of common stock.  The annual amounts paid in common stock (also referred to as “salary stock”) are $0.020 million and $0.015 million for 2013 and 2012, respectively.  During the first quarter of 2011, pursuant to a management transition plan, our former chief executive officer’s annual salary was increased by $0.2 million effective January 1, 2011 through December 31, 2012. This increase was paid entirely in the form of salary stock. These shares were issued each pay period and vested immediately.

During the second quarter of 2013 and third quarter of 2012, we issued 0.1 million and 0.2 million, respectively, of restricted stock units to six of our executive officers.  These restricted stock units do not vest for a minimum of three years and until we repay in full our obligations related to the Troubled Asset Relief Program (“TARP”).  Since we repaid in full our obligations related to TARP (see note #15) the only vesting provision remaining on these restricted stock units is the three year vesting period from the date of grant.  Also, during the second quarter of 2013 and third quarter of 2012, pursuant to our performance-based compensation plans we granted 0.1 million stock options in each period to certain officers, none of whom is a named executive officer.  The stock options have an exercise price equal to the market value on the date of grant, vest ratably over a three year period and expire 10 years from date of grant.  We use the Black Scholes option pricing model to measure compensation cost for stock options.  We also estimate expected forfeitures over the vesting period.

Our directors have elected to receive at least a portion of their quarterly cash retainer fees in the form of common stock (either on a current basis or on a deferred basis pursuant to the non-employee director stock purchase plan referenced above). Shares equal in value to that portion of each director’s quarterly cash retainer are issued each quarter and vest immediately. We issued 0.05 million shares and 0.17 million shares to directors during the first nine months of 2013 and 2012, respectively and expensed their value during those same periods.
40

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Total compensation expense recognized for stock option grants, restricted stock grants, restricted stock unit grants and salary stock was $0.5 million and $0.7 million during the three and nine month periods ended September 30, 2013, respectively, and was $0.2 million and $0.3 million during the same periods in 2012, respectively.  The corresponding tax benefit relating to this expense was zero for both the three and nine month periods ended September 30, 2013 and 2012, respectively.  Total expense recognized for non-employee director share based payments was $0.1 million in both three month periods ended September 30, 2013 and 2012 and $0.3 million in both nine month periods ended September 30, 2013 and 2012.

At September 30, 2013, the total expected compensation cost related to non-vested stock options, restricted stock and restricted stock unit awards not yet recognized was $1.3 million.  The weighted-average period over which this amount will be recognized is 2.3 years.

A summary of outstanding stock option grants and related transactions follows:

 
 
   
   
Weighted-
   
 
 
 
   
   
Average
   
 
 
 
   
Average
   
Remaining
   
Aggregated
 
 
 
Number of
   
Exercise
   
Contractual
   
Intrinsic
 
 
 
Shares
   
Price
   
Term (Years)
   
Value
 
 
 
   
   
   
(In thousands)
 
Outstanding at January 1, 2013
   
275,933
   
$
4.46
   
   
 
Granted
   
77,500
     
6.42
   
   
 
Exercised
   
(14,006
)
   
2.00
   
   
 
Forfeited
   
(8,198
)
   
2.64
   
   
 
Expired
   
(4,652
)
   
46.46
   
   
 
Outstanding at September 30, 2013
   
326,577
   
$
4.48
     
8.31
   
$
1,960
 
Vested and expected to vest at September 30, 2013
   
308,793
   
$
4.49
     
8.26
   
$
1,861
 
Exercisable at September 30, 2013
   
137,660
   
$
5.03
     
7.36
   
$
842
 

A summary of outstanding non-vested restricted stock and stock units and transactions follows:

 
 
   
Weighted-
 
 
 
   
Average
 
 
 
Number
   
Grant Date
 
 
 
of Shares
   
Fair Value
 
Outstanding at January 1, 2013
   
375,416
   
$
6.21
 
Granted
   
82,833
     
6.42
 
Vested
   
(154,261
)
   
11.12
 
Forfeited
   
-
         
Outstanding at September 30, 2013
   
303,988
   
$
3.77
 

During the third quarter of 2013, as a result of the repayment in full of our obligations related to TARP (see note #15) 0.14 million restricted stock units originally granted during 2011 vested.  In addition, as permitted by our long-term incentive plan, 0.05 million shares were withheld from the shares that would otherwise have been issued to executive officers for these vesting restricted stock units in order to satisfy tax withholding obligations.
41

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

A summary of the weighted-average assumptions used in the Black-Scholes option pricing model for grants of stock options during 2013 follows:

Expected dividend yield
   
0.31
%
Risk-free interest rate
   
1.12
 
Expected life (in years)
   
6.00
 
Expected volatility
   
101.30
%
Per share weighted-average fair value
 
$
4.98
 

Certain information regarding options exercised during the periods follows:

 
 
Three Months Ended
   
Nine Months Ended
 
 
 
September 30,
   
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
 
 
(In thousands)
 
Intrinsic value
 
$
46
   
$
1
   
$
67
   
$
1
 
Cash proceeds received
 
$
15
   
$
3
   
$
28
   
$
3
 
Tax benefit realized
 
$
-
   
$
-
   
$
-
   
$
-
 

10. Income Tax

We assess whether a valuation allowance on our deferred tax assets is necessary each quarter.  Reversing or reducing the valuation allowance requires us to conclude that the realization of the deferred tax assets is “more likely than not.”  The ultimate realization of this asset is primarily based on generating future income.  As of June 30, 2013, we concluded that the realization of substantially all of our deferred tax assets was now more likely than not.  This conclusion was primarily based upon the following factors:

· Achieving a sixth consecutive quarter of profitability;
· A forecast of future profitability that supports that the realization of the deferred tax assets is more likely than not; and
· A forecast that future asset quality continues to be stable to improving and that other factors do not exist that could cause a significant adverse impact on future profitability.

We also concluded at September 30, 2013 that the realization of substantially all of our deferred tax assets continued to be more likely than not for substantially the same reasons as enumerated above for June 30, 2013.

We recorded $0.3 million of income tax expense in the third quarter of 2013, which represents an adjustment of the valuation allowance reversal on our deferred tax assets that we initially recorded in June 2013.  At June 30, 2013, we did not reverse that portion of the valuation allowance we estimated would be absorbed by the tax impact of the income expected to be earned between July 1 and December 31, 2013.  To the extent our current forecast of income for the year differs from our projections at June 30, 2013, the tax impact is recorded as income tax expense (or a benefit) which resulted in this adjustment in the third quarter of 2013.
42

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Prior to the second quarter of 2013, we had established a deferred tax asset valuation allowance against all of our net deferred tax assets.  Accordingly, in these prior periods, the income tax expense related to any income before income tax was largely being offset by changes in the deferred tax valuation allowance.

Income tax expense (benefit) was $0.3 million and $(56.2) million in the three and nine month periods ending September 30, 2013, respectively and zero during the same periods in the prior year.  The reversal of substantially all of the valuation allowance on our deferred tax assets resulted in our recording an income tax benefit of $57.3 million ($57.6 million in the second quarter of 2013 less the above described $0.3 million adjustment in the third quarter of 2013).  In addition, during the second quarter of 2013, we recorded $1.4 million of income tax expense to clear from accumulated other comprehensive loss (“AOCL”) the disproportionate tax effects from cash flow hedges.  These disproportionate tax effects had been charged to other comprehensive income and credited to income tax expense due to our valuation allowance on deferred tax assets (see Note #16).  Because we terminated our last remaining cash flow hedge in the second quarter of 2013, it was appropriate to clear these disproportionate tax effects from AOCL.

We did not at June 30, 2013 and still have not reversed approximately $1.0 million of valuation allowance on our deferred tax assets that primarily relates to state income taxes from our Mepco segment.  In this instance, we determined that the future realization of these particular deferred tax assets was not more likely than not.  This conclusion was primarily based on the uncertainty of Mepco’s future earnings attributable to particular states (given the various apportionment criteria) and the significant reduction in the size of Mepco’s business over the past three years.

At September 30, 2013 and December 31, 2012, we had approximately $1.7 million and $1.9 million, respectively of gross unrecognized tax benefits.  We do not expect the total amount of unrecognized tax benefits to significantly increase or decrease during the balance of 2013.

11. Regulatory Matters

Capital guidelines adopted by Federal and State regulatory agencies and restrictions imposed by law limit the amount of cash dividends our Bank can pay to us. Under these guidelines, the amount of dividends that may be paid in any calendar year is limited to the Bank’s current year’s net profits, combined with the retained net profits of the preceding two years. Further, the Bank cannot pay a dividend at any time that it has negative undivided profits.  As of September 30, 2013 the Bank had negative undivided profits of $55.3 million. It is not our intent to have dividends paid in amounts which would reduce the capital of our Bank to levels below those which we consider prudent and in accordance with guidelines of regulatory authorities.

On October 25, 2011, the respective Boards of Directors of the Company and the Bank entered into a Memorandum of Understanding (“MOU”) with the Federal Reserve Bank (“FRB”) and the Michigan Department of Insurance and Financial Services (“DIFS”). The MOU largely duplicated certain provisions of board resolutions that were already in place, but also had the following specific requirements:

·
Submission of a joint revised capital plan by November 30, 2011 to maintain sufficient capital at the Company on a consolidated basis and at the Bank on a stand-alone basis;
·
Submission of quarterly progress reports regarding disposition plans for any assets in excess of $1.0 million that are in ORE, are 90 days or more past due, are on our “watch list,” or were adversely classified in our most recent examination;
43

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

·
Enhanced reporting and monitoring at Mepco regarding risk management and the internal classification of assets; and
·
Enhanced interest rate risk modeling practices.

Effective March 26, 2013, the FRB and DIFS terminated the MOU.  Also on that date, the respective Boards of Directors of the Company and the Bank passed resolutions that required the following:

·
Submission of quarterly progress reports to the FRB and DIFS regarding disposition plans for any assets in excess of $1.0 million that are in ORE, are 90 days or more past due, are on our “watch list,” or are adversely classified;
·
Prior approval of the FRB and DIFS for the Bank to pay any dividend to the Company; and
·
Prior approval of the FRB and DIFS for the Company to pay any dividend to its shareholders, to make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities, to increase borrowings or guarantee any debt, and/or to purchase or redeem any of its stock.

During the third quarter of 2013 the FRB and DIFS informed us that the Board resolutions no longer needed to be in place.  Accordingly, on October 22, 2013, the above described resolutions were rescinded by the Board of Directors of the Company and the Bank.

Also during the third quarter of 2013 we received regulatory approval for each of the following initiatives:

·
A transfer of capital from our Bank to the parent company of $7.5 million to permit the payment of all deferred and unpaid interest on our trust preferred securities.
· The resumption of interest payments on our trust preferred securities.
· The purchase of our Series B Fixed Rate Cumulative Mandatorily Convertible Preferred Stock, with an original liquidation preference of $1,000 per share (“Series B Preferred Stock”), including any and all accrued and unpaid dividends, and the purchase of the Amended and Restated Warrant to purchase 346,154 shares of our common stock at an exercise price of $7.234 per share and expiring on December 12, 2018 (the “Amended Warrant”) for total cash consideration of $81.0 million, all as provided for in a securities purchase agreement (see Note #15).
· Redemption of the trust preferred securities issued by IBC Capital Finance II. On October 11, 2013 we redeemed all ($9.2 million) of the outstanding trust preferred securities issued by IBC Capital Finance II and liquidated this entity shortly thereafter.

We are also subject to various regulatory capital requirements. The prompt corrective action regulations establish quantitative measures to ensure capital adequacy and require minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and Tier 1 capital to average assets. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly discretionary, actions by regulators that could have a material effect on our consolidated financial statements. Under capital adequacy guidelines, we must meet specific capital requirements that involve quantitative measures as well as qualitative judgments by the regulators. The most recent regulatory filings as of September 30, 2013 and December 31, 2012 categorized our Bank as well capitalized. Management is not aware of any conditions or events that would have changed the most recent Federal Deposit Insurance Corporation (“FDIC”) categorization.
44

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Our actual capital amounts and ratios follow:

 
 
   
   
Minimum for
   
Minimum for
 
 
 
   
   
Adequately Capitalized
   
Well-Capitalized
 
 
 
Actual
   
Institutions
   
Institutions
 
 
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
 
 
(Dollars in thousands)
 
 
 
   
   
   
   
   
 
September 30, 2013
 
   
   
   
   
   
 
Total capital to risk-weighted assets
 
   
   
   
   
   
 
Consolidated
 
$
245,754
     
17.49
%
 
$
112,424
     
8.00
%
 
NA
   
NA
 
Independent Bank
   
224,855
     
16.01
     
112,326
     
8.00
   
$
140,408
     
10.00
%
 
                                               
Tier 1 capital to risk-weighted assets
                                               
Consolidated
 
$
227,876
     
16.22
%
 
$
56,212
     
4.00
%
 
NA
   
NA
 
Independent Bank
   
206,999
     
14.74
     
56,163
     
4.00
   
$
84,245
     
6.00
%
 
                                               
Tier 1 capital to average assets
                                               
Consolidated
 
$
227,876
     
10.87
%
 
$
83,849
     
4.00
%
 
NA
   
NA
 
Independent Bank
   
206,999
     
9.88
     
83,775
     
4.00
   
$
104,719
     
5.00
%
 
                                               
December 31, 2012
                                               
Total capital to risk-weighted assets
                                               
Consolidated
 
$
204,663
     
14.71
%
 
$
111,268
     
8.00
%
 
NA
   
NA
 
Independent Bank
   
207,553
     
14.95
     
111,063
     
8.00
   
$
138,829
     
10.00
%
 
                                               
Tier 1 capital to risk-weighted assets
                                               
Consolidated
 
$
185,948
     
13.37
%
 
$
55,634
     
4.00
%
 
NA
   
NA
 
Independent Bank
   
189,777
     
13.67
     
55,531
     
4.00
   
$
83,297
     
6.00
%
 
                                               
Tier 1 capital to average assets
                                               
Consolidated
 
$
185,948
     
8.08
%
 
$
92,026
     
4.00
%
 
NA
   
NA
 
Independent Bank
   
189,777
     
8.26
     
91,919
     
4.00
   
$
114,899
     
5.00
%
 

NA - Not applicable
45

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The components of our regulatory capital are as follows:

 
 
Consolidated
   
Independent Bank
 
 
 
September 30,
   
December 31,
   
September 30,
   
December 31,
 
 
 
2013
   
2012
   
2013
   
2012
 
 
 
(In thousands)
 
Total shareholders' equity
 
$
226,601
   
$
134,975
   
$
245,083
   
$
186,384
 
Add (deduct)
                               
Qualifying trust preferred securities
   
48,668
     
47,678
     
-
     
-
 
Accumulated other comprehensive loss
   
9,170
     
8,058
     
9,170
     
8,156
 
Intangible assets
   
(3,366
)
   
(3,975
)
   
(3,366
)
   
(3,975
)
Disallowed deferred tax assets
   
(52,769
)
   
-
     
(43,460
)
   
-
 
Disallowed capitalized mortgage loan servicing rights
   
(428
)
   
(788
)
   
(428
)
   
(788
)
Tier 1 capital
   
227,876
     
185,948
     
206,999
     
189,777
 
Qualifying trust preferred securities
   
-
     
990
     
-
     
-
 
Allowance for loan losses and allowance for unfunded lending commitments limited to 1.25% of total risk-weighted assets
   
17,878
     
17,725
     
17,856
     
17,776
 
Total risk-based capital
 
$
245,754
   
$
204,663
   
$
224,855
   
$
207,553
 

On July 2, 2013, the Federal Reserve Board approved a final rule that establishes an integrated regulatory capital framework (the “New Capital Rules”). The rule will implement in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act.
 
In general, under the New Capital Rules, minimum requirements will increase for both the quantity and quality of capital held by banking organizations. Consistent with the international Basel framework, the New Capital Rules include a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5% and a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets that will apply to all supervised financial institutions. The rule also raises the minimum ratio of tier 1 capital to risk-weighted assets from 4% to 6% and includes a minimum leverage ratio of 4% for all banking organizations.  As to the quality of capital, the New Capital Rules emphasize common equity tier 1 capital, the most loss-absorbing form of capital, and implements strict eligibility criteria for regulatory capital instruments. The New Capital Rules also change the methodology for calculating risk-weighted assets to enhance risk sensitivity.
 
We are subject to the New Capital Rules beginning on January 1, 2015.  The 2.5% capital conservation buffer is being phased in over a four-year period beginning in 2016.  Also, under the New Capital Rules our existing trust preferred securities are grandfathered as qualifying regulatory capital.  We believe that we currently exceed all of the capital ratio requirements of the New Capital Rules.
46

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

12. Fair Value Disclosures

FASB ASC topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Valuation is based upon quoted prices for identical instruments traded in active markets. Level 1 instruments include securities traded on active exchange markets, such as the New York Stock Exchange, as well as U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets.

Level 2:  Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 2 instruments include securities traded in less active dealer or broker markets.

Level 3:  Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

We used the following methods and significant assumptions to estimate fair value:

Securities:  Where quoted market prices are available in an active market, securities (trading or available for sale) are classified as Level 1 of the valuation hierarchy.  Level 1 securities include certain preferred stocks included in our trading portfolio for which there are quoted prices in active markets.  If quoted market prices are not available for the specific security, then fair values are estimated by (1) using quoted market prices of securities with similar characteristics, (2) matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices, or (3) a discounted cash flow analysis whose significant fair value inputs can generally be verified and do not typically involve judgment by management. These securities are classified as Level 2 of the valuation hierarchy and include agency and private label residential mortgage-backed securities, municipal securities, trust preferred securities and corporate securities.

Loans held for sale:  The fair value of mortgage loans held for sale is based on mortgage backed security pricing for comparable assets (recurring Level 2).  The fair value of loans held for sale relating to branch sale was based on a discount provided for in the branch sale agreement (non-recurring Level 2).
47

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Impaired loans with specific loss allocations based on collateral value:  From time to time, certain loans are considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. We measure our investment in an impaired loan based on one of three methods: the loan’s observable market price, the fair value of the collateral or the present value of expected future cash flows discounted at the loan’s effective interest rate. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2013 and December 31, 2012, all of our total impaired loans were evaluated based on either the fair value of the collateral or the present value of expected future cash flows discounted at the loan’s effective interest rate. When the fair value of the collateral is based on an appraised value or when an appraised value is not available we record the impaired loan as nonrecurring Level 3.  These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments can be significant and thus will typically result in a Level 3 classification of the inputs for determining fair value.

Other real estate:  At the time of acquisition, other real estate is recorded at fair value, less estimated costs to sell, which becomes the property’s new basis. Subsequent write-downs to reflect declines in value since the time of acquisition may occur from time to time and are recorded in loss on other real estate and repossessed assets in the Condensed Consolidated Statements of Operations. The fair value of the property used at and subsequent to the time of acquisition is typically determined by a third party appraisal of the property.  These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments can be significant and typically result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by us.  Once received, an independent third party (for commercial properties over $0.25 million) or a member of  our special assets group (for commercial properties under $0.25 million and retail properties) reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics.  On an annual basis, we compare the actual selling price of collateral that has been sold to the most recent appraised value to determine what additional adjustment, if any, should be made to the appraisal value to arrive at fair value.  For commercial properties we typically do not discount an appraisal while for retail properties we generally discount the value by 5%.  In addition, we will adjust the appraised values for expected liquidation costs including sales commissions and transfer taxes.
48

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Capitalized mortgage loan servicing rights:  The fair value of capitalized mortgage loan servicing rights is based on a valuation model used by an independent third party that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income. Since the secondary servicing market has not been active since the later part of 2009, model assumptions are generally unobservable and are based upon the best information available including data relating to our own servicing portfolio, reviews of mortgage servicing assumption and valuation surveys and input from various mortgage servicers and, therefore, are recorded as nonrecurring Level 3.  Management evaluates the third party valuation for reasonableness each quarter as part of our financial reporting control processes.

Derivatives:  The fair value of rate-lock mortgage loan commitments and mandatory commitments to sell mortgage loans is based on mortgage backed security pricing for comparable assets (recurring Level 2).  The fair value of interest rate swap agreements, in general, was determined using a discounted cash flow model whose significant fair value inputs could generally be verified and did not typically involve judgment by management (recurring Level 2).  The fair value of the Amended Warrant was determined using a simulation analysis which considers potential outcomes for a large number of independent scenarios regarding the future prices of our common stock and uses several unobservable variables (recurring Level 3).
49

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Assets and liabilities measured at fair value, including financial assets for which we have elected the fair value option, were as follows:

 
 
   
Fair Value Measurements Using
 
 
 
   
Quoted
   
   
 
 
 
   
Prices
   
   
 
 
 
   
in Active
   
   
 
 
 
   
Markets
   
Significant
   
Significant
 
 
 
   
for
   
Other
   
Un-
 
 
 
Fair Value
   
Identical
   
Observable
   
observable
 
 
 
Measure-
   
Assets
   
Inputs
   
Inputs
 
 
 
ments
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
 
 
(In thousands)
 
September 30, 2013:
 
 
   
 
   
 
   
 
 
Measured at Fair Value on a Recurring Basis:
 
   
   
   
 
Assets
 
   
   
   
 
Trading securities
 
$
308
   
$
308
   
$
-
   
$
-
 
Securities available for sale
                               
U.S. agency
   
23,392
     
-
     
23,392
     
-
 
U.S. agency residential mortgage-backed
   
198,339
     
-
     
198,339
     
-
 
Private label residential mortgage-backed
   
6,893
     
-
     
6,893
     
-
 
Other asset backed
   
26,830
             
26,830
         
Obligations of states and political subdivisions
   
140,939
     
-
     
140,939
     
-
 
Corporate
   
17,016
     
-
     
17,016
     
-
 
Trust preferred
   
2,476
     
-
     
2,476
     
-
 
Loans held for sale
   
27,622
     
-
     
27,622
     
-
 
Derivatives (1)
   
692
     
-
     
692
     
-
 
Liabilities
                               
Derivatives (2)
   
658
     
-
     
658
     
-
 
 
                               
Measured at Fair Value on a Non-recurring basis:
                               
Assets
                               
Capitalized mortgage loan servicing rights (3)
   
7,146
     
-
     
-
     
7,146
 
Impaired loans (4)
                               
Commercial
                               
Income producing - real estate
   
1,652
     
-
     
-
     
1,652
 
Land, land development &construction-real estate
   
679
     
-
     
-
     
679
 
Commercial and industrial
   
1,850
     
-
     
-
     
1,850
 
Mortgage
                               
1-4 Family
   
1,491
     
-
     
-
     
1,491
 
Resort Lending
   
347
     
-
     
-
     
347
 
Other real estate (5)
                               
Commercial
                               
Income producing - real estate
   
560
     
-
     
-
     
560
 
Land, land development & construction-real estate
   
1,507
     
-
     
-
     
1,507
 
Mortgage
                               
1-4 Family
   
402
     
-
     
-
     
402
 
Resort Lending
   
1,531
     
-
     
-
     
1,531
 
Installment
                               
Home equity installment - 1st lien
   
82
     
-
     
-
     
82
 
Payment plan receivables
Full refund/partial refund
   
2,668
     
-
     
-
     
2,668
 
 
(1) Included in accrued income and other assets
(2) Included in accrued expenses and other liabilities
(3) Only includes servicing rights that are carried at fair value due to recognition of a valuation allowance.
(4) Only includes impaired loans with specific loss allocations based on collateral value.
(5) Only includes other real estate with subsequent write downs to fair value.
50

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

 
 
   
Fair Value Measurements Using
 
 
 
   
Quoted
   
   
 
 
 
   
Prices
   
   
 
 
 
   
in Active
   
   
 
 
 
   
Markets
   
Significant
   
Significant
 
 
 
   
for
   
Other
   
Un-
 
 
 
Fair Value
   
Identical
   
Observable
   
observable
 
 
 
Measure-
   
Assets
   
Inputs
   
Inputs
 
 
 
ments
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
 
 
(In thousands)
 
December 31, 2012:
 
   
   
   
 
Measured at Fair Value on a Recurring Basis:
 
   
   
   
 
Assets
 
   
   
   
 
Trading securities
 
$
110
   
$
110
   
$
-
   
$
-
 
Securities available for sale
                               
U.S. agency
   
30,667
     
-
     
30,667
     
-
 
U.S. agency residential mortgage-backed
   
127,412
     
-
     
127,412
     
-
 
Private label residential mortgage-backed
   
8,194
     
-
     
8,194
     
-
 
Obligations of states and political subdivisions
   
39,051
     
-
     
39,051
     
-
 
Trust preferred
   
3,089
     
-
     
3,089
     
-
 
Loans held for sale
   
47,487
     
-
     
47,487
     
-
 
Derivatives (1)
   
1,368
     
-
     
1,368
     
-
 
Liabilities
                               
Derivatives (2)
   
1,320
     
-
     
861
     
459
 
 
                               
Measured at Fair Value on a Non-recurring basis:
                               
Assets
                               
Capitalized mortgage loan servicing rights (3)
   
8,814
     
-
     
-
     
8,814
 
Impaired loans (4)
                               
Commercial
                               
Income producing - real estate
   
3,727
     
-
     
-
     
3,727
 
Land, land development &construction-real estate
   
2,882
     
-
     
-
     
2,882
 
Commercial and industrial
   
6,581
     
-
     
-
     
6,581
 
Mortgage
                               
1-4 Family
   
2,694
     
-
     
-
     
2,694
 
Resort Lending
   
380
     
-
     
-
     
380
 
Other real estate (5)
                               
Commercial
                               
Income producing - real estate
   
86
     
-
     
-
     
86
 
Land, land development &construction-real estate
   
3,190
     
-
     
-
     
3,190
 
Mortgage
                               
1-4 Family
   
405
     
-
     
-
     
405
 
Resort Lending
   
3,535
     
-
     
-
     
3,535
 
Installment
                               
Home equity installment - 1st lien
   
59
     
-
     
-
     
59
 
Loans held for sale relating to branch sale
   
3,292
     
-
     
3,292
     
-
 

(1) Included in accrued income and other assets
(2) Included in accrued expenses and other liabilities
(3) Only includes servicing rights that are carried at fair value due to recognition of a valuation allowance.
(4) Only includes impaired loans with specific loss allocations based on collateral value.
(5) Only includes other real estate with subsequent write downs to fair value.
51

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

There were no transfers between Level 1 and Level 2 during the nine months ended September 30, 2013 and 2012.

Changes in fair values for financial assets which we have elected the fair value option for the periods presented were as follows:
 
 
Changes in Fair Values for the Nine-Month
Periods Ended September 30 for Items Measured at
 
Fair Value Pursuant to Election of the Fair Value Option
  2013
2012
 
Net Gains (Losses)
Total
Change
in Fair
Values
Included
in Current
Net Gains (Losses)
Total
Change
in Fair
Values
Included
in Current
 
on Assets
Period
on Assets
Period
 
Securities
   
Loans
   
Earnings
   
Securities
   
Loans
   
Earnings
 
 
(In thousands)
 
Trading securities
 
$
197
   
$
-
   
$
197
   
$
(39
)
 
$
-
   
$
(39
)
Loans held for sale
   
-
     
(765
)
   
(765
)
   
-
     
587
     
587
 
 
For those items measured at fair value pursuant to our election of the fair value option, interest income is recorded within the Condensed Consolidated Statements of Operations based on the contractual amount of interest income earned on these financial assets and dividend income is recorded based on cash dividends.

The following represent impairment charges recognized during the three and nine month periods ended September 30, 2013 and 2012 relating to assets measured at fair value on a non-recurring basis:
 
· Capitalized mortgage loan servicing rights, whose individual strata are measured at fair value, had a carrying amount of $7.1 million which is net of a valuation allowance of $3.6 million at September 30, 2013 and had a carrying amount of $8.8 million which is net of a valuation allowance of $6.1 million at December 31, 2012.  A recovery (charge) of $0.04 million and $2.5 million was included in our results of operations for the three and nine month periods ending September 30, 2013, respectively and $(0.4) million and $(0.6) million during the same periods in 2012.
· Loans which are measured for impairment using the fair value of collateral for collateral dependent loans, had a carrying amount of $9.1 million, with a valuation allowance of $3.1 million at September 30, 2013 and had a carrying amount of $22.8 million, with a valuation allowance of $6.5 million at December 31, 2012.  The provision for loan losses included in our results of operations relating to impaired loans was an expense of $0.5 million and $0.3 million for the three month periods ending September 30, 2013 and 2012, respectively and a credit of $0.1 million and an expense of $1.9 million for the nine month periods ending September 30, 2013 and 2012, respectively.
· Other real estate, which is measured using the fair value of the property, had a carrying amount of $6.8 million which is net of a valuation allowance of $4.6 million at September 30, 2013 and a carrying amount of $7.3 million which is net of a valuation allowance of $6.0 million at December 31, 2012.  An additional charge relating to ORE measured at fair value of $0.3 million and $1.8 million was included in our results of operations during the three and nine month periods ended September 30, 2013, respectively and $1.1 million and $1.5 million during the same periods in 2012.
52

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

A reconciliation for all liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30 follows:

 
 
(Liability)
 
 
 
Amended Warrant
 
 
 
Three Months Ended
   
Nine Months Ended
 
 
 
September 30,
   
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
 
 
(In thousands)
 
Beginning balance
 
$
-
   
$
(353
)
 
$
(459
)
 
$
(174
)
Total gains (losses) realized and unrealized:
                               
Included in results of operations
   
-
     
(32
)
   
(1,025
)
   
(211
)
Included in other comprehensive income
   
-
     
-
     
-
     
-
 
Purchases, issuances, settlements, maturities and calls
   
-
     
-
     
-
     
-
 
Reclassification to shareholders' equity
   
-
     
-
     
1,484
     
-
 
Transfers in and/or out of Level 3
   
-
     
-
     
-
     
-
 
Ending balance
 
$
-
   
$
(385
)
 
$
-
   
$
(385
)
Amount of total gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to assets and liabilities still held at September 30
 
$
-
   
$
(32
)
 
$
(1,025
)
 
$
(211
)

Because of certain anti-dilution features included in the Amended Warrant, it was not considered to be indexed to our common stock and was therefore accounted for as a derivative instrument (see Note #7). Any change in value of this warrant was recorded in other income in our Condensed Consolidated Statements of Operations.  However, the anti-dilution features in the Amended Warrant which caused it to be accounted for as a derivative and included in accrued expenses and other liabilities expired on April 16, 2013.  As a result, the Amended Warrant was reclassified into shareholders’ equity on that date at its then fair value which totaled $1.5 million.  During the third quarter of 2013 we repurchased the Amended Warrant from the UST (see Note #15).

The fair value of the Amended Warrant was determined using a simulation analysis which considered potential outcomes for a large number of independent scenarios regarding the future prices of our common stock. The simulation analysis relied on a binomial lattice model, a standard technique usually applied to the valuation of stock options. The binomial lattice maps out possible price paths of our common stock, the underlying asset of the Amended Warrant. The simulation was based on a 500-step lattice covering the term of the Amended Warrant. The binomial lattice required specification of 14 variables, of which several were unobservable in the market.
53

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Quantitative information about the Amended Warrant at December 31, 2012 follows:

(Liability)
 
 
 
 
 
Fair
 
Valuation
Unobservable
 
Unobservable
 
Value
 
Technique
Inputs
 
Input Values
 
(In thousands)
 
 
 
 
 
 
 
 
$
(459
)
Binomial Lattice Model
Probability of non-permitted equity raise
   
0.5
%
     
  
Expected discount to stock price in anequity raise
   
10.0
%
     
  
Dollar amount of expected capital raise
 
$100 Million
     
  
Expected time of non-permitted equity raise
 
April, 2013

The significant unobservable inputs used in the fair value measurement of Amended Warrant were probability of a non-permitted capital raise, expected discount to stock price in an equity raise, dollar amount of expected capital raise and expected time of equity raise. Significant increases/(decreases) in any of those inputs in isolation would have resulted in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of a non-permitted capital raise and dollar amount of equity raise would have been accompanied by a directionally consistent change in fair value and a directionally opposite change in the assumption used for expected discount to stock price in an equity raise and expected time of equity raise.
54

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Quantitative information about Level 3 fair value measurements measured on a non-recurring basis follows:

 
 
Asset
 
 
 
 
 
 
 
(Liability)
 
 
 
 
 
 
 
Fair
 
Valuation
Unobservable
 
Weighted
 
 
 
Value
 
Technique
Inputs
 
Average
 
 
 
(In thousands)
 
September 30, 2013
 
 
 
 
 
 
Capitalized mortgage loan servicing rights
 
$
7,146
 
Present value of net servicing revenue
Discount rate
   
10.12
%
 
       
Cost to service
 
$
81
 
 
       
   
Ancillary income
   
29
 
 
       
   
Float rate
   
1.54
%
Impaired loans
       
 
 
       
Commercial
   
4,181
 
Sales comparison approach
Adjustment for differences between comparable sales
   
(1.2
)%
 
       
Income approach
Capitalization rate
   
9.3
 
Mortgage
   
1,838
 
Sales comparison approach
Adjustment for differences between comparable sales
   
3.4
 
Other real estate
       
 
 
       
Commercial
   
2,067
 
Sales comparison approach
Adjustment for differences between comparable sales
   
(5.7
)
 
       
Income approach
Capitalization rate
   
11.0
 
 
       
 
 
       
Mortgage and installment
   
2,015
 
Sales comparison approach
Adjustment for differences between comparable sales
   
36.5
 
 
       
 
 
       
Payment plan receivables
   
2,668
 
Sales comparison approach
Adjustment for differences between comparable sales
   
7.5
 
 
       
 
 
       
December 31, 2012
Capitalized mortgage loan servicing rights
 
$
8,814
 
Present value of net servicing revenue
Discount rate
   
11.00
%
       
Cost to service
 
$
83
 
 
       
   
Ancillary income
   
43
 
 
       
   
Float rate
   
0.84
%
Impaired loans
       
 
 
       
Commercial
   
13,190
 
Sales comparison approach
Adjustment for differences between comparable sales
   
16.7
%
 
       
Income approach
Capitalization rate
   
10.8
 
Mortgage
   
3,074
 
Sales comparison approach
Adjustment for differences between comparable sales
   
9.5
 
Other real estate
       
 
 
       
Commercial
   
3,276
 
Sales comparison approach
Adjustment for differences between comparable sales
   
(12.4
)
 
       
Income approach
Capitalization rate
   
12.3
 
 
       
 
 
       
Mortgage and installment
   
3,999
 
Sales comparison approach
Adjustment for differences between comparable sales
   
(6.3
)

55

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The following table reflects the difference between the aggregate fair value and the aggregate remaining contractual principal balance outstanding for loans held for sale for which the fair value option has been elected for the periods presented.

 
 
Aggregate
Fair Value
   
Difference
   
Contractual Principal
 
 
 
(In thousands)
 
Loans held for sale
 
   
   
 
September 30, 2013
 
$
27,622
   
$
1,078
   
$
26,544
 
December 31, 2012
   
47,487
     
1,843
     
45,644
 

13. Fair Values of Financial Instruments

Most of our assets and liabilities are considered financial instruments. Many of these financial instruments lack an available trading market and it is our general practice and intent to hold the majority of our financial instruments to maturity. Significant estimates and assumptions were used to determine the fair value of financial instruments. These estimates are subjective in nature, involving uncertainties and matters of judgment, and therefore, fair values cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Estimated fair values have been determined using available data and methodologies that are considered suitable for each category of financial instrument. For instruments with adjustable-interest rates which reprice frequently and without significant credit risk, it is presumed that estimated fair values approximate the recorded book balances.

Cash and due from banks and interest bearing deposits:  The recorded book balance of cash and due from banks and interest bearing deposits approximate fair value and are classified as Level 1.

Interest bearing deposits - time:  Interest bearing deposits - time have been valued based on a model using a benchmark yield curve plus a base spread and are classified as Level 2.

Securities:  Financial instrument assets actively traded in a secondary market have been valued using quoted market prices.  Trading securities are classified as Level 1 while securities available for sale are classified as Level 2 as described in Note #12.

Federal Home Loan Bank and Federal Reserve Bank Stock:  It is not practicable to determine the fair value of FHLB and FRB Stock due to restrictions placed on transferability.

Net loans and loans held for sale:  The fair value of loans is calculated by discounting estimated future cash flows using estimated market discount rates that reflect credit and interest-rate risk inherent in the loans resulting in a Level 3 classification.  Impaired loans are valued at the lower of cost or fair value as described in Note #12.  Loans held for sale are classified as Level 2 as described in Note #12.

Accrued interest receivable and payable:  The recorded book balance of accrued interest receivable and payable approximate fair value and are classified at the same Level as the asset and liability they are associated with.
56

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Derivative financial instruments:  Rate-lock mortgage loan commitments and mandatory commitments to sell mortgage loans have been valued based on mortgage backed security pricing for comparable assets.  Interest rate swaps (at December 31, 2012) were valued based on the discounted value of contractual cash flows using a discount rate approximating current market rates.  Each of these instruments has been classified as Level 2 as described in Note #12.  The Amended Warrant (at December 31, 2012) was valued based on a simulation analysis which considers potential outcomes for a large number of independent scenarios and is classified as Level 3 as described in Note #12.

Deposits:  Deposits without a stated maturity, including demand deposits, savings, NOW and money market accounts, have a fair value equal to the amount payable on demand.  Each of these instruments is classified as Level 1.  Deposits with a stated maturity, such as certificates of deposit have generally been valued based on the discounted value of contractual cash flows using a discount rate approximating current market rates for liabilities with a similar maturity resulting in a Level 2 classification.

Other borrowings:  Other borrowings have been valued based on the discounted value of contractual cash flows using a discount rate approximating current market rates for liabilities with a similar maturity resulting in a Level 2 classification.

Subordinated debentures:  Subordinated debentures have generally been valued based on a quoted market price of the specific or similar instruments resulting in a Level 1 or Level 2 classification.
57

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The estimated recorded book balances and fair values follow:

 
 
   
   
Fair Value Measurements Using
 
 
 
   
   
Quoted
   
   
 
 
 
   
   
Prices
   
   
 
 
 
   
   
in Active
   
   
 
 
 
   
   
Markets
   
Significant
   
Significant
 
 
 
   
   
for
   
Other
   
Un-
 
 
 
Recorded
   
Fair Value
   
Identical
   
Observable
   
observable
 
 
 
Book
   
Measure-
   
Assets
   
Inputs
   
Inputs
 
 
 
Balance
   
ments
   
(Level 1)
   
(Level 2)
   
(Level 3)
 
 
 
(In thousands)
 
September 30, 2013
 
   
   
   
   
 
Assets
 
   
   
   
   
 
Cash and due from banks
 
$
56,179
   
$
56,179
   
$
56,179
   
$
-
   
$
-
 
Interest bearing deposits
   
74,766
     
74,766
     
74,766
     
-
     
-
 
Interest bearing deposits - time
   
16,946
     
16,940
     
-
     
16,940
     
-
 
Trading securities
   
308
     
308
     
308
     
-
     
-
 
Securities available for sale
   
415,885
     
415,885
     
-
     
415,885
     
-
 
Federal Home Loan Bank and Federal Reserve Bank Stock
   
21,496
   
NA
   
NA
   
NA
   
NA
 
Net loans and loans held for sale
   
1,373,168
     
1,355,728
     
-
     
27,622
     
1,328,106
 
Accrued interest receivable
   
6,064
     
6,064
     
9
     
1,492
     
4,563
 
Derivative financial instruments
   
692
     
692
     
-
     
692
     
-
 
 
                                       
Liabilities
                                       
Deposits with no stated maturity (1)
 
$
1,429,569
   
$
1,429,569
   
$
1,429,569
   
$
-
   
$
-
 
Deposits with stated maturity (1)
   
419,749
     
419,617
     
-
     
419,617
     
-
 
Other borrowings
   
17,282
     
20,049
     
-
     
20,049
     
-
 
Subordinated debentures
   
50,175
     
37,165
     
9,452
     
27,713
     
-
 
Accrued interest payable
   
332
     
332
     
57
     
275
     
-
 
Derivative financial instruments
   
658
     
658
     
-
     
658
     
-
 
 
                                       
December 31, 2012
                                       
Assets
                                       
Cash and due from banks
 
$
55,487
   
$
55,487
   
$
55,487
   
$
-
   
$
-
 
Interest bearing deposits
   
124,295
     
124,295
     
124,295
     
-
     
-
 
Trading securities
   
110
     
110
     
110
     
-
     
-
 
Securities available for sale
   
208,413
     
208,413
     
-
     
208,413
     
-
 
Federal Home Loan Bank and Federal
                                       
Reserve Bank Stock
   
20,838
   
NA
   
NA
   
NA
   
NA
 
Net loans and loans held for sale
   
1,425,643
     
1,400,385
     
-
     
50,779
     
1,349,606
 
Accrued interest receivable
   
5,814
     
5,814
     
102
     
934
     
4,778
 
Derivative financial instruments
   
1,368
     
1,368
     
-
     
1,368
     
-
 
 
                                       
Liabilities
                                       
Deposits with no stated maturity (1)
 
$
1,360,609
   
$
1,360,609
   
$
1,360,609
   
$
-
   
$
-
 
Deposits with stated maturity (1)
   
418,928
     
420,374
     
-
     
420,374
     
-
 
Other borrowings
   
17,625
     
21,463
     
-
     
21,463
     
-
 
Subordinated debentures
   
50,175
     
42,235
     
7,956
     
34,279
     
-
 
Accrued interest payable
   
7,197
     
7,197
     
2,942
     
4,255
     
-
 
Derivative financial instruments
   
1,320
     
1,320
     
-
     
861
     
459
 

(1)
Deposits with no stated maturity include reciprocal deposits with a recorded book balance of $12.0 million and $1.2 million at September 30, 2013 and December 31, 2012, respectively.  Deposits with a stated maturity include reciprocal deposits with a recorded book balance of $43.9 million and $32.0 million at September 30, 2013 and December 31, 2012, respectively.

The fair values for commitments to extend credit and standby letters of credit are estimated to approximate their aggregate book balance, which is nominal and therefore are not disclosed.
58

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

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 the entire holdings of a particular financial instrument.

Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business, the value of future earnings attributable to off-balance sheet activities and the value of assets and liabilities that are not considered financial instruments.

Fair value estimates for deposit accounts do not include the value of the core deposit intangible asset resulting from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.

14. Contingent Liabilities

We are involved in various litigation matters in the ordinary course of business. At the present time, we do not believe any of these matters will have a significant impact on our Condensed Consolidated Financial Statements.  The aggregate amount we have accrued for losses we consider probable as a result of these litigation matters is immaterial. However, because of the inherent uncertainty of outcomes from any litigation matter, we believe it is reasonably possible we may incur losses in addition to the amounts we have accrued.  At this time, we estimate the maximum amount of additional losses that are reasonably possible is approximately $0.5 million.  However, because of a number of factors, including the fact that certain of these litigation matters are still in their early stages, this maximum amount may change in the future.

The litigation matters described in the preceding paragraph primarily include claims that have been brought against us for damages, but do not include litigation matters where we seek to collect amounts owed to us by third parties (such as litigation initiated to collect delinquent loans or vehicle service contract counterparty receivables). These excluded, collection-related matters may involve claims or counterclaims by the opposing party or parties, but we have excluded such matters from the disclosure contained in the preceding paragraph in all cases where we believe the possibility of us paying damages to any opposing party is remote. Risks associated with the likelihood that we will not collect the full amount owed to us, net of reserves, are disclosed elsewhere in this report.

Our Mepco segment conducts its payment plan business activities across the United States. Mepco acquires the payment plans from companies (which we refer to as Mepco’s “counterparties”) at a discount from the face amount of the payment plan. Each payment plan (which are classified as payment plan receivables in our Condensed Consolidated Statements of Financial Condition) permits a consumer to purchase a vehicle service contract by making installment payments, generally for a term of 12 to 24 months, to the sellers of those contracts (one of the “counterparties”). Mepco thereafter collects the payments from consumers. In acquiring the payment plan, Mepco generally funds a portion of the cost to the seller of the service contract and a portion of the cost to the administrator of the service contract. The administrator, in turn, pays the necessary contractual liability insurance policy (“CLIP”) premium to the insurer or risk retention group.
59

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Consumers are allowed to voluntarily cancel the service contract at any time and are generally entitled to receive a refund from the administrator of the unearned portion of the service contract at the time of cancellation. As a result, while Mepco does not owe any refund to the consumer, it also does not have any recourse against the consumer for nonpayment of a payment plan and therefore does not evaluate the creditworthiness of the individual consumer. If a consumer stops making payments on a payment plan or exercises the right to voluntarily cancel the service contract, the service contract seller and administrator are each obligated to refund to Mepco the amount necessary to make Mepco whole as a result of its funding of the service contract. In addition, the insurer or risk retention group that issued the CLIP for the service contract often guarantees all or a portion of the refund to Mepco. See Note #4 above for a breakdown of Mepco’s payment plan receivables by the level of recourse Mepco has against various counterparties.

Upon the cancellation of a service contract and the completion of the billing process to the counterparties for amounts due to Mepco, there is a decrease in the amount of “payment plan receivables” and an increase in the amount of “vehicle service contract counterparty receivables” until such time as the amount due from the counterparty is collected. These amounts represent funds actually due to Mepco from its counterparties for cancelled service contracts. At September 30, 2013, the aggregate amount of such obligations owing to Mepco by counterparties, net of write-downs and reserves made through the recognition of vehicle service contract counterparty contingencies expense, totaled $9.8 million. This compares to a balance of $18.4 million at December 31, 2012.  Mepco is currently in the process of working to recover these receivables, including through liquidation of collateral and litigation against counterparties.

In some cases, Mepco requires collateral or guaranties by the principals of the counterparties to secure these refund obligations; however, this is generally only the case when no rated insurance company is involved to guarantee the repayment obligation of the seller and administrator counterparties. In most cases, there is no collateral to secure the counterparties’ refund obligations to Mepco, but Mepco has the contractual right to offset unpaid refund obligations against amounts Mepco would otherwise be obligated to fund to the counterparties. In addition, even when collateral is involved, the refund obligations of these counterparties are not fully secured. Mepco incurs losses when it is unable to fully recover funds owing to it by counterparties upon cancellation of the underlying service contracts. The sudden failure of one of Mepco’s major counterparties (an insurance company, administrator, or seller/dealer) could expose us to significant losses.

When counterparties do not honor their contractual obligations to Mepco to repay advanced funds, we recognize estimated losses. Mepco pursues collection (including commencing legal action if necessary) of funds due to it under its various contracts with counterparties.  Mepco has had to initiate litigation against certain counterparties, including one of the third party insurers, to collect amounts owed to Mepco as a result of those parties' dispute of their contractual obligations to Mepco.  Charges related to estimated losses for vehicle service contract counterparty contingencies included in non-interest expenses were $0.1 million and $0.3 million for the three months ended September 30, 2013 and 2012, respectively and $3.4 million and $1.1 million for the nine months ended September 30, 2013 and 2012, respectively.  The significant increase in this expense in 2013 is due to write-downs of vehicle service contract counterparty receivables in the second quarter of 2013.  We reached tentative settlements in certain litigation to collect these receivables.  Given the costs and uncertainty of continued litigation, we determined it was in our best interest to resolve these matters.  These charges are being classified in non-interest expense because they are associated with a default or potential default of a contractual obligation under our counterparty contracts as opposed to loss on the administration of the payment plan itself.
60

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Our estimate of probable incurred losses from vehicle service contract counterparty contingencies requires a significant amount of judgment because a number of factors can influence the amount of loss that we may ultimately incur. These factors include our estimate of future cancellations of vehicle service contracts, our evaluation of collateral that may be available to recover funds due from our counterparties, and our assessment of the amount that may ultimately be collected from counterparties in connection with their contractual obligations.  We apply a rigorous process, based upon historical payment plan activity and past experience, to estimate probable incurred losses and quantify the necessary reserves for our vehicle service contract counterparty contingencies, but there can be no assurance that our modeling process will successfully identify all such losses.

We believe our assumptions regarding the collection of vehicle service contract counterparty receivables are reasonable, and we based them on our good faith judgments using data currently available. We also believe the current amount of reserves we have established and the vehicle service contract counterparty contingencies expense that we have recorded are appropriate given our estimate of probable incurred losses at the applicable Condensed Consolidated Statement of Financial Condition date. However, because of the uncertainty surrounding the numerous and complex assumptions made, actual losses could exceed the charges we have taken to date.

We have established a reserve (which totaled $3.5 million and $1.4 million at September 30, 2013 and December 31, 2012, respectively) for loss reimbursements on sold mortgage loans. This reserve is included in accrued expenses and other liabilities in our Condensed Consolidated Statements of Financial Condition. This reserve is based on an analysis of mortgage loans that we have sold which are further categorized by delinquency status, loan to value, and year of origination. The calculation includes factors such as probability of default, probability of loss reimbursement (breach of representation or warranty) and estimated loss severity. While we believe that the amounts we have accrued for incurred losses on sold loans are appropriate given these analyses, future losses could exceed our current estimate.
61

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The provision for loss reimbursement on sold loans represents our estimate of incurred losses related to mortgage loans that we have sold to investors (primarily Fannie Mae and Freddie Mac). Since we sell mortgage loans without recourse, loss reimbursements only occur in those instances where we have breached a representation or warranty or other contractual requirement related to the loan sale. Historically, loss reimbursements on mortgage loans sold without recourse were very rare. In 2009, we had only one actual loss reimbursement (for $0.06 million). Prior to 2009, we had years in which we incurred no such loss reimbursements. However, our loss reimbursements increased to $0.2 million in 2010 and to $0.5 million and $1.2 million in 2011 and 2012, respectively, as over the past two years Fannie Mae and Freddie Mac, in particular, have been doing more reviews of mortgage loans where they have incurred or expect to incur a loss and have been more aggressive in pursuing loss reimbursements from the sellers of such mortgage loans.  Actual loss reimbursements in the third quarter and first nine months of 2013 totaled $0.1 million and $0.4 million, respectively. Although we are successful in the vast majority of cases where file reviews are conducted on mortgage loans that we have sold to investors and actual loss reimbursements have remained relatively modest, the levels of such file reviews and loss reimbursement requests have increased.  Further, in October 2013 we reached an agreement in principle (the “Resolution Agreement”) to resolve our existing and future repurchase and make whole obligations (collectively “Repurchase Obligations”) related to mortgage loans originated between January 1, 2000 and December 31, 2008 and delivered to Fannie Mae by January 31, 2009.  The terms of the Resolution Agreement are subject to final approval by Fannie Mae.  Under the proposed terms of the Resolution Agreement, we will pay Fannie Mae approximately $1.6 million with respect to the Repurchase Obligations, subject to reconciliation and adjustment.  This amount is included in our total reserve at September 30, 2013.  We believe that it is in our best interest to execute the Resolution Agreement in order to bring finality to the loss reimbursement exposure with Fannie Mae for these years and reduce the resources spent on individual file reviews and defending loss reimbursement requests.

15. Shareholders’ Equity

On April 2, 2010, we entered into an Exchange Agreement with the UST pursuant to which the UST agreed to exchange all 72,000 shares of our Series A Fixed Rate Cumulative Perpetual Preferred Stock, with an original liquidation preference of $1,000 per share (“Series A Preferred Stock”), beneficially owned and held by the UST, plus accrued and unpaid dividends on such Series A Preferred Stock, for shares of our Series B Preferred Stock. As part of the terms of the Exchange Agreement, we also agreed to amend and restate the terms of the warrant, dated December 12, 2008, issued to the UST to purchase 346,154 shares of our common stock.

On April 16, 2010, we closed the transactions described in the Exchange Agreement and we issued to the UST: (1) 74,426 shares of our Series B Preferred Stock and (2) the Amended Warrant.  These securities were issued in exchange for all of the 72,000 shares of Series A Preferred Stock and the original warrant that had been issued to the UST in December 2008 pursuant to the TARP Capital Purchase Program, plus approximately $2.4 million in accrued dividends on such Series A Preferred Stock.

With the exception of being convertible into shares of our common stock, the terms of the Series B Preferred Stock were substantially similar to the terms of the Series A Preferred Stock that was exchanged. The Series B Preferred Stock qualified as Tier 1 regulatory capital and paid cumulative dividends quarterly at a rate of 5% per annum.
62

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

On July 26, 2013 we executed a Securities Purchase Agreement (“SPA”) with the UST.  Under the terms of the SPA, we agreed to purchase from the UST for $81.0 million in cash consideration:  (i) 74,426 shares of our Series B Preferred Stock, including any and all accrued and unpaid dividends; and (ii) the Amended Warrant.  On August 30, 2013 we closed the SPA transaction with the UST and we exited TARP.  On that date the Series B Preferred Stock and Amended Warrant had book balances of $87.2 million (including accrued dividends) and $1.5 million, respectively. This transaction resulted in a discount of $7.7 million of which $7.6 million was allocated to the Series B Preferred Stock and included in net income applicable to common stock and $0.1 million was allocated to the Amended Warrant and recorded to common stock.

On August 28, 2013 we sold 11.5 million shares of our common stock for gross proceeds of $89.1 million in a public offering and on September 10, 2013 we sold an additional 1.725 million shares of our common stock for gross proceeds of $13.4 million pursuant to the underwriters’ overallotment option (collectively, the “Common Stock Offering”).  The net proceeds from the Common Stock Offering were approximately $97.1 million.

On July 7, 2010 we executed an Investment Agreement and Registration Rights Agreement with Dutchess Opportunity Fund, II, LP (“Dutchess”) for the sale of shares of our common stock. These agreements served to establish an equity line facility as a contingent source of liquidity at the parent company level. Pursuant to the Investment Agreement, Dutchess committed to purchase up to $15.0 million of our common stock over a 36-month period ending November 1, 2013. We had the right, but no obligation, to draw on this equity line facility from time to time during such 36-month period by selling shares of our common stock to Dutchess. The sales price was at a 5% discount to the market price of our common stock at the time of the draw (as such market price was determined pursuant to the terms of the Investment Agreement).  Through September 30, 2013, we had sold a total of 1.40 million shares (zero shares during the second and third quarters of 2013, 0.17 million shares during the first quarter of 2013, 0.45 million shares during 2012, 0.43 million shares during 2011 and 0.35 million shares during 2010) of our common stock to Dutchess under this equity line for total net proceeds of approximately $4.2 million ($0.9 million and $0.6 million of these total net proceeds were received during the nine months ending September 30, 2013 and 2012, respectively).  Given the existing cash levels and our forecasted future cash needs at the parent company along with our expectation that the Bank will be able to transfer funds to the parent company at a future date, we determined to not renew this equity line facility on November 1, 2013.

On November 15, 2011, we entered into a Tax Benefits Preservation Plan (the "Preservation Plan") with our stock transfer agent, American Stock Transfer & Trust Company. Our Board of Directors adopted the Preservation Plan in an effort to protect the value to our shareholders of our ability to use deferred tax assets such as net operating loss carry forwards to reduce potential future federal income tax obligations. Under federal tax rules, this value could be lost in the event we experienced an "ownership change," as defined in Section 382 of the federal Internal Revenue Code. The Preservation Plan attempts to protect this value by reducing the likelihood that we will experience such an ownership change by discouraging any person who is not already a 5% shareholder from becoming a 5% shareholder (with certain limited exceptions).
63

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

On November 15, 2011, our Board of Directors declared a dividend of one preferred share purchase right (a "Right") for each outstanding share of our common stock under the terms of the Preservation Plan. The dividend is payable to the holders of common stock outstanding as of the close of business on November 15, 2011 or outstanding at any time thereafter but before the earlier of a "Distribution Date" and the date the Preservation Plan terminates. Each Right entitles the registered holder to purchase from us 1/1000 of a share of our Series C Junior Participating Preferred Stock, no par value per share ("Series C Preferred Stock"). Each 1/1000 of a share of Series C Preferred Stock has economic and voting terms similar to those of one whole share of common stock. The Rights are not exercisable and generally do not become exercisable until a person or group has acquired, subject to certain exceptions and conditions, beneficial ownership of 4.99% or more of the outstanding shares of common stock. At that time, each Right will generally entitle its holder to purchase securities of the Company at a discount of 50% to the current market price of the common stock. However, the Rights owned by the person acquiring beneficial ownership of 4.99% or more of the outstanding shares of common stock would automatically be void. The significant dilution that would result is expected to deter any person from acquiring beneficial ownership of 4.99% or more and thereby triggering the Rights.

To date, none of the Rights have been exercised or have become exercisable because no unpermitted 4.99% or more change in the beneficial ownership of the outstanding common stock has occurred. The Rights will generally expire on the earlier to occur of the close of business on November 15, 2016 and certain other events described in the Preservation Plan, including such date as our Board of Directors determines that the Preservation Plan is no longer necessary for its intended purposes.
64

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

16. Accumulated Other Comprehensive Loss

A summary of changes in AOCL follows (1):

 
 
   
Dispropor-
   
   
   
   
 
 
 
   
tionate
   
   
   
Dispropor-
   
 
 
 
Unrealized
   
Tax Effects
   
   
   
tionate
   
 
 
 
Losses on
   
from
   
Unrealized
   
Unrealized
   
Tax Effects
   
 
 
 
Available
   
Securities
   
Losses on
   
Losses on
   
from Cash
   
 
 
 
for Sale
   
Available
   
Cash Flow
   
Settled
   
Flow
   
 
 
 
Securities
   
for Sale
   
Hedges
   
Derivatives
   
Hedges
   
Total
 
For the three months ended September 30,  
2013
(In thousands)
Balances at beginning of period
 
$
(1,102
)
 
$
(5,798
)
 
$
-
   
$
(370
)
 
$
-
   
$
(7,270
)
Other comprehensive income (loss) before reclassifications
   
(1,962
)
   
-
     
-
     
-
     
-
     
(1,962
)
Amounts reclassified from AOCL
   
-
     
-
     
-
     
62
     
-
     
62
 
Net current period other comprehensive income (loss)
   
(1,962
)
   
-
     
-
     
62
     
-
     
(1,900
)
Balances at end of period
 
$
(3,064
)
 
$
(5,798
)
 
$
-
   
$
(308
)
 
$
-
   
$
(9,170
)
2012
                                               
Balances at beginning of period
 
$
(2,193
)
 
$
(5,617
)
 
$
(873
)
 
$
(145
)
 
$
(1,186
)
 
$
(10,014
)
Other comprehensive income (loss) before reclassifications
   
1,679
     
-
     
(54
)
   
-
     
-
     
1,625
 
Amounts reclassified from AOCL
   
(280
)
   
-
     
92
     
145
     
-
     
(43
)
Net current period other comprehensive income (loss)
   
1,399
     
-
     
38
     
145
     
-
     
1,582
 
Balances at end of period
 
$
(794
)
 
$
(5,617
)
 
$
(835
)
 
$
-
   
$
(1,186
)
 
$
(8,432
)
For the nine months ended September 30,
2013
                                               
Balances at beginning of period
 
$
(516
)
 
$
(5,617
)
 
$
(739
)
 
$
-
   
$
(1,186
)
 
$
(8,058
)
Income tax
   
181
     
(181
)
   
258
     
-
     
(258
)
   
-
 
Balances at beginning of period, net of tax
   
(335
)
   
(5,798
)
   
(481
)
   
-
     
(1,444
)
   
(8,058
)
Terminated cash flow hedge
   
-
     
-
     
370
     
(370
)
   
-
     
-
 
Other comprehensive income (loss) before reclassifications
   
(2,741
)
   
-
     
(24
)
   
-
     
-
     
(2,765
)
Amounts reclassified from AOCL
   
12
     
-
     
135
     
62
     
1,444
     
1,653
 
Net current period other comprehensive income (loss)
   
(2,729
)
   
-
     
111
     
62
     
1,444
     
(1,112
)
Balances at end of period
 
$
(3,064
)
 
$
(5,798
)
 
$
-
   
$
(308
)
 
$
-
   
$
(9,170
)
 
                                               
2012
                                               
Balances at beginning of period
 
$
(3,579
)
 
$
(5,617
)
 
$
(1,103
)
 
$
(436
)
 
$
(1,186
)
 
$
(11,921
)
Other comprehensive income (loss) before reclassifications
   
3,646
     
-
     
(129
)
   
-
     
-
     
3,517
 
Amounts reclassified from AOCL
   
(861
)
   
-
     
397
     
436
     
-
     
(28
)
Net current period other comprehensive income (loss)
   
2,785
     
-
     
268
     
436
     
-
     
3,489
 
Balances at end of period
 
$
(794
)
 
$
(5,617
)
 
$
(835
)
 
$
-
   
$
(1,186
)
 
$
(8,432
)
 
(1)
2013 amounts are presented net of tax as we removed substantially all of the valuation allowance on our deferred tax assets during the second quarter of 2013 (see Note #10).
65

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The disproportionate tax effects from securities available for sale and cash flow hedges arose due to tax effects of other comprehensive income (“OCI”) in the presence of a valuation allowance against our deferred tax assets and a pretax loss from operations.  Generally, the amount of income tax expense or benefit allocated to operations is determined without regard to the tax effects of other categories of income or loss, such as OCI. However, an exception to the general rule is provided when, in the presence of a valuation allowance against deferred tax assets, there is a pretax loss from operations and pretax income from other categories in the current period.  In such instances, income from other categories must offset the current loss from operations, the tax benefit of such offset being reflected in operations.  During the second quarter of 2013, we terminated our last remaining cash flow hedge and cleared the disproportionate tax effects relating to cash flow hedges from accumulated other comprehensive income (see Note #10).
66

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

A summary of reclassifications out of each component of AOCL for the three months ended September 30 follows:

 
 
Amount
 
 
 
 
Reclassified
 
 
 
 
From
 
 Affected Line Item in Condensed
AOCL Component
 
AOCL
 
 Consolidated Statements of Operations
 
 
(In thousands)
 
 
2013
 
 
  
Unrealized losses on available for sale securities
 
$
-
 
 Net gains on securities
 
   
-
 
 Net impairment loss recognized in earnings
 
   
-
 
 Total reclassifications before tax
 
   
-
 
 Tax expense (benefit)
 
 
$
-
 
 Reclassifications, net of tax
 
       
   
Unrealized losses on cash flow hedges
 
$
-
 
 Interest expense
 
   
-
 
 Tax expense (benefit)
 
 
$
-
 
 Reclassification, net of tax
 
       
   
Unrealized losses on settled derivatives
 
$
(95
)
 Interest expense
 
   
(33
)
 Tax expense (benefit)
 
   
(62
)
 Reclassification, net of tax
 
       
   
Disproportionate tax effects from cash flow hedges
 
$
-
 
 Tax expense (benefit)
 
       
   
 
 
$
(62
)
 Total reclassifications for the period, net of tax
2012
       
  
Unrealized losses on available for sale securities
 
$
350
 
 Net gains on securities
 
   
(70
)
 Net impairment loss recognized in earnings
 
   
280
 
 Total reclassifications before tax
 
   
-
 
 Tax expense (benefit)
 
 
$
280
 
 Reclassifications, net of tax
 
       
   
Unrealized losses on cash flow hedges
 
$
(92
)
 Interest expense
 
   
-
 
 Tax expense (benefit)
 
   
(92
)
 Reclassification, net of tax
 
       
   
Unrealized losses on settled derivatives
 
$
(145
)
 Interest expense
 
   
-
 
 Tax expense (benefit)
 
   
(145
)
 Reclassification, net of tax
 
       
   
 
 
$
43
 
 Total reclassifications for the period, net of tax

67

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

A summary of reclassifications out of each component of AOCL for the nine months ended September 30 follows:

 
 
Amount
 
 
 
 
Reclassified
 
 
 
 
From
 
 Affected Line Item in Condensed
AOCL Component
 
AOCL
 
 Consolidated Statements of Operations
 
 
(In thousands)
 
 
2013
 
 
  
Unrealized losses on available for sale securities
 
$
8
 
Net gains on securities
 
   
(26
)
Net impairment loss recognized in earnings
 
   
(18
)
Total reclassifications before tax
 
   
(6
)
Tax expense (benefit)
 
 
$
(12
)
Reclassifications, net of tax
 
       
   
Unrealized losses on cash flow hedges
 
$
(208
)
Interest expense
 
   
(73
)
Tax expense (benefit)
 
 
$
(135
)
Reclassification, net of tax
 
       
  
Unrealized losses on settled derivatives
 
$
(95
)
Interest expense
 
   
(33
)
Tax expense (benefit)
 
   
(62
)
Reclassification, net of tax
 
       
   
Disproportionate tax effects from cash flow hedges
 
$
1,444
 
Tax expense (benefit)
 
       
  
 
 
$
(1,653
)
Total reclassifications for the period, net of tax
 
2012
       
  
Unrealized losses on available for sale securities
 
$
1,193
 
Net gains on securities
 
   
(332
)
Net impairment loss recognized in earnings
 
   
861
 
Total reclassifications before tax
 
   
-
 
Tax expense (benefit)
 
 
$
861
 
Reclassifications, net of tax
       
  
Unrealized losses on cash flow hedges
 
$
(397
)
Interest expense
 
   
-
 
Tax expense (benefit)
 
   
(397
)
Reclassification, net of tax
 
       
   
Unrealized losses on settled derivatives
 
$
(436
)
Interest expense
 
   
-
 
Tax expense (benefit)
 
   
(436
)
Reclassification, net of tax
 
       
   
 
 
$
28
 
Total reclassifications for the period, net of tax

68

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following section presents additional information that may be necessary to assess our financial condition and results of operations.  This section should be read in conjunction with our condensed consolidated financial statements contained elsewhere in this report as well as our 2012 Annual Report on Form 10-K.  The Form 10-K includes a list of risk factors that you should consider in connection with any decision to buy or sell our securities.

Introduction. Our success depends to a great extent upon the economic conditions in Michigan’s Lower Peninsula. We have in general experienced a difficult economy in Michigan since 2001, although economic conditions in the state began to show signs of improvement during 2010 and generally these improvements have continued into 2013, albeit at a slower pace, as evidenced, in part, by an overall decline in the unemployment rate. However, Michigan’s unemployment rate has been consistently above the national average.

We provide banking services to customers located primarily in Michigan’s Lower Peninsula. Our loan portfolio, the ability of the borrowers to repay these loans and the value of the collateral securing these loans has been and will be impacted by local economic conditions. The weaker economic conditions faced in Michigan have had and may continue to have adverse consequences as described below in “Portfolio Loans and asset quality.” However, since early- to mid-2009, we have generally seen an improvement in asset quality metrics.  In particular, since early 2012, we have experienced a decline in non-performing assets, reduced levels of new loan defaults and reduced levels of net loan charge-offs.  These factors have resulted in a more significant decline in the provision for loan losses over the past few quarters.  Additionally, housing prices and other related statistics (such as home sales and new building permits) have generally been improving.

In July 2010, Congress passed and the President signed into law the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the “Dodd-Frank Act”). The Dodd-Frank Act included the creation of the Consumer Financial Protection Bureau with power to promulgate and enforce consumer protection laws; the creation of the Financial Stability Oversight Council chaired by the Secretary of the Treasury with authority to identify institutions and practices that might pose a systemic risk; provisions affecting corporate governance and executive compensation of all companies whose securities are registered with the SEC; a provision that broadened the base for Federal Deposit Insurance Corporation (“FDIC”) insurance assessments; a provision under which interchange fees for debit cards are set by the Federal Reserve under a restrictive “reasonable and proportional cost” per transaction standard; a provision that requires bank regulators to set minimum capital levels for bank holding companies that are as strong as those required for their insured depository subsidiaries, subject to a grandfather clause for financial institutions with less than $15 billion in assets as of December 31, 2009; and new restrictions on how mortgage brokers and loan originators may be compensated. Certain provisions of the Dodd-Frank Act only apply to institutions with more than $10 billion in assets. The Dodd-Frank Act has had (and we expect it will continue to have) a significant impact on the banking industry, including our organization.
69

On May 23, 2012 we executed a definitive agreement to sell 21 branches to another financial institution (the “Branch Sale”).  The branches sold included six branch locations in the Battle Creek, Michigan market area and 15 branch locations in Northeast Michigan.  The Branch Sale closed on December 7, 2012 and resulted in the transfer of approximately $403.1 million of deposits in exchange for our receipt of a deposit premium of approximately $11.5 million.  We also sold approximately $48.0 million of loans at a discount of 1.75% and premises and equipment totaling approximately $8.1 million.  The Branch Sale also resulted in our transfer of $336.1 million of cash to the purchaser.  We recorded a net gain on the Branch Sale of approximately $5.4 million in the fourth quarter of 2012.

In addition to the Branch Sale, we have closed or consolidated a total of 15 other branch locations since 2011.
 
On July 2, 2013, the Federal Reserve Board approved a final rule that establishes an integrated regulatory capital framework (the “New Capital Rules”). The rule will implement in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act.
 
In general, under the New Capital Rules, minimum requirements will increase for both the quantity and quality of capital held by banking organizations. Consistent with the international Basel framework, the New Capital Rules include a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5% and a common equity tier 1 capital conservation buffer of 2.5% of risk-weighted assets that will apply to all supervised financial institutions. The rule also raises the minimum ratio of tier 1 capital to risk-weighted assets from 4% to 6% and includes a minimum leverage ratio of 4% for all banking organizations.  As to the quality of capital, the New Capital Rules emphasize common equity tier 1 capital, the most loss-absorbing form of capital, and implements strict eligibility criteria for regulatory capital instruments. The New Capital Rules also change the methodology for calculating risk-weighted assets to enhance risk sensitivity.
 
We are subject to the New Capital Rules beginning on January 1, 2015.  The 2.5% capital conservation buffer is being phased in over a four-year period beginning in 2016.  Also, under the New Capital Rules our existing trust preferred securities are grandfathered as qualifying regulatory capital.  We believe that we currently exceed all of the capital ratio requirements of the New Capital Rules.

On July 26, 2013 we executed a Securities Purchase Agreement (“SPA”) with the United States Department of the Treasury (“UST”).  Under the terms of the SPA, we agreed to purchase from the UST for $81.0 million in cash consideration:  (i) 74,426 shares of our Series B Fixed Rate Cumulative Mandatorily Convertible Preferred Stock, with an original liquidation preference of $1,000 per share (“Series B Preferred Stock”), including any and all accrued and unpaid dividends; and (ii) the Amended and Restated Warrant to purchase up to 346,154 shares of our common stock at an exercise price of $7.234 per share and expiring on December 12, 2018 (the “Amended Warrant”).
 
We completed the following transactions during the third quarter relative to our capital plan initiatives:
 
· On August 28, 2013 we sold 11.5 million shares of our common stock for gross proceeds of $89.1 million in a public offering and on September 10, 2013 we sold an additional 1.725 million shares of our common stock for gross proceeds of $13.4 million pursuant to the underwriters’ overallotment option (collectively, the “Common Stock Offering”).  The net proceeds from the Common Stock Offering were approximately $97.1 million.
70

· On August 29, 2013 we brought current the interest payments that we had previously been deferring (since the fourth quarter of 2009) on all of our subordinated debentures which permitted the resumption of interest payments on the trust preferred securities issued by IBC Capital Finance II, III, and IV and Midwest Guaranty Trust I.
 
· On August 30, 2013 we closed the SPA transaction with the UST and we exited the Troubled Asset Relief Program (TARP).
 
· On September 11, 2013 we announced that we would redeem all of the 8.25% trust preferred securities ($9.2 million) issued by IBC Capital Finance II.  This redemption occurred on October 11, 2013 and will reduce our annual interest expense by approximately $0.8 million.
 
It is against this backdrop that we discuss our results of operations for the third quarter and first nine months of 2013 as compared to 2012 and our financial condition as of September 30, 2013.

RESULTS OF OPERATIONS

Summary.  We recorded net income of $3.5 million and $6.4 million, respectively, and net income applicable to common stock of $10.3 million and $5.4 million, respectively, during the three months ended September 30, 2013 and 2012.  The decline in net income on a comparative quarterly basis is due primarily to decreases in net interest income and non-interest income that were partially offset by decreases in the provision for loan losses and non-interest expenses.  Third quarter 2013 net income applicable to common stock included a $7.6 million benefit from the redemption of our Series B Preferred Stock at a discount.

We recorded net income of $72.7 million and $14.3 million, respectively, and net income applicable to common stock of $77.3 million and $11.0 million, respectively, during the nine months ended September 30, 2013 and 2012.  The significant improvement in 2013 year-to-date results as compared to 2012 primarily reflects the income tax benefit associated with the reversal of substantially all of the valuation allowance on our deferred tax assets (see “Income tax benefit.”) and decreases in the provision for loan losses and in non-interest expenses, which were partially offset by a decreases in net interest income and non-interest income.
71

Key performance ratios
 
 
 
Three months ended
   
Nine months ended
 
 
 
September 30,
   
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
Net income (annualized) to(1)(2)
 
   
   
   
 
Average assets
   
1.90
%
   
0.89
%
   
4.93
%
   
0.62
%
Average common shareholders’ equity
   
25.64
     
62.71
     
110.70
     
52.38
 
 
                               
Net income per common share(1)
                               
Basic
 
$
0.73
   
$
0.61
   
$
7.03
   
$
1.28
 
Diluted
   
0.17
     
0.16
     
3.40
     
0.36
 
 
(1) These amounts are calculated using net income applicable to common stock.
(2) Income before tax less preferred stock dividends and discount accretion (annualized) to average assets and average common shareholders’ equity were 0.86% and 19.38% for the nine months ended September 30, 2013, respectively.

Net interest income.  Net interest income is the most important source of our earnings and thus is critical in evaluating our results of operations. Changes in our net interest income are primarily influenced by our level of interest-earning assets and the income or yield that we earn on those assets and the manner and cost of funding our interest-earning assets. Certain macro-economic factors can also influence our net interest income such as the level and direction of interest rates, the difference between short-term and long-term interest rates (the steepness of the yield curve) and the general strength of the economies in which we are doing business. Finally, risk management plays an important role in our level of net interest income. The ineffective management of credit risk and interest-rate risk in particular can adversely impact our net interest income.

Our net interest income totaled $19.5 million during the third quarter of 2013, a decrease of $1.9 million, or 9.0% from the year-ago period.  The decrease in net interest income in 2013 compared to 2012 primarily reflects a $267.4 million decrease in average interest-earning assets that was partially offset by a 15 basis point increase in our tax equivalent net interest income as a percent of average interest-earning assets (the “net interest margin”).  The decline in average interest-earning assets is a result of the Branch Sale.  Our net interest margin was 4.10% during the third quarter of 2013, compared to 3.95% in the year-ago period.  The increase in the net interest margin is due primarily to a reduction in our cost of funds.

Interest rates have generally been at extremely low levels over the past four to five years due primarily to the Federal Reserve’s monetary policies and its efforts to stimulate the U.S. economy.  This very low interest rate environment has had an adverse impact on our interest income and net interest income.   Based on recent announcements by the Federal Reserve, short-term interest rates are expected to remain extremely low until late-2014 or early-2015 (until the U.S. unemployment rate declines to approximately 6.5%).  However, during the second and third quarters of 2013, mid- to long-term interest rates began to increase (for example the ten year U.S. treasury yield increased from 1.87% at the end of the first quarter of 2013 to 2.64% at the end of the third quarter of 2013).  Given the repricing characteristics of our interest-earning assets and interest-bearing liabilities (and our level of non-interest bearing demand deposits), our net interest margin will generally benefit on a long-term basis from rising interest rates.
72

For the first nine months of 2013, net interest income totaled $58.6 million, a decrease of $6.8 million, or 10.4% from 2012.  The Company’s net interest margin for the first nine months of 2013 increased to 4.17% compared to 4.06% in 2012.  The reasons for the decline in net interest income for the first nine months of 2013 are generally consistent with those described above for the comparative quarterly periods.

Our net interest income is also adversely impacted by our level of non-accrual loans.  In the third quarter and first nine months of 2013 non-accrual loans averaged $20.5 million and $25.4 million, respectively compared to $41.7 million and $48.5 million, respectively for the same periods in 2012.  In addition, in the third quarter and first nine months of 2013 we had net recoveries of $0.2 million and $0.4 million, respectively, of accrued and unpaid interest on loans placed on or taken off non-accrual during each period compared to net recoveries of $0.2 million and $0.2 million, respectively, during the same periods in 2012.
 
Average Balances and Tax Equivalent Rates
 
 
 
Three Months Ended September 30,
 
 
 
2013
   
2012
 
 
 
Average
Balance
   
 
Interest
   
 
Rate(3)
   
Average
Balance
   
 
Interest
   
 
Rate(3)
 
Assets (1)
 
(Dollars in thousands)
 
Taxable loans
 
$
1,396,709
   
$
20,027
     
5.70
%
 
$
1,532,773
   
$
23,312
     
6.06
%
Tax-exempt loans (2)
   
5,321
     
86
     
6.41
     
6,709
     
111
     
6.58
 
Taxable securities
   
337,299
     
1,109
     
1.30
     
217,427
     
655
     
1.20
 
Tax-exempt securities (2)
   
35,242
     
433
     
4.87
     
26,116
     
398
     
6.06
 
Cash – interest bearing
   
117,971
     
68
     
0.23
     
377,899
     
243
     
0.26
 
Other investments
   
21,496
     
242
     
4.47
     
20,494
     
189
     
3.67
 
Interest Earning Assets
   
1,914,038
     
21,965
     
4.57
     
2,181,418
     
24,908
     
4.55
 
Cash and due from banks
   
46,069
                     
56,289
                 
Other assets, net
   
188,705
                     
161,971
                 
Total Assets
 
$
2,148,812
                   
$
2,399,678
                 
 
                                               
Liabilities
                                               
Savings and interest-bearing checking
 
$
910,422
     
294
     
0.13
   
$
1,079,389
     
494
     
0.18
 
Time deposits
   
415,090
     
1,077
     
1.03
     
549,319
     
1,729
     
1.25
 
Other borrowings
   
67,578
     
884
     
5.19
     
67,994
     
1,059
     
6.20
 
Interest Bearing Liabilities
   
1,393,090
     
2,255
     
0.64
     
1,696,702
     
3,282
     
0.77
 
Non-interest bearing deposits
   
502,357
                     
545,945
                 
Other liabilities
   
37,143
                     
40,477
                 
Shareholders’ equity
   
216,222
                     
116,554
                 
Total liabilities and shareholders’ equity
 
$
2,148,812
                   
$
2,399,678
                 
 
                                               
Net Interest Income
         
$
19,710
               
$
21,626
         
 
                                               
Net Interest Income as a Percent of Average Interest Earning Assets
                   
4.10
%
               
3.95
%
 
(1) All domestic.
(2) Interest on tax-exempt loans and securities is presented on a fully tax equivalent basis assuming a marginal tax rate of 35%
(3) Annualized.
73

Average Balances and Tax Equivalent Rates
 
Nine Months Ended
 
September 30,
 
2013
2012
 
Average
Balance
 
Interest
 
Rate(3)
Average
Balance
 
Interest
 
Rate(3)
Assets (1)
 
(Dollars in thousands)
 
Taxable loans
 
$
1,415,545
   
$
60,919
     
5.75
%
 
$
1,557,164
   
$
71,209
     
6.11
%
Tax-exempt loans (2)
   
5,628
     
272
     
6.46
     
7,010
     
336
     
6.40
 
Taxable securities
   
274,002
     
2,772
     
1.35
     
221,245
     
2,246
     
1.36
 
Tax-exempt securities (2)
   
28,873
     
1,164
     
5.39
     
26,563
     
1,220
     
6.13
 
Cash – interest bearing
   
149,807
     
272
     
0.24
     
334,426
     
638
     
0.25
 
Other investments
   
21,274
     
694
     
4.36
     
20,628
     
572
     
3.70
 
  Interest Earning Assets
   
1,895,129
     
66,093
     
4.66
     
2,167,036
     
76,221
     
4.70
 
Cash and due from banks
   
44,866
                     
54,619
                 
Other assets, net
   
157,038
                     
163,058
                 
Total Assets
 
$
2,097,033
                   
$
2,384,713
                 
 
                                               
Liabilities
                                               
Savings and interest-bearing checking
 
$
906,046
     
864
     
0.13
   
$
1,071,169
     
1,452
     
0.18
 
Time deposits
   
418,193
     
3,499
     
1.12
     
565,731
     
5,500
     
1.30
 
Other borrowings
   
67,716
     
2,625
     
5.18
     
73,714
     
3,351
     
6.07
 
Interest Bearing Liabilities
   
1,391,955
     
6,988
     
0.67
     
1,710,614
     
10,303
     
0.80
 
Non-interest bearing deposits
   
496,777
                     
524,615
                 
Other liabilities
   
39,292
                     
39,810
                 
Shareholders’ equity
   
169,009
                     
109,674
                 
Total liabilities and shareholders’ equity
 
$
2,097,033
                   
$
2,384,713
                 
 
                                               
Net Interest Income
         
$
59,105
                   
$
65,918
         
 
                                               
Net Interest Income as a Percent
of Average Interest Earning Assets
                   
4.17
%
                   
4.06
%
 
(1) All domestic.
(2) Interest on tax-exempt loans and securities is presented on a fully tax equivalent basis assuming a marginal tax rate of 35%
(3) Annualized.

Provision for loan losses.  The provision for loan losses was a credit of $0.4 million and an expense of $0.3 million during the three months ended September 30, 2013 and 2012, respectively. During the nine-month periods ended September 30, 2013 and 2012, the provision was a credit of $3.2 million and an expense of $6.4 million, respectively. The provision reflects our assessment of the allowance for loan losses taking into consideration factors such as loan mix, levels of non-performing and classified loans and loan net charge-offs.  While we use relevant information to recognize losses on loans, additional provisions for related losses may be necessary based on changes in economic conditions, customer circumstances and other credit risk factors.  The decrease in the provision for loan losses in the third quarter and first nine months of 2013 primarily reflects reduced levels of non-performing loans, lower total loan balances and a decline in loan net charge-offs.  See “Portfolio Loans and asset quality” for a discussion of the various components of the allowance for loan losses and their impact on the provision for loan losses in the third quarter and first nine months of 2013.
74

Non-interest income.  Non-interest income is a significant element in assessing our results of operations. We regard net gains on mortgage loans as a core recurring source of revenue but they are quite cyclical and thus can be volatile. We regard net gains (losses) on securities as a “non-operating” component of non-interest income.

Non-interest income totaled $9.8 million during the three months ended September 30, 2013, a decrease of $4.7 million from the comparable period in 2012.  For the first nine months of 2013 non-interest income totaled $33.9 million, an $8.3 million decrease from the comparable period in 2012.  These declines are primarily due to decreases in service charges on deposit accounts, interchange income, net gains on mortgage loans, net gains on securities, and in other non-interest income that were partially offset by an increase in mortgage loan servicing income.
 
Non-Interest Income
 
   
 
 
 
Three months ended
September 30,
   
Nine months ended
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
 
 
(In thousands)
 
Service charges on deposit accounts
 
$
3,614
   
$
4,739
   
$
10,603
   
$
13,492
 
Interchange income
   
1,852
     
2,324
     
5,542
     
7,053
 
Net gains (losses) on assets:
                               
Mortgage loans
   
1,570
     
4,602
     
8,415
     
12,041
 
Securities
   
14
     
301
     
205
     
1,154
 
Other than temporary loss on securities available for sale:
                               
Total impairment loss
   
-
     
(70
)
   
(26
)
   
(332
)
Recognized in other comprehensive loss
   
-
     
-
     
-
     
-
 
Net impairment loss in earnings
   
-
     
(70
)
   
(26
)
   
(332
)
Mortgage loan servicing
   
338
     
(364
)
   
2,614
     
(716
)
Investment and insurance commissions
   
447
     
491
     
1,280
     
1,586
 
Bank owned life insurance
   
353
     
398
     
1,028
     
1,221
 
Title insurance fees
   
409
     
482
     
1,261
     
1,479
 
(Increase) decrease in fair value of U.S. Treasury warrant
   
-
     
(32
)
   
(1,025
)
   
(211
)
Other
   
1,240
     
1,671
     
4,019
     
5,401
 
      Total non-interest income
 
$
9,837
   
$
14,542
   
$
33,916
   
$
42,168
 
 
Service charges on deposit accounts declined on both a comparative quarterly and year-to-date basis in 2013 as compared to 2012.  The decrease in such service charges in 2013 principally results from the Branch Sale.  In addition, even after considering the Branch Sale, we have generally experienced a decline in non-sufficient funds (“NSF”) occurrences and related NSF fees. We believe the decline in NSF occurrences is principally due to our customers managing their finances more closely in order to reduce NSF activity and avoid the associated fees.
75

Interchange income declined on both a comparative quarterly and year-to-date basis in 2013 as compared to 2012.  The decrease in interchange income primarily results from the Branch Sale.  As described earlier, the Dodd-Frank Act includes a provision under which interchange fees for debit cards are set by the FRB under a restrictive “reasonable and proportional cost” per transaction standard. On June 29, 2011 the FRB issued final rules (that were effective October 1, 2011) on interchange fees for debit cards. Overall, these final rules established price caps for debit card interchange fees that were approximately 50% lower than previous averages. However, debit card issuers with less than $10 billion in assets (like us) are exempt from this rule. On a long-term basis, it is not clear how competitive market factors may impact debit card issuers who are exempt from the rule.  However, we have been experiencing some reduction in interchange income due to certain transaction routing changes, particularly at large merchants.

Net gains on mortgage loans decreased on both a quarterly and a year to date basis. Mortgage loan activity is summarized as follows:

Mortgage Loan Activity
 
 
 
Three months ended
   
Nine months ended
 
 
 
September 30,
   
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
 
 
(Dollars in thousands)
 
Mortgage loans originated
 
$
97,391
   
$
135,263
   
$
347,177
   
$
384,896
 
Mortgage loans sold
   
96,989
     
128,196
     
340,318
     
367,350
 
Mortgage loans sold with servicing rights released
   
16,017
     
21,942
     
46,250
     
59,837
 
Net gains on the sale of mortgage loans
   
1,570
     
4,602
     
8,415
     
12,041
 
Net gains as a percent of mortgage loans sold (“Loan Sales Margin”)
   
1.62
%
   
3.59
%
   
2.47
%
   
3.28
%
Fair value adjustments included in the Loan Sales Margin
   
(0.89
)
   
0.29
     
(0.58
)
   
0.45
 

The volume of loans sold is dependent upon our ability to originate mortgage loans as well as the demand for fixed-rate obligations and other loans that we choose to not put into portfolio because of our established interest-rate risk parameters. (See “Portfolio Loans and asset quality.”) Net gains on mortgage loans are also dependent upon economic and competitive factors as well as our ability to effectively manage exposure to changes in interest rates and thus can often be a volatile part of our overall revenues.  The declines in mortgage loan originations and sales in 2013 is due primarily to an increase in mortgage loan interest rates beginning in the second quarter that significantly reduced mortgage loan refinance volumes.

Net gains as a percentage of mortgage loans sold (our “Loan Sales Margin”) are impacted by several factors including competition and the manner in which the loan is sold (with servicing rights retained or released). Our decision to sell or retain mortgage loan servicing rights is primarily influenced by an evaluation of the price being paid for mortgage loan servicing by outside third parties compared to our calculation of the economic value of retaining such servicing. The sale of mortgage loan servicing rights may result in declines in mortgage loan servicing income in future periods. Net gains on mortgage loans are also impacted by recording fair value accounting adjustments. Excluding the aforementioned accounting adjustments, the Loan Sales Margin would have been 2.51% and 3.30% in the third quarters of 2013 and 2012, respectively and 3.05% and 2.83% for the comparative 2013 and 2012 year-to-date periods, respectively. The decrease in the Loan Sales Margin (excluding fair value adjustments) in the third quarter of 2013 was primarily due to a change in mix, with significantly fewer mortgage loan refinances (which generally have higher margins) as well as more competitive market conditions due to the industry-wide decline in mortgage loan origination volumes.  The changes in the fair value accounting adjustments are primarily due to changes in the amount of commitments to originate mortgage loans for sale.
76

Net securities gains totaled $0.014 million and $0.2 million during the three and nine months ended September 30, 2013, respectively, and $0.3 million and $1.2 million for the respective comparable periods in 2012.  The 2013 net securities gains were due primarily to an increase in the fair value of trading securities.  The 2012 net securities gains were due primarily to the sale of U.S. agency residential mortgage-backed investment securities.

We recorded net other than temporary impairment charges on securities available for sale of zero and $0.026 million during the three and nine months ended September 30, 2013, respectively, and $0.1 million and $0.3 million for the respective comparable periods in 2012.  These impairment charges all related to private label residential mortgage-backed investment securities.  (See “Securities.”)

Mortgage loan servicing generated income of $0.3 million and $2.6 million in the third quarter and first nine months of 2013, respectively, compared to a loss of $0.4 million and $0.7 million in the corresponding periods of 2012, respectively. These variances are primarily due to changes in the valuation allowance on and the amortization of capitalized mortgage loan servicing rights. The period end valuation allowance is based on the valuation of the mortgage loan servicing portfolio.  The recovery of previously recorded impairment charges in 2013 reflects higher mortgage loan interest rates during the year resulting in lower estimated future prepayment rates being used in the period end valuations.  The impairment charges incurred during 2012 primarily reflected lower mortgage loan interest rates during that period resulting in higher estimated future prepayment rates being used in the period end valuations.  Activity related to capitalized mortgage loan servicing rights is as follows:

Capitalized Mortgage Loan Servicing Rights
   
   
   
 
 
 
Three months ended
September 30,
   
Nine months ended
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
 
 
(In thousands)
 
Balance at beginning of period
 
$
13,037
   
$
10,651
   
$
11,013
   
$
11,229
 
Originated servicing rights capitalized
   
772
     
996
     
2,661
     
2,948
 
Amortization
   
(793
)
   
(1,052
)
   
(3,111
)
   
(3,351
)
(Increase)/decrease in impairment reserve
   
35
     
(390
)
   
2,488
     
(621
)
Balance at end of period
 
$
13,051
   
$
10,205
   
$
13,051
   
$
10,205
 
 
                               
Impairment reserve at end of period
 
$
3,599
   
$
7,165
   
$
3,599
   
$
7,165
 

At September 30, 2013 we were servicing approximately $1.74 billion in mortgage loans for others on which servicing rights have been capitalized. This servicing portfolio had a weighted average coupon rate of 4.54% and a weighted average service fee of approximately 25.4 basis points. Remaining capitalized mortgage loan servicing rights at September 30, 2013 totaled $13.1 million, representing approximately 75 basis points on the related amount of mortgage loans serviced for others. The capitalized mortgage loan servicing had an estimated fair market value of $14.0 million at September 30, 2013.
77

Investment and insurance commissions decreased on both a comparative quarterly and year-to-date basis in 2013 compared to 2012. These decreases primarily reflect the impact of the Branch Sale.

Income from bank owned life insurance decreased on both a comparative quarterly and year-to-date basis in 2013 compared to 2012 primarily reflecting a lower average crediting rate on our cash surrender value due to reduced total returns on the underlying separate account assets. Our separate account is primarily invested in U.S. agency residential mortgage-backed securities and managed by PIMCO. The crediting rate (on which the earnings are based) reflects the performance of the separate account. The total cash surrender value of our bank owned life insurance was $51.9 million and $50.9 million at September 30, 2013 and December 31, 2012, respectively.

Title insurance fees were lower on both a comparative quarterly and year-to-date basis in 2013 as compared to 2012 primarily as a result of our mortgage loan origination volume declining.

Changes in the fair value of the Amended Warrant issued to the UST in April 2010 had been recorded as a component of non-interest income. Up until April 16, 2013, the fair value of this Amended Warrant was included in accrued expenses and other liabilities in our Condensed Consolidated Statements of Financial Condition.  The provision in the Amended Warrant which caused it to be accounted for as a derivative and included in accrued expenses and other liabilities expired on April 16, 2013.  As a result, the Amended Warrant was reclassified into shareholders’ equity on that date at its then fair value (which was approximately $1.5 million).  The fair value of the warrant was $0.5 million at December 31, 2012. (See “Liquidity and capital resources.”)  The Amended Warrant was purchased from the UST and then retired on August 30, 2013 pursuant to the SPA.

Two significant inputs in the valuation model for the Amended Warrant were our common stock price and the probability percentage of triggering anti-dilution provisions in this instrument related to certain equity transactions.  The fair value of the Amended Warrant increased by $1.0 million in 2013 (through April 16) and by $0.2 million in the first nine months of 2012, respectively, due primarily to a rise in our common stock price during the relevant periods.

Other non-interest income decreased on both a comparative quarterly and year-to-date basis in 2013 compared to 2012.    This decrease is primarily due to declines in certain revenue categories (ATM fees, check charges, money order fees, and safe deposit box rental) primarily as a result of the Branch Sale as well as a decline in rental income on other real estate (“ORE”) due to a decline in the amount of such properties.

Non-interest expense.  Non-interest expense is an important component of our results of operations. We strive to efficiently manage our cost structure and management is focused on a number of initiatives to reduce and contain non-interest expenses.

Non-interest expense decreased by $3.4 million to $25.9 million and by $7.7 million to $79.1 million during the three- and nine-month periods ended September 30, 2013, respectively, compared to the like periods in 2012.  These decreases were primarily due to the Branch Sale.  In addition, the decreases were also due to declines in credit related costs (loan and collection expenses and net losses on ORE and repossessed assets). Partially offsetting these declines were increases in the provision for loss reimbursement on sold loans on both a comparative quarterly and year to date basis and in vehicle service contract counterparty contingencies expense on a year to date basis as described in more detail below.
78

Non-Interest Expense
   
   
   
 
 
Three months ended
   
Nine months ended
 
 
September 30,
   
September 30,
 
 
2013    
2012
   
2013
   
2012
 
(in thousands)
 
Compensation
 
$
8,529
   
$
9,702
   
$
25,080
   
$
29,198
 
Performance-based compensation
   
2,104
     
1,712
     
4,686
     
3,532
 
Payroll taxes and employee benefits
   
1,958
     
2,196
     
5,847
     
6,868
 
Compensation and employee benefits
   
12,591
     
13,610
     
35,613
     
39,598
 
Occupancy, net
   
2,017
     
2,482
     
6,588
     
7,688
 
Data processing
   
2,090
     
2,024
     
6,048
     
5,960
 
Loan and collection
   
1,584
     
2,832
     
5,512
     
8,129
 
Vehicle service contract counterparty contingencies
   
149
     
281
     
3,403
     
1,078
 
Furniture, fixtures and equipment
   
1,051
     
1,083
     
3,171
     
3,490
 
Provision for loss reimbursement on sold loans
   
1,417
     
193
     
2,436
     
751
 
Communications
   
695
     
896
     
2,205
     
2,791
 
FDIC deposit insurance
   
685
     
816
     
2,026
     
2,489
 
Advertising
   
652
     
647
     
1,881
     
1,842
 
Legal and professional fees
   
487
     
952
     
1,843
     
3,117
 
Interchange expense
   
410
     
468
     
1,238
     
1,321
 
Net losses on ORE and repossessed assets
   
119
     
291
     
1,091
     
1,911
 
Credit card and bank service fees
   
310
     
433
     
975
     
1,708
 
Supplies
   
277
     
299
     
771
     
1,033
 
Amortization of intangible assets
   
203
     
272
     
609
     
816
 
Write-down of property and equipment held for sale
   
-
     
860
     
-
     
860
 
Recoveries related to unfunded lending commitments
   
(86
)
   
(538
)
   
(57
)
   
(597
)
Other
   
1,283
     
1,395
     
3,796
     
2,843
 
Total non-interest expense
 
$
25,934
   
$
29,296
   
$
79,149
   
$
86,828
 

Compensation and employee benefits expenses, in total, decreased by $1.0 million, or 7.5%, and by $4.0 million, or 10.1%, in the third quarter and first nine months of 2013, respectively, compared to the like periods in 2012. These decreases are primarily because of the Branch Sale and the branch closings/consolidations we completed in 2012.  Compensation expense decreased by $1.2 million, or 12.1%, and by $4.1 million, or 14.1%, in the third quarter and first nine months of 2013, respectively, compared to the like periods in 2012.  These declines are due primarily to a reduction of 173 average full-time equivalent employees (“FTE’s”), or 16.7%, and 200 average FTE’s, or 18.9%, during the third quarter and first nine months of 2013, respectively, compared to the year ago periods.  The FTE reduction was due to the Branch Sale, branch closings or consolidations during 2012 and other FTE reductions.  The impact of the FTE reductions was partially offset by merit raises in 2013.
79

Performance-based compensation increased by $0.4 million and $1.2 million in the third quarter and first nine months of 2013, respectively, compared to the like periods in 2012. The quarterly and year-to-date comparative increases are due primarily to an increased accrual for incentive-based compensation under our Management Incentive Compensation Plan due to our overall improved financial performance (based principally on year to date earnings, deposit growth and asset quality measures).  Also, because of our exit from TARP, some restricted stock units vested sooner than originally estimated and the third quarter of 2013 included $0.3 million to expense the remaining unamortized cost of these awards.

Payroll taxes and employee benefits decreased by $0.2 million and by $1.0 million in the third quarter and first nine months of 2013, respectively, compared to the like periods in 2012, due primarily to declines in payroll taxes and medical and dental insurance costs principally resulting from the FTE reductions enumerated above.

Occupancy, net, furniture, fixtures and equipment, communications, FDIC deposit insurance and supplies expenses collectively decreased by $0.9 million, or 15.3%, and by $2.7 million, or 15.6%, in the third quarter and first nine months of 2013, respectively, compared to the like periods in 2012.  These declines are due primarily to the Branch Sale and branch closings and consolidations that occurred in the fourth quarter of 2012.

Data processing and advertising expenses were both relatively unchanged in the third quarter and first nine months of 2013 as compared to the year ago periods.  Reductions in data processing expenses related to the Branch Sale were offset by increased costs due to other factors, such as increased software amortization and system maintenance costs at Mepco Finance Corporation (“Mepco”).

Loan and collection expenses primarily reflect costs related to the management and collection of non-performing loans and other problem credits. These expenses (although still at a somewhat elevated level compared to historic norms) have further declined in 2013, which primarily reflects the overall decrease in the volume of problem credits (non-performing loans and “watch” credits). (See “Portfolio Loans and asset quality.”)

We record estimated incurred losses associated with Mepco’s vehicle service contract payment plan receivables in our provision for loan losses and establish a related allowance for loan losses. (See “Portfolio Loans and asset quality.”) We record estimated incurred losses associated with defaults by Mepco’s counterparties as “vehicle service contract counterparty contingencies expense,” which is included in non-interest expenses in our Condensed Consolidated Statements of Operations.

We recorded an expense of $0.1 million and $3.4 million for vehicle service contract payment plan counterparty contingencies in the third quarter and first nine months of 2013, respectively, compared to $0.3 million and $1.1 million, respectively, for the comparable periods in 2012.  The significant increase in this expense for the first nine months of 2013 is due to write-downs of vehicle service contract counterparty receivables in the second quarter of 2013.  We reached settlements in certain litigation to collect these receivables.  Given the costs and uncertainty of continued litigation, we determined it was in our best interest to resolve these matters.

Our estimate of probable incurred losses from vehicle service contract counterparty contingencies requires a significant amount of judgment because a number of factors can influence the amount of loss that we may ultimately incur. These factors include our estimate of future cancellations of vehicle service contracts, our evaluation of collateral that may be available to recover funds due from our counterparties, and our assessment of the amount that may ultimately be collected from counterparties in connection with their contractual obligations. We apply a rigorous process, based upon historical payment plan activity and past experience, to estimate probable incurred losses and quantify the necessary reserves for our vehicle service contract counterparty contingencies, but there can be no assurance that our modeling process will successfully identify all such losses.
80

In particular, as noted in our Risk Factors included in Part I - Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2012, Mepco has had to initiate litigation against certain counterparties, including one of the respective third party insurers, to collect amounts owed to Mepco as a result of those parties' dispute of their contractual obligations to Mepco.  In July 2013, Mepco reached a tentative settlement with the third party insurer related to this litigation.  In the third quarter of 2013 the settlement with this third party insurer was finalized and Mepco received a $5.4 million cash payment in September 2013, which reduced vehicle service contract counterparty receivables, net.  In addition, see Note #14 to the Interim Condensed Consolidated Financial Statements included within this report for more information about Mepco's business, certain risks and difficulties we currently face with respect to that business, and reserves we have established (through vehicle service contract counterparty contingencies expense) for losses related to the business.

The provision for loss reimbursement on sold loans represents our estimate of incurred losses related to mortgage loans that we have sold to investors (primarily Fannie Mae and Freddie Mac). Since we sell mortgage loans without recourse, loss reimbursements only occur in those instances where we have breached a representation or warranty or other contractual requirement related to the loan sale. Historically, loss reimbursements on mortgage loans sold without recourse were very rare. In 2009, we had only one actual loss reimbursement (for $0.06 million). Prior to 2009, we had years in which we incurred no such loss reimbursements. However, our loss reimbursements increased to $0.2 million in 2010 and to $0.5 million and $1.2 million in 2011 and 2012, respectively, as over the past two years Fannie Mae and Freddie Mac, in particular, have been doing more reviews of mortgage loans where they have incurred or expect to incur a loss and have been more aggressive in pursuing loss reimbursements from the sellers of such mortgage loans.  Actual loss reimbursements in the third quarter and first nine months of 2013 totaled $0.1 million and $0.4 million, respectively. Although we are successful in the vast majority of cases where file reviews are conducted on mortgage loans that we have sold to investors and actual loss reimbursements have remained relatively modest, the levels of such file reviews and loss reimbursement requests have increased.  Further, in October 2013 we reached an agreement in principle (the “Resolution Agreement”) to resolve our existing and future repurchase and make whole obligations (collectively “Repurchase Obligations”) related to mortgage loans originated between January 1, 2000 and December 31, 2008 and delivered to Fannie Mae by January 31, 2009.  The terms of the Resolution Agreement are subject to final approval by Fannie Mae. Under the proposed terms of the Resolution Agreement, we will pay Fannie Mae approximately $1.6 million with respect to the Repurchase Obligations, subject to reconciliation and adjustment.  This amount is included in our total reserve at September 30, 2013.  We believe that it is in our best interest to execute the Resolution Agreement in order to bring finality to the loss reimbursement exposure with Fannie Mae for these years and reduce the resources spent on individual file reviews and defending loss reimbursement requests.  As a result, we have established a reserve (which totaled $3.5 million and $1.4 million at September 30, 2013 and December 31, 2012, respectively) for loss reimbursements on sold mortgage loans. This reserve is included in accrued expenses and other liabilities in our Condensed Consolidated Statements of Financial Condition. This reserve is based on an analysis of mortgage loans that we have sold which are further categorized by delinquency status, loan to value, and year of origination. The calculation includes factors such as probability of default, probability of loss reimbursement (breach of representation or warranty) and estimated loss severity. While we believe that the amounts we have accrued for incurred losses on sold loans are appropriate given these analyses, future losses could exceed our current estimate.
81

Legal and professional fees decreased on both a comparative quarterly and year-to-date basis due primarily to a decline in legal fees at Mepco related to counterparty litigation associated with collection matters as further described above. In addition, 2012 included expenses associated with certain consulting services, various regulatory matters, and the Branch Sale.

Interchange expense decreased on both a comparative quarterly and year-to-date basis due primarily to reduced levels of interchange income because of the Branch Sale.  However, the decline in interchange income has been somewhat more pronounced than the decline in interchange expenses principally due to lower transaction revenue because of changes in transaction routing by large merchants.

Net losses on ORE and repossessed assets primarily represent the loss on the sale or additional write downs on these assets subsequent to the transfer of the asset from our loan portfolio. This transfer occurs at the time we acquire the collateral that secured the loan. At the time of acquisition, the other real estate or repossessed asset is valued at fair value, less estimated costs to sell, which becomes the new basis for the asset. Any write-downs at the time of acquisition are charged to the allowance for loan losses.  The reduced net losses in 2013, as compared to 2012, primarily reflects a decline in ORE balances as well as some stability in real estate prices during the last twelve months, with some markets even experiencing modest price increases. However, foreclosed properties generally continue to have somewhat distressed valuations.

Credit card and bank service fees decreased on both a comparative quarterly and year-to-date basis primarily due to a decline in the number of payment plans being serviced by Mepco in 2013 compared to 2012.

The amortization of intangible assets primarily relates to branch acquisitions and the amortization of the deposit customer relationship value, including core deposit value, which was acquired in connection with those acquisitions. We had remaining unamortized intangible assets of $3.4 million and $4.0 million at September 30, 2013 and December 31, 2012, respectively. See Note #8 to the Condensed Consolidated Financial Statements for a schedule of future amortization of intangible assets.  The decline in the amortization of intangible assets in the third quarter and first nine months of 2013 as compared to the year-ago period is primarily due to a reduction in the total amount of intangible assets, which were reduced by $2.6 million in the fourth quarter of 2012 due to the Branch Sale.

In the third quarter of 2012, we adopted a plan to close or consolidate several branch offices and recorded a $0.9 million write-down of property and equipment based on the expected disposal price of the assets.

The changes in costs (recoveries) related to unfunded lending commitments are primarily impacted by changes in the amounts of such commitments to originate portfolio loans as well as (for commercial loan commitments) the grade (pursuant to our loan rating system) of such commitments.
82

Other non-interest expenses decreased by $0.1 million and increased by $1.0 million in the third quarter and first nine months of 2013, respectively, compared to the like periods in 2012. The third quarter comparative decrease is primarily due to the Branch Sale.  The year to date comparative increase is because the first quarter of 2012 included the reversal of a $1.4 million previously established accrual at Mepco that was determined to no longer be necessary.

Income tax benefit.  We assess whether a valuation allowance on our deferred tax assets is necessary each quarter.  Reversing or reducing the valuation allowance requires us to conclude that the realization of the deferred tax assets is “more likely than not.”  The ultimate realization of this asset is primarily based on generating future income.  As of June 30, 2013, we concluded that the realization of substantially all of our deferred tax assets was more likely than not.  This conclusion was primarily based upon the following factors:

· Achieving a sixth consecutive quarter of profitability;
· A forecast of future profitability that supports that the realization of the deferred tax assets is more likely than not; and
· A forecast that future asset quality continues to be stable to improving and that other factors do not exist that could cause a significant adverse impact on future profitability.

We also concluded at September 30, 2013 that the realization of substantially all of our deferred tax assets continued to be more likely than not for substantially the same reasons as enumerated above for June 30, 2013.

We recorded $0.3 million of income tax expense in the third quarter of 2013, which represents an adjustment of the valuation allowance reversal on our deferred tax assets that we initially recorded in June 2013.  At June 30, 2013, we did not reverse that portion of the valuation allowance we estimated would be absorbed by the tax impact of the income expected to be earned between July 1 and December 31, 2013.  To the extent our current forecast of income for the year differs from our projections at June 30, 2013, the tax impact is recorded as income tax expense (or a benefit) which resulted in this adjustment in the third quarter of 2013.

Prior to the second quarter of 2013, we had established a deferred tax asset valuation allowance against all of our net deferred tax assets.  Accordingly, in these prior periods, the income tax expense related to any income before income tax was largely being offset by changes in the deferred tax valuation allowance.

The reversal of substantially all of the valuation allowance on our deferred tax assets resulted in our recording an income tax benefit $57.3 million ($57.6 million in the second quarter of 2013 less the above described $0.3 million adjustment in the third quarter of 2013).  In addition, during the second quarter of 2013, we recorded $1.4 million of income tax expense to clear from accumulated other comprehensive loss (“AOCL”) the disproportionate tax effects from cash flow hedges.  These disproportionate tax effects had been charged to other comprehensive income and credited to income tax expense due to our valuation allowance on deferred tax assets as more fully discussed in Note #16 to the Interim Condensed Consolidated Financial Statements.  Because we terminated our last remaining cash flow hedge in the second quarter of 2013, it was appropriate to clear these disproportionate tax effects from AOCL.

83

We did not at June 30, 2013, and still have not reversed approximately $1.0 million of valuation allowance on our deferred tax assets that primarily relates to state income taxes from our Mepco segment.  In this instance, we determined that the future realization of these particular deferred tax assets was not more likely than not.  This conclusion was primarily based on the uncertainty of Mepco’s future earnings attributable to particular states (given the various apportionment criteria) and the significant reduction in the size of Mepco’s business over the past three years.

Because of our net operating loss and tax credit carryforwards, we are still subject to the rules of Section 382 of the Internal Revenue Code of 1986, as amended.  An ownership change, as defined by these rules, would negatively affect our ability to utilize our net operating loss carryforwards and other deferred tax assets in the future. If such an ownership change were to occur, we may suffer higher-than-anticipated tax expense, and consequently lower net income and cash flow, in those future years.  Although we cannot control our shareholders’ activities in buying and selling our common stock, we do have in place a Tax Benefits Preservation Plan to dissuade any movement in our stock that would trigger an ownership change, and we limited the size of our Common Stock Offering to avoid triggering any Section 382 limitations.

Our actual federal income tax expense (benefit) is different than the amount computed by applying our statutory federal income tax rate to our pre-tax income (loss) primarily due to tax-exempt interest income and tax-exempt income from the increase in the cash surrender value on life insurance, as well as the impact of changes in the deferred tax asset valuation allowance.

Business Segments.  Our reportable segments are based upon legal entities.  We currently have two reportable segments:  Independent Bank and Mepco.  These business segments are also differentiated based on the products and services provided.  We evaluate performance based principally on net income (loss) of the respective reportable segments.

The following table presents net income (loss) by business segment.
 
Business Segments
 
 
 
Three months ended
September 30,
   
Nine months ended
September 30,
 
 
 
2013
   
2012
   
2013
   
2012
 
 
 
(in thousands)
 
Independent Bank
 
$
3,831
   
$
7,125
   
$
68,337
   
$
15,726
 
Mepco
   
172
     
268
     
(1,124
)
   
1,517
 
Other(1)
   
(474
)
   
(923
)
   
5,558
     
(2,889
)
Elimination
   
(24
)
   
(24
)
   
(71
)
   
(71
)
Net income (loss)
 
$
3,505
   
$
6,446
   
$
72,700
   
$
14,283
 
 
(1) Includes amounts relating to our parent company and certain insignificant operations.

The decline in the quarterly comparative net income of the Independent Bank segment is due primarily to decreases in net interest income and in non-interest income due principally to the Branch Sale as well as from a decline in net gains on mortgage loans due to a significant reduction in mortgage loan refinance volumes.  These revenue declines were partially offset by a decrease in non-interest expenses (also primarily due to the Branch Sale) as well as a decrease in the provision for loan losses.  The improvement in the results of operations of Independent Bank on a year to date basis in 2013 compared to 2012 is primarily due to the reversal of the valuation allowance on deferred tax assets resulting in recording a significant income tax benefit, as well as a lower provision for loan losses and a decrease in non-interest expenses that were partially offset by declines in net interest income and non-interest income.  See “Provision for loan losses,” “Portfolio Loans and asset quality,” “Net interest income,” “Non-interest income,” “Non-interest expense,” and “Income tax benefit.”
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The change in Mepco’s results is primarily due to a decrease in net interest income because of a decline in payment plan receivables as well as (for the year-to-date comparative periods) to an increase in vehicle service contract counterparty contingencies expense.  See “Net interest income” and “Non-interest expense.”  All of Mepco’s funding is provided by Independent Bank through an intercompany loan (that is eliminated in consolidation).  The rate on this intercompany loan is based on the Prime Rate (currently 3.25%). Mepco might not be able to obtain such favorable funding costs on its own in the open market.

The change in Other on a comparative quarterly basis is primarily due to a decline in interest expense and a tax benefit recorded at the parent company.   The change in Other on a year to date basis in the table above is primarily due to the reversal of the valuation allowance on deferred tax assets resulting in recording a significant income tax benefit at the parent company.  See “Income tax benefit.”

FINANCIAL CONDITION

Summary.  Our total assets increased by $159.6 million during the first nine months of 2013 due primarily to an increase in securities available for sale and deferred tax assets, net that were partially offset by declines in cash and cash equivalents and loans.  Loans, excluding loans held for sale ("Portfolio Loans"), totaled $1.38 billion at September 30, 2013, down 2.8% from $1.42 billion at December 31, 2012.  (See "Portfolio Loans and asset quality").

Deposits totaled $1.85 billion at September 30, 2013, compared to $1.78 billion at December 31, 2012.  The increase in deposits during the first nine months of 2013 is primarily due to growth in checking and savings account balances.  Other borrowings totaled $17.3 million at September 30, 2013, a decrease of $0.3 million from December 31, 2012.

Securities.  We maintain diversified securities portfolios, which include obligations of U.S. government-sponsored agencies, securities issued by states and political subdivisions, residential mortgage-backed securities, asset-backed securities, corporate securities and trust preferred securities. We regularly evaluate asset/liability management needs and attempt to maintain a portfolio structure that provides sufficient liquidity and cash flow. Except as discussed below, we believe that the unrealized losses on securities available for sale are temporary in nature and are expected to be recovered within a reasonable time period. We believe that we have the ability to hold securities with unrealized losses to maturity or until such time as the unrealized losses reverse. (See “Asset/liability management.”)
 
Securities
 
Unrealized
 
Amortized
Cost
 
Gains
 
Losses
Fair
Value
Securities available for sale
 
   (In thousands)
 
September 30, 2013
 
$
420,599
   
$
1,574
   
$
6,288
   
$
415,885
 
December 31, 2012
   
208,929
     
2,070
     
2,586
     
208,413
 
 
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Securities available for sale increased during the first nine months of 2013 due primarily to the purchase of U.S. government-sponsored agency residential mortgage-backed securities, asset-backed securities, municipal securities and corporate securities. The securities were purchased to utilize cash and cash equivalents as well as to utilize funds generated from the decline in Portfolio Loans and from the increase in total deposits. (See “Deposits” and “Liquidity and capital resources.”)

Our portfolio of available-for-sale securities is reviewed quarterly for impairment in value. In performing this review, management considers (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) the impact of changes in market interest rates on the market value of the security and (4) an assessment of whether we intend to sell, or it is more likely than not that we will be required to sell a security in an unrealized loss position before recovery of its amortized cost basis. For securities that do not meet these recovery criteria, the amount of impairment recognized in earnings is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income or loss.

We recorded net other than temporary impairment charges on securities of zero and $0.1 million in the third quarters of 2013 and 2012, respectively.  We recorded net other than temporary impairment charges on securities of $0.026 million and $0.3 million in the first nine months of 2013 and 2012, respectively. In these instances, we believe that the decline in value is directly due to matters other than changes in interest rates, are not expected to be recovered within a reasonable timeframe based upon available information and are therefore other than temporary in nature.  These net other than temporary impairment charges are all related to private label residential mortgage-backed securities.  (See “Non-interest income” and “Asset/liability management.”)

Sales of securities were as follows (See “Non-interest income.”):
 
 
Nine months ended
 
September 30,
 
2013
2012
 
 
(In thousands)
 
Proceeds
 
$
2,940
   
$
37,176
 
 
               
Gross gains
 
$
15
   
$
1,193
 
Gross losses
   
(7
)
   
-
 
Net impairment charges
   
(26
)
   
(332
)
Fair value adjustments
   
197
     
(39
)
Net gains
 
$
179
   
$
822
 
 
Portfolio Loans and asset quality.  In addition to the communities served by our Bank branch network, our principal lending markets also include nearby communities and metropolitan areas. Subject to established underwriting criteria, we also historically participated in commercial lending transactions with certain non-affiliated banks and also purchased mortgage loans from third-party originators. We have not engaged in any new commercial loan participations with non-affiliated banks or purchased any mortgage loans from third party originators over the past several years, although we may consider new commercial loan participations in 2013.
86


The senior management and board of directors of our Bank retain authority and responsibility for credit decisions and we have adopted uniform underwriting standards. Our loan committee structure and the loan review process attempt to provide requisite controls and promote compliance with such established underwriting standards. However, there can be no assurance that our lending procedures and the use of uniform underwriting standards will prevent us from the possibility of incurring significant credit losses in our lending activities.

We generally retain loans that may be profitably funded within established risk parameters. (See “Asset/liability management.”) As a result, we may hold adjustable-rate mortgage loans as Portfolio Loans, while 15- and 30-year, fixed-rate obligations are generally sold to mitigate exposure to changes in interest rates. (See “Non-interest income.”)
 
Non-performing assets(1)
 
   
 
 
 
September 30,
   
December 31,
 
 
 
2013
   
2012
 
 
 
(Dollars in thousands)
 
Non-accrual loans
 
$
20,014
   
$
32,929
 
Loans 90 days or more past due and still accruing interest
   
356
     
7
 
Total non-performing loans
   
20,370
     
32,936
 
Other real estate and repossessed assets
   
16,637
     
26,133
 
Total non-performing assets
$
37,007
$
59,069
As a percent of Portfolio Loans
Non-performing loans
1.48
%
2.32
%
Allowance for loan losses
2.50
3.12
Non-performing assets to total assets
1.69
2.92
Allowance for loan losses as a percent of non-performing loans
169.06
134.43
 
(1)Excludes loans classified as “troubled debt restructured” that are not past due and vehicle service contract counterparty receivables, net.
87

Troubled debt restructurings (“TDR”)
 
 
 
   
   
 
 
 
September 30, 2013
 
 
 
Commercial
   
Retail
   
Total
 
 
 
(In thousands)
 
Performing TDR’s
 
$
38,299
   
$
80,630
   
$
118,929
 
Non-performing TDR’s (1)
   
5,338
     
5,630
(2) 
   
10,968
 
Total
 
$
43,637
   
$
86,260
   
$
129,897
 
 
 
 
December 31, 2012
 
 
 
Commercial
   
Retail
   
Total
 
 
 
(In thousands)
 
Performing TDR’s
 
$
40,753
   
$
85,977
   
$
126,730
 
Non-performing TDR’s (1)
   
7,756
     
9,177
(2) 
   
16,933
 
Total
 
$
48,509
   
$
95,154
   
$
143,663
 
 
 
(1)
Included in non-performing loans in the “Non-performing assets” table above.
 
(2)
Also includes loans on non-accrual at the time of modification until six payments are received on a timely basis.

Non-performing loans declined by $12.6 million, or 38.2%, during the first nine months of 2013 due principally to declines in non-performing commercial loans and residential mortgage loans. These declines primarily reflect reduced levels of new defaults on loans as well as loan net charge-offs, pay-offs, negotiated transactions, and the migration of loans into ORE.  Additionally, during the second quarter of 2013 we sold $6.5 million of commercial loans ($8.6 million of “book” balance less $2.1 million of allocated loan loss reserves) for total proceeds of approximately $6.7 million.  Included in this sale was $2.9 million of non-accrual commercial loans.  Non-performing commercial loans relate largely to delinquencies caused by cash-flow difficulties encountered by owners of income-producing properties (due to higher vacancy rates and/or lower rental rates). Non-performing residential mortgage loans are primarily due to delinquencies reflecting both uneven economic conditions and somewhat soft real estate values in parts of Michigan and in certain markets where we have mortgage loans secured by resort properties (see Note #4 to the Condensed Consolidated Financial Statements). Non-performing loans exclude performing loans that are classified as TDRs. Performing TDRs totaled $118.9 million, or 8.6% of total Portfolio Loans, and $126.7 million, or 8.9% of total Portfolio Loans, at September 30, 2013 and December 31, 2012, respectively.

ORE and repossessed assets totaled $16.6 million at September 30, 2013, compared to $26.1 million at December 31, 2012. This decrease is primarily the result of sales and write-downs of ORE being in excess of the migration of non-performing loans secured by real estate into ORE as the foreclosure process is completed and any redemption period expires.

We will place a loan that is 90 days or more past due on non-accrual, unless we believe the loan is both well secured and in the process of collection. Accordingly, we have determined that the collection of the accrued and unpaid interest on any loans that are 90 days or more past due and still accruing interest is probable.
88

The ratio of loan net charge-offs to average loans was 0.65% on an annualized basis in the first nine months of 2013 compared to 1.46% in the first nine months of 2012.  The $10.0 million decline in loan net charge-offs primarily reflects a decrease of $5.0 million for commercial loans and $4.2 million for mortgage loans. These decreases in loan net charge-offs primarily reflect reduced levels of non-performing loans and some stabilization in collateral liquidation values.

Allowance for loan losses
 
Nine months ended
 
 
 
September 30,
 
 
 
2013
    2012  
 
 
   
Unfunded
   
   
Unfunded
 
 
 
Loans
   
Commitments
   
Loans
   
Commitments
 
 
 
(Dollars in thousands)
 
Balance at beginning of period
 
$
44,275
   
$
598
   
$
58,884
   
$
1,286
 
Additions (deduction)
                               
Provision for loan losses
   
(3,153
)
   
-
     
6,438
     
-
 
Recoveries credited to allowance
   
6,893
     
-
     
4,603
     
-
 
Loans charged against the allowance
   
(13,578
)
   
-
     
(21,294
)
   
-
 
Reclassification to loans held for sale
   
-
     
-
     
(610
)
   
-
 
Additions (deductions) included in non-interest expense
   
-
     
(57
)
   
-
     
(597
)
Balance at end of period
 
$
34,437
   
$
541
   
$
48,021
   
$
689
 
 
                               
Net loans charged against the allowance to average Portfolio Loans (annualized)
   
0.65
%
           
1.46
%
       

Allocation of the Allowance for Loan Losses
 
   
 
 
 
September 30,
   
December 31,
 
 
 
2013
   
2012
 
 
 
(In thousands)
 
Specific allocations
 
$
16,183
   
$
21,009
 
Other adversely rated loans
   
1,626
     
2,419
 
Historical loss allocations
   
10,284
     
12,943
 
Additional allocations based on subjective factors
   
6,344
     
7,904
 
Total
 
$
34,437
   
$
44,275
 

Some loans will not be repaid in full. Therefore, an allowance for loan losses (“AFLL”) is maintained at a level which represents our best estimate of losses incurred. In determining the AFLL and the related provision for loan losses, we consider four principal elements: (i) specific allocations based upon probable losses identified during the review of the loan portfolio, (ii) allocations established for other adversely rated commercial loans, (iii) allocations based principally on historical loan loss experience, and (iv) additional allowances based on subjective factors, including local and general economic business factors and trends, portfolio concentrations and changes in the size and/or the general terms of the loan portfolios.
89

The first AFLL element (specific allocations) reflects our estimate of probable incurred losses based upon our systematic review of specific loans. These estimates are based upon a number of factors, such as payment history, financial condition of the borrower, discounted collateral exposure and discounted cash flow analysis. Impaired commercial, mortgage and installment loans are allocated allowance amounts using this first element. The second AFLL element (other adversely rated commercial loans) reflects the application of our commercial loan rating system. This rating system is similar to those employed by state and federal banking regulators. Commercial loans that are rated below a certain predetermined classification are assigned a loss allocation factor for each loan classification category that is based upon a historical analysis of both the probability of default and the expected loss rate (“loss given default”). The lower the rating assigned to a loan or category, the greater the allocation percentage that is applied. The third AFLL element (historical loss allocations) is determined by assigning allocations to higher rated (“non-watch credit”) commercial loans using a probability of default and loss given default similar to the second AFLL element and to homogenous mortgage and installment loan groups based upon borrower credit score and portfolio segment.  For homogenous mortgage and installment loans a probability of default for each homogenous pool is calculated by way of credit score migration.  Historical loss data for each homogenous pool coupled with the associated probability of default is utilized to calculate an expected loss allocation rate.  The fourth AFLL element (additional allocations based on subjective factors) is based on factors that cannot be associated with a specific credit or loan category and reflects our attempt to ensure that the overall allowance for loan losses appropriately reflects a margin for the imprecision necessarily inherent in the estimates of expected credit losses. We consider a number of subjective factors when determining this fourth element, including local and general economic business factors and trends, portfolio concentrations and changes in the size, mix and the general terms of the overall loan portfolio.

Increases in the AFLL are recorded by a provision for loan losses charged to expense. Although we periodically allocate portions of the AFLL to specific loans and loan portfolios, the entire AFLL is available for incurred losses. We generally charge-off commercial, homogenous residential mortgage, and installment loans and payment plan receivables when they are deemed uncollectible or reach a predetermined number of days past due based on product, industry practice and other factors. Collection efforts may continue and recoveries may occur after a loan is charged against the allowance.

While we use relevant information to recognize losses on loans, additional provisions for related losses may be necessary based on changes in economic conditions, customer circumstances and other credit risk factors.

Mepco’s allowance for losses is determined in a similar manner as discussed above, and primarily takes into account historical loss experience and other subjective factors deemed relevant to Mepco’s payment plan business. Estimated incurred losses associated with Mepco’s outstanding vehicle service contract payment plans are included in the provision for loan losses. Mepco recorded a $0.056 million credit and a $0.002 million expense in the first nine months of 2013 and 2012, respectively, for its provision for loan losses.  Mepco’s allowance for loan losses totaled $0.1 million and $0.2 million at September 30, 2013 and December 31, 2012, respectively. Mepco has established procedures for vehicle service contract payment plan servicing, administration and collections, including the timely cancellation of the vehicle service contract, in order to protect our position in the event of payment default or voluntary cancellation by the customer. Mepco has also established procedures to attempt to prevent and detect fraud since the payment plan origination activities and initial customer contacts are done entirely through unrelated third parties (vehicle service contract administrators and sellers or automobile dealerships). However, there can be no assurance that the aforementioned risk management policies and procedures will prevent us from the possibility of incurring significant credit or fraud related losses in this business segment. The estimated incurred losses described in this paragraph should be distinguished from the possible losses we may incur from counterparties failing to pay their obligations to Mepco.  See Note #14 to the Condensed Consolidated Financial Statements included within this report.
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The allowance for loan losses decreased $9.8 million to $34.4 million at September 30, 2013 from $44.3 million at December 31, 2012 and was equal to 2.50% of total Portfolio Loans at September 30, 2013 compared to 3.12% at December 31, 2012. All four components of the allowance for loan losses outlined above declined in the first nine months of 2013. The allowance for loan losses related to specific loans decreased $4.8 million in 2013 due primarily to a decline in the balance of individually impaired loans as well as charge-offs. The allowance for loan losses related to other adversely rated commercial loans decreased $0.8 million in 2013 primarily due to a decrease in the balance of such loans included in this component to $44.2 million at September 30, 2013 from $52.8 million at December 31, 2012. The allowance for loan losses related to historical losses decreased $2.7 million during 2013 due principally to the use of a lower estimated probability of default for homogenous mortgage and installment loans (resulting from lower loan net charge-offs and reduced levels of new defaults on loans) as well as due to a decline in the loan balances included in this component of the allowance calculation. The allowance for loan losses related to subjective factors decreased $1.6 million during 2013 primarily due to the improvement of various economic indicators used in computing this portion of the allowance as well as the overall reduction in total Portfolio Loans.

Deposits and borrowings.  Historically, the loyalty of our customer base has allowed us to price deposits competitively, contributing to a net interest margin that compares favorably to our peers. However, we still face a significant amount of competition for deposits within many of the markets served by our branch network, which limits our ability to materially increase deposits without adversely impacting the weighted-average cost of core deposits.

To attract new core deposits, we have implemented a direct mail account acquisition program as well as branch staff sales training. Our new account acquisition initiatives have historically generated increases in customer relationships. Over the past three to four years we have also expanded our treasury management products and services for commercial businesses and municipalities or other governmental units and have also increased our sales calling efforts in order to attract additional deposit relationships from these sectors. We view long-term core deposit growth as an important objective. Core deposits generally provide a more stable and lower cost source of funds than alternative sources such as short-term borrowings. (See “Liquidity and capital resources.”)

Deposits totaled $1.85 billion and $1.78 billion at September 30, 2013 and December 31, 2012, respectively.  The $69.8 million increase in deposits in 2013 is primarily due to growth in checking and savings account balances.  Reciprocal deposits totaled $55.9 million and $33.2 million at September 30, 2013 and December 31, 2012, respectively.  These deposits represent demand, money market and time deposits from our customers that have been placed through Promontory Interfinancial Network’s Insured Cash Sweep® service and Certificate of Deposit Account Registry Service®.  These services allow our customers to access multi-million dollar FDIC deposit insurance on deposit balances greater than the standard FDIC insurance maximum.  With the expiration of the Transaction Account Guarantee Program (“TAGP”) on December 31, 2012, we have experienced an increase in reciprocal deposits during 2013.
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We cannot be sure that we will be able to maintain our current level of core deposits. In particular, those deposits that are uninsured may be particularly susceptible to outflow. At September 30, 2013 we had approximately $333.5 million of uninsured deposits. A reduction in core deposits would likely increase our need to rely on wholesale funding sources.

During the fourth quarter of 2009 we prepaid our estimated quarterly deposit insurance premium assessments to the FDIC for periods through the fourth quarter of 2012. These estimated quarterly deposit insurance premium assessments were based on projected deposit balances over the assessment periods. The prepaid deposit insurance premium assessments totaled zero and $9.4 million at September 30, 2013 and December 31, 2012, respectively. The actual expense over the assessment periods was significantly lower than the original prepaid amount due to various factors including variances in the estimated compared to the actual assessment base and rates used during each assessment period.  We received the return of the overpayment of our prepaid assessment from the FDIC in June 2013.

We have also implemented strategies that incorporate using federal funds purchased, other borrowings and Brokered CDs to fund a portion of our interest-earning assets. The use of such alternate sources of funds supplements our core deposits and is also an integral part of our asset/liability management efforts.

Alternative Sources of Funds
 
 
September 30,
December 31,
  2013 2012
 
Average
Average
 
Amount
Maturity
Rate
Amount
Maturity
Rate
 
 
(Dollars in thousands)
 
Brokered CDs
 
$
13,227
 
0.4 years
   
1.35
%
 
$
14,591
 
0.6 years
   
1.70
%
Fixed rate FHLB advances
   
17,281
 
3.8 years
   
6.38
     
17,622
 
4.5 years
   
6.38
 
      Total
 
$
30,508
 
2.3 years
   
4.20
%
 
$
32,213
 
2.7 years
   
4.26
%
 
Other borrowings, comprised almost entirely of advances from the Federal Home Loan Bank (the “FHLB”), totaled $17.3 million and $17.6 million at September 30, 2013 and December 31, 2012, respectively.

As described above, we utilize wholesale funding, including FHLB borrowings and Brokered CDs to augment our core deposits and fund a portion of our assets. At September 30, 2013, our use of such wholesale funding sources (including reciprocal deposits) amounted to approximately $86.4 million, or 4.6% of total funding (deposits and total borrowings, excluding subordinated debentures). Because wholesale funding sources are affected by general market conditions, the availability of such funding may be dependent on the confidence these sources have in our financial condition and operations. The continued availability to us of these funding sources is not certain, and Brokered CDs may be difficult for us to retain or replace at attractive rates as they mature. Our liquidity may be constrained if we are unable to renew our wholesale funding sources or if adequate financing is not available in the future at acceptable rates of interest or at all.

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Our financial performance could also be affected if we are unable to maintain our access to funding sources or if we are required to rely more heavily on more expensive funding sources. In such case, our net interest income and results of operations could be adversely affected.
 
We historically employed derivative financial instruments to manage our exposure to changes in interest rates. We discontinued the active use of derivative financial instruments during 2008. In June 2013, we terminated our last remaining interest-rate swap, which had an aggregate notional amount of $10.0 million.
 
Liquidity and capital resources. Liquidity risk is the risk of being unable to timely meet obligations as they come due at a reasonable funding cost or without incurring unacceptable losses. Our liquidity management involves the measurement and monitoring of a variety of sources and uses of funds. Our Condensed Consolidated Statements of Cash Flows categorize these sources and uses into operating, investing and financing activities. We primarily focus our liquidity management on maintaining adequate levels of liquid assets (primarily funds on deposit with the FRB and certain investment securities) as well as developing access to a variety of borrowing sources to supplement our deposit gathering activities and provide funds for purchasing investment securities or originating Portfolio Loans as well as to be able to respond to unforeseen liquidity needs.

Our primary sources of funds include our deposit base, secured advances from the FHLB, a federal funds purchased borrowing facility with another commercial bank, and access to the capital markets (for Brokered CDs).

At September 30, 2013 we had $269.1 million of time deposits that mature in the next twelve months. Historically, a majority of these maturing time deposits are renewed by our customers. Additionally, $1.43 billion of our deposits at September 30, 2013 were in account types from which the customer could withdraw the funds on demand. Changes in the balances of deposits that can be withdrawn upon demand are usually predictable and the total balances of these accounts have generally grown (excluding the Branch Sale) or have been stable over time as a result of our marketing and promotional activities. However, there can be no assurance that historical patterns of renewing time deposits or overall growth or stability in deposits will continue in the future.

We have developed contingency funding plans that stress test our liquidity needs that may arise from certain events such as an adverse change in our financial metrics (for example, credit quality or regulatory capital ratios). Our liquidity management also includes periodic monitoring that measures quick assets (defined generally as short-term assets with maturities less than 30 days and loans held for sale) to total assets, short-term liability dependence and basic surplus (defined as quick assets compared to short-term liabilities). Policy limits have been established for our various liquidity measurements and are monitored on a monthly basis. In addition, we also prepare cash flow forecasts that include a variety of different scenarios.

We believe that we currently have adequate liquidity at our Bank because of our cash and cash equivalents, our portfolio of securities available for sale, our access to secured advances from the FHLB, our ability to issue Brokered CDs and our improved financial metrics.

93

We also believe that the available cash on hand of approximately $20.8 million at the parent company as of September 30, 2013 (this cash balance was reduced by approximately $9.2 million with the redemption of the trust preferred securities issued by IBC Capital Finance II on October 11, 2013), as well as the potential future transfer of funds from the Bank to the parent company through returns of capital or through dividends, provide sufficient liquidity resources at the parent company to meet operating expenses and to make interest payments on the subordinated debentures for the foreseeable future.

During the third quarter of 2013 we received regulatory approval for each of the following initiatives:

· A transfer of capital from our Bank to the parent company of $7.5 million to permit the payment of all deferred and unpaid interest on our trust preferred securities.
· The resumption of interest payments on our trust preferred securities.
· The purchase of our Series B Preferred Stock, including any and all accrued and unpaid dividends, and the purchase of the Amended Warrant for total cash consideration of $81.0 million, all as provided for in the SPA.
· Redemption of the trust preferred securities issued by IBC Capital Finance II.

Effective management of capital resources is critical to our mission to create value for our shareholders. Our capital structure currently includes cumulative trust preferred securities.

Capitalization
 
   
 
 
 
September 30,
   
December 31,
 
 
 
2013
   
2012
 
 
 
(In thousands)
 
Subordinated debentures
 
$
50,175
   
$
50,175
 
Amount not qualifying as regulatory capital
   
(1,507
)
   
(1,507
)
Amount qualifying as regulatory capital
   
48,668
     
48,668
 
Shareholders’ Equity
               
Convertible preferred stock
   
-
     
84,204
 
Common stock
   
350,926
     
251,237
 
Accumulated deficit
   
(115,155
)
   
(192,408
)
Accumulated other comprehensive loss
   
(9,170
)
   
(8,058
)
Total shareholders’ equity
   
226,601
     
134,975
 
Total capitalization
 
$
275,269
   
$
183,643
 

We have four special purpose entities that originally issued $90.1 million of cumulative trust preferred securities. On June 23, 2010, we issued 5.1 million shares of our common stock (having a fair value of approximately $23.5 million on the date of the exchange) in exchange for $41.4 million in liquidation amount of trust preferred securities and $2.3 million of accrued and unpaid interest on such securities. As a result, at September 30, 2013 and December 31, 2012, $48.7 million of cumulative trust preferred securities remained outstanding. These special purpose entities issued common securities and provided cash to our parent company that in turn, issued subordinated debentures to these special purpose entities equal to the trust preferred securities and common securities. The subordinated debentures represent the sole asset of the special purpose entities. The common securities and subordinated debentures are included in our Condensed Consolidated Statements of Financial Condition.  On October 11, 2013 we redeemed all ($9.2 million) of the outstanding trust preferred securities issued by IBC Capital Finance II and liquidated this entity shortly thereafter.  The trust preferred securities issued by IBC Capital Finance II had an interest rate of 8.25%.  The redemption of these securities will reduce our interest expense by approximately $0.8 million annually.
94

The Federal Reserve Board has issued rules regarding trust preferred securities as a component of the Tier 1 capital of bank holding companies. The aggregate amount of trust preferred securities (and certain other capital elements) are limited to 25 percent of Tier 1 capital elements, net of goodwill (net of any associated deferred tax liability). The amount of trust preferred securities and certain other elements in excess of the limit can be included in Tier 2 capital, subject to restrictions. At the parent company, all of these securities qualified as Tier 1 capital at September 30, 2013. Although the Dodd-Frank Act further limited Tier 1 treatment for trust preferred securities, those new limits did not apply to our outstanding trust preferred securities.  Further, the New Capital Rules grandfathered the treatment of our trust preferred securities as qualifying regulatory capital.

On August 30, 2013 we redeemed the Series B Preferred Stock and the Amended Warrant and exited TARP by making an $81.0 million payment to the UST pursuant to the SPA.  See Note #15 to the Condensed Consolidated Financial Statements included within this report for additional information about the Series B Preferred Stock and the Amended Warrant.

Shareholders’ equity applicable to common stock increased to $226.6 million at September 30, 2013 from $50.8 million at December 31, 2012 due primarily to our Common Stock Offering and our net income during the first nine months of 2013. Our tangible common equity (“TCE”) totaled $223.2 million and $46.8 million, respectively, at those same dates. Our ratio of TCE to tangible assets was 10.24% at September 30, 2013 compared to 2.32% at December 31, 2012.

Because the Bank currently has negative “undivided profits” (i.e. a retained deficit) of $55.3 million at September 30, 2013, under Michigan banking regulations the Bank is not currently permitted to pay a dividend.  We can request regulatory approval for a return of capital from the Bank to the parent company. Also see Note #11 to the Condensed Consolidated Financial Statements included within this report.

The payment of dividends on our common stock is also restricted and governed by the terms of our trust preferred securities, as follows:

The terms of the subordinated debentures and trust indentures (the “Indentures”) related to our trust preferred securities allow us to defer payment of interest at any time or from time to time for up to 20 consecutive quarters provided no event of default (as defined in the Indentures) has occurred and is continuing. We are not in default with respect to the Indentures, and the deferral of interest does not constitute an event of default under the Indentures. While we defer the payment of interest, we will continue to accrue the interest expense owed at the applicable interest rate. Upon the expiration of the deferral, all accrued and unpaid interest is due and payable. During the deferral period on the Indentures, we may not declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to, any of our capital stock.  We resumed interest payments on our outstanding trust preferred securities in the third quarter of 2013.

95

As of September 30, 2013, our Bank (and holding company) continued to meet the requirements to be considered “well-capitalized” under federal regulatory standards (also see Note #11 to the Condensed Consolidated Financial Statements included within this report).

On July 7, 2010 we executed an Investment Agreement and Registration Rights Agreement with Dutchess Opportunity Fund, II, LP (“Dutchess”) for the sale of shares of our common stock. These agreements served to establish an equity line facility as a contingent source of liquidity at the parent company level. Pursuant to the Investment Agreement, Dutchess committed to purchase up to $15.0 million of our common stock over a 36-month period that ended November 1, 2013. We had the right, but no obligation, to draw on this equity line facility from time to time during such 36-month period by selling shares of our common stock to Dutchess. The sales price was at a 5% discount to the market price of our common stock at the time of the draw (as such market price was determined pursuant to the terms of the Investment Agreement). Through September 30, 2013, we had sold a total of 1,399,422 shares (including 168,941 shares during the first nine months of 2013) of our common stock to Dutchess under this equity line for total net proceeds of approximately $4.2 million.  Given the existing cash levels and our forecasted future cash needs at the parent company along with our expectation that the Bank will be able to transfer funds to the parent company at a future date, we determined to not renew this equity line facility on November 1, 2013.

Asset/liability management.  Interest-rate risk is created by differences in the cash flow characteristics of our assets and liabilities. Options embedded in certain financial instruments, including caps on adjustable-rate loans as well as borrowers’ rights to prepay fixed-rate loans, also create interest-rate risk.

Our asset/liability management efforts identify and evaluate opportunities to structure our statement of financial condition in a manner that is consistent with our mission to maintain profitable financial leverage within established risk parameters. We evaluate various opportunities and alternate asset/liability management strategies carefully and consider the likely impact on our risk profile as well as the anticipated contribution to earnings. The marginal cost of funds is a principal consideration in the implementation of our asset/liability management strategies, but such evaluations further consider interest-rate and liquidity risk as well as other pertinent factors. We have established parameters for interest-rate risk. We regularly monitor our interest-rate risk and report at least quarterly to our board of directors.

We employ simulation analyses to monitor our interest-rate risk profile and evaluate potential changes in our net interest income and market value of portfolio equity that result from changes in interest rates. The purpose of these simulations is to identify sources of interest-rate risk inherent in our Statement of Financial Condition. The simulations do not anticipate any actions that we might initiate in response to changes in interest rates and, accordingly, the simulations do not provide a reliable forecast of anticipated results. The simulations are predicated on immediate, permanent and parallel shifts in interest rates and generally assume that current loan and deposit pricing relationships remain constant. The simulations further incorporate assumptions relating to changes in customer behavior, including changes in prepayment rates on certain assets and liabilities.
96

Changes in Market Value of Portfolio Equity and Net Interest Income
 
 
 
   
   
   
 
 
 
Market Value
   
   
   
 
Change in Interest
 
Of Portfolio
   
Percent
   
Net Interest
   
Percent
 
Rates
 
Equity(1)
   
Change
   
Income(2)
   
Change
 
 
 
(Dollars in thousands)
 
September 30, 2013
 
   
   
   
 
200 basis point rise
 
$
392,200
     
8.49
%
 
$
78,500
     
5.37
%
100 basis point rise
   
378,400
     
4.67
     
76,100
     
2.15
 
Base-rate scenario
   
361,500
     
-
     
74,500
     
-
 
100 basis point decline
   
338,600
     
(6.33
)
   
73,800
     
(0.94
)
 
                               
December 31, 2012
                               
200 basis point rise
 
$
262,100
     
24.81
%
 
$
81,200
     
6.01
%
100 basis point rise
   
240,000
     
14.29
     
78,600
     
2.61
 
Base-rate scenario
   
210,000
     
-
     
76,600
     
-
 
100 basis point decline
   
180,400
     
(14.10
)
   
75,500
     
(1.44
)
 

(1) Simulation analyses calculate the change in the net present value of our assets and liabilities, including debt and related financial derivative instruments, under parallel shifts in interest rates by discounting the estimated future cash flows using a market-based discount rate. Cash flow estimates incorporate anticipated changes in prepayment speeds and other embedded options.
(2) Simulation analyses calculate the change in net interest income under immediate parallel shifts in interest rates over the next twelve months, based upon a static statement of financial condition, which includes debt and related financial derivative instruments, and do not consider loan fees.

Accounting standards update. See Note #2  to  the Condensed Consolidated Financial Statements included elsewhere in this report for details on recently issued accounting pronouncements and their impact on our financial statements.

Fair valuation of financial instruments.  Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) topic 820 - “Fair Value Measurements and Disclosures” (“FASB ASC topic 820”) defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

We utilize fair value measurements to record fair value adjustments to certain financial instruments and to determine fair value disclosures. FASB ASC topic 820 differentiates between those assets and liabilities required to be carried at fair value at every reporting period (“recurring”) and those assets and liabilities that are only required to be adjusted to fair value under certain circumstances (“nonrecurring”). Trading securities, securities available-for-sale, loans held for sale, and derivatives are financial instruments recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other financial assets on a nonrecurring basis, such as loans held for investment, capitalized mortgage loan servicing rights and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets. See Note #12 to the Condensed Consolidated Financial Statements included within this report for a complete discussion on our use of fair valuation of financial instruments and the related measurement techniques.
97

Regulatory developments.  On October 25, 2011, the respective Boards of Directors of the Company and the Bank entered into a Memorandum of Understanding (“MOU”) with the FRB and the Michigan Department of Insurance and Financial Services (“DIFS”). The MOU largely duplicated certain provisions of board resolutions that were already in place, but also had the following specific requirements:

·
Submission of a joint revised capital plan by November 30, 2011 to maintain sufficient capital at the Company on a consolidated basis and at the Bank on a stand-alone basis;
·
Submission of quarterly progress reports regarding disposition plans for any assets in excess of $1.0 million that are in ORE, are 90 days or more past due, are on our “watch list,” or were adversely classified in our most recent examination;
·
Enhanced reporting and monitoring at Mepco regarding risk management and the internal classification of assets; and
·
Enhanced interest rate risk modeling practices.

Effective March 26, 2013, the FRB and DIFS terminated the MOU.  Also on that date, the respective Boards of Directors of the Company and the Bank passed resolutions that required the following:

·
Submission of quarterly progress reports to the FRB and DIFS regarding disposition plans for any assets in excess of $1.0 million that are in ORE, are 90 days or more past due, are on our “watch list,” or are adversely classified;
·
Prior approval of the FRB and DIFS for the Bank to pay any dividend to the Company; and
·
Prior approval of the FRB and DIFS for the Company to pay any dividend to its shareholders, to make any distributions of interest, principal or other sums on subordinated debentures or trust preferred securities, to increase borrowings or guarantee any debt, and/or to purchase or redeem any of its stock.

During the third quarter of 2013 the FRB and DIFS informed us that the Board resolutions no longer needed to be in place.  Accordingly, on October 22, 2013, the above described resolutions were rescinded by the Board of Directors of the Company and the Bank.
 
 LITIGATION MATTERS

We are involved in various litigation matters in the ordinary course of business. At the present time, we do not believe any of these matters will have a significant impact on our consolidated financial position or results of operations. The aggregate amount we have accrued for losses we consider probable as a result of these litigation matters is immaterial. However, because of the inherent uncertainty of outcomes from any litigation matter, we believe it is reasonably possible we may incur losses in addition to the amounts we have accrued.  At this time, we estimate the maximum amount of additional losses that are reasonably possible is approximately $0.5 million.  However, because of a number of factors, including the fact that certain of these litigation matters are still in their early stages, this maximum amount may change in the future.
98

The litigation matters described in the preceding paragraph primarily include claims that have been brought against us for damages, but do not include litigation matters where we seek to collect amounts owed to us by third parties (such as litigation initiated to collect delinquent loans or vehicle service contract counterparty receivables). These excluded, collection-related matters may involve claims or counterclaims by the opposing party or parties, but we have excluded such matters from the disclosure contained in the preceding paragraph in all cases where we believe the possibility of us paying damages to any opposing party is remote. Risks associated with the likelihood that we will not collect the full amount owed to us, net of reserves, are disclosed elsewhere in this report.

 CRITICAL ACCOUNTING POLICIES

Our accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Accounting and reporting policies for other than temporary impairment of investment securities, the allowance for loan losses, originated mortgage loan servicing rights, vehicle service contract payment plan counterparty contingencies, and income taxes are deemed critical since they involve the use of estimates and require significant management judgments. Application of assumptions different than those that we have used could result in material changes in our consolidated financial position or results of operations.  There have been no material changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2012.
 
99

Item 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

See applicable disclaimers set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 2 under the caption “Asset/liability management.”

Item 4.

CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures.

With the participation of management, our chief executive officer and chief financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a – 15(e) and 15d – 15(e)) for the period ended September 30, 2013, have concluded that, as of such date, our disclosure controls and procedures were effective.

(b) Changes in Internal Controls.

During the quarter ended September 30, 2013, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
100

Part II

Item 1A. Risk Factors

There have been no material changes to the risk factors disclosed in Item 1A. Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2012.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The Company maintains a Deferred Compensation and Stock Purchase Plan for Non-Employee Directors (the "Plan") pursuant to which non-employee directors can elect to receive shares of the Company's common stock in lieu of fees otherwise payable to the director for his or her service as a director.  A director can elect to receive shares on a current basis or to defer receipt of the shares, in which case the shares are issued to a trust to be held for the account of the director and then generally distributed to the director after his or her retirement from the Board.  Pursuant to this Plan, during the third quarter of 2013, the Company issued 8,192 shares of common stock to non-employee directors on a current basis and 5,355 shares of common stock to the trust for distribution to directors on a deferred basis.  The shares were issued on July 1, 2013, at a price of $6.29 per share, representing aggregate fees of $0.1 million.   The price per share was the consolidated closing bid price per share of the Company's common stock as of the date of issuance, as determined in accordance with NASDAQ Marketplace Rules.  The Company issued the shares pursuant to an exemption from registration under Section 4(2) of the Securities Act of 1933 due to the fact that the issuance of the shares was made on a private basis pursuant to the Plan.

The following table shows certain information relating to purchases of common stock for the three-months ended September 30, 2013:

 
 
   
   
Total Number of
 
Remaining
 
 
   
   
Shares Purchased
 
Number of
 
 
   
   
as Part of a
 
Shares Authorized
 
 
Total Number of
   
Average Price
   
Publicly
 
for Purchase
Period
 
Shares Purchased
   
Paid Per Share
   
Announced Plan
 
Under the Plan
July 2013
   
-
   
$
-
     
-
 
NA
August 2013
   
53,044
(1) 
   
9.50
     
-
 
NA
September 2013
   
-
     
-
     
-
 
NA
Total
   
53,044
   
$
9.50
     
-
 
NA
 
(1) Restricted stock units granted in 2011 vested during August, 2013.  The shares disclosed in this table are shares withheld from the shares that would otherwise have been issued to certain executive officers in order to satisfy tax withholding obligations resulting from such vesting.
101

Item 6. Exhibits
 
(a) The following exhibits (listed by number corresponding to the Exhibit Table as Item 601 in Regulation S-K) are filed with this report:
Computation of Earnings Per Share.
Certificate of the Chief Executive Officer of Independent Bank Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
Certificate of the Chief Financial Officer of Independent Bank Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
Certificate of the Chief Executive Officer of Independent Bank Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
Certificate of the Chief Financial Officer of Independent Bank Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
101.
INS Instance Document
101.
SCH XBRL Taxonomy Extension Schema Document
101.
CAL XBRL Taxonomy Extension Calculation Linkbase Document
101.
DEF XBRL Taxonomy Extension Definition Linkbase Document
101.
LAB XBRL Taxonomy Extension Label Linkbase Document
101.
PRE XBRL Taxonomy Extension Presentation Linkbase Document
102

SIGNATURES

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

Date
November 7, 2013
By
/s/ Robert N. Shuster
 
 
 
 Robert N. Shuster, Principal Financial Officer
 
 
 
 
Date
November 7, 2013
By
/s/ James J. Twarozynski
 
 
 
              James J. Twarozynski, Principal
 
 
 
Accounting Officer
 
 
103