Quarterly Report (10-q)

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mac

UNITED STATES

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 March 31, 2020

☐TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from <> to <>

Commission file number: 0-20167

MACKINAC FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

MICHIGAN		38-2062816
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)

130 SOUTH CEDAR STREET, MANISTIQUE, MI		49854
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (888) 343-8147

Securities registered pursuant to Section 12(b) of the Act:


Title of each class:	Trading Symbol	Name of each exchange on which registered:
Commmon Stock, No par value	MFNC	The NASDAQ Stock Market, LLC

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

Yes ☒ No ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes ☒ No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer ☐

Accelerated Filer ☒

Non-accelerated Filer ☐

Smaller reporting company ☒

Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes ☐ No ☒

As of May 11, 2020, there were outstanding 10,533,589 shares of the registrant’s common stock, no par value.

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MACKINAC FINANCIAL CORPORATION

INDEX


		Page No.

PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements

	Condensed Consolidated Balance Sheets – March 31, 2020 (Unaudited), December 31, 2019	1

	Condensed Consolidated Statements of Operations — Three Months Ended March 31, 2020 (Unaudited) and March 31, 2019 (Unaudited)	2

	Condensed Consolidated Statements of Comprehensive Income — Three Months Ended March 31, 2020 (Unaudited) and March 31, 2019 (Unaudited)	3

	Condensed Consolidated Statements of Changes in Shareholders’ Equity — Three Months Ended March 31, 2020 (Unaudited) and March 31, 2019 (Unaudited)	4

	Condensed Consolidated Statements of Cash Flows - Three Months Ended March 31, 2020 (Unaudited) and March 31, 2019 (Unaudited)	5

	Notes to Condensed Consolidated Financial Statements (Unaudited)	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	28

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	39

Item 4.	Controls and Procedures	42

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	43

Item 1A.	Risk Factors	43

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	43

Item 6.	Exhibits and Reports on Form 8-K	44

SIGNATURES		45

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MACKINAC FINANCIAL CORPORATION

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)


	March 31,		December 31,
	2020		2019
	(Unaudited)

ASSETS

Cash and due from banks	$	97,041	$	49,794
Federal funds sold		31		32
Cash and cash equivalents		97,072		49,826

Interest-bearing deposits in other financial institutions		8,825		10,295
Securities available for sale		114,734		107,972
Federal Home Loan Bank stock		4,924		4,924

Loans:
Commercial		760,357		765,524
Mortgage		263,445		272,014
Consumer		20,375		21,238
Total Loans		1,044,177		1,058,776
Allowance for loan losses		(5,292)		(5,308)
Net loans		1,038,885		1,053,468

Premises and equipment		24,522		23,608
Other real estate held for sale		2,228		2,194
Deferred tax asset		3,154		3,732
Deposit based intangibles		4,874		5,043
Goodwill		19,574		19,574
Other assets		37,589		39,433

TOTAL ASSETS	$	1,356,381	$	1,320,069

LIABILITIES AND SHAREHOLDERS’ EQUITY

LIABILITIES:
Deposits:
Noninterest bearing deposits	$	278,191	$	287,611
NOW, money market, interest checking		369,003		373,165
Savings		109,818		109,548
CDs<$250,000		227,924		233,956
CDs>$250,000		14,152		12,775
Brokered		96,293		58,622
Total deposits		1,095,381		1,075,677

Federal funds purchased		22,790		6,225
Borrowings		67,120		64,551
Other liabilities		11,030		11,697
Total liabilities		1,196,321		1,158,150

SHAREHOLDERS’ EQUITY:
Common stock and additional paid in capital - No par value Authorized - 18,000,000 shares Issued and outstanding - 10,533,589 and 10,748,712 respectively		127,003		129,564
Retained earnings		33,316		31,740
Accumulated other comprehensive income (loss)
Unrealized gains on available for sale securities		151		1,025
Minimum pension liability		(410)		(410)
Total shareholders’ equity		160,060		161,919

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	1,356,381	$	1,320,069

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MACKINAC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in Thousands, Except per Share Data)


	Three Months Ended
	March 31,
	2020		2019
	(Unaudited)
INTEREST INCOME:
Interest and fees on loans:
Taxable	$	14,613	$	14,595
Tax-exempt		74		47
Interest on securities:
Taxable		621		703
Tax-exempt		87		98
Other interest income		270		385
Total interest income		15,665		15,828

INTEREST EXPENSE:
Deposits		1,927		2,354
Borrowings		341		238
Total interest expense		2,268		2,592

Net interest income		13,397		13,236
Provision for loan losses		100		100
Net interest income after provision for loan losses		13,297		13,136

OTHER INCOME:
Deposit service fees		403		406
Income from mortgage loans sold on the secondary market		538		312
SBA/USDA loan sale gains		710		125
Net mortgage servicing fees		259		120
Other		27		154
Total other income		1,937		1,117

OTHER EXPENSE:
Salaries and employee benefits		6,051		5,435
Occupancy		1,124		1,081
Furniture and equipment		802		718
Data processing		825		709
Advertising		212		309
Professional service fees		498		434
Loan origination expenses and deposit and card related fees		381		179
Writedowns and losses on other real estate held for sale		3		28
FDIC insurance assessment		150		134
Communications		213		228
Other		1,113		989
Total other expenses		11,372		10,244

Income before provision for income taxes		3,862		4,009
Provision for income taxes		811		842

NET INCOME	$	3,051	$	3,167

INCOME PER COMMON SHARE:
Basic	$	0.28	$	0.30
Diluted	$	0.28	$	0.30

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MACKINAC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS COMPREHENSIVE INCOME

(Dollars in Thousands)

(Unaudited)


	Three Months Ended
	March 31,
	2020		2019
Net income	$	3,051	$	3,167
Other comprehensive income
Change in securities available for sale:
Unrealized (losses) gains arising during the period		(1,106)		973
Tax effect		232		(315)
Net change in unrealized gains on available for sale securities		(874)		658

Total comprehensive income	$	2,177	$	3,825

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MACKINAC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Dollars in Thousands)

(Unaudited)


	Three Months Ended
	March 31,
	2020
		Common				Accumulated
	Shares of	Stock and				Other
	Common	Additional		Retained		Comprehensive
	Stock	Paid in Capital		Earnings		Income (loss)		Total

Balance, beginning of period	10,748,712	$	129,564	$	31,740	$	615	$	161,919

Net income for period	—		—		3,051		—		3,051
Other comprehensive income
Net unrealized loss on securities available for sale	—		—		—		(874)		(874)
Total comprehensive income	—		—		3,051		(874)		2,177
Stock compensation	—		168		—		—		168
Issuance of common stock:
Restricted stock award vesting	25,521		—		—		—		—
Repurchase of common stock	(240,644)		(2,729)		—		—		(2,729)
Dividend on common stock	—		—		(1,475)		—		(1,475)

Balance, end of period	10,533,589	$	127,003	$	33,316	$	(259)	$	160,060


	Three Months Ended
	March 31,
	2019
		Common				Accumulated
	Shares of	Stock and				Other
	Common	Additional		Retained		Comprehensive
	Stock	Paid in Capital		Earnings		Income (Loss)		Total

Balance, beginning of period	10,712,745	$	129,066	$	23,466	$	(463)	$	152,069

Net income for period	—		—		3,167		—		3,167
Other comprehensive income
Net unrealized gain on securities available for sale	—		—		—		658		658
Total comprehensive income	—		—		3,167		658		3,825
Stock compensation	—		138		—		—		138
Issuance of common stock:
Restricted stock award vesting	27,967		—		—		—		—
Dividend on common stock	—		—		(1,286)		—		(1,286)

Balance, end of period	10,740,712	$	129,204	$	25,347	$	195	$	154,746

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MACKINAC FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

(Unaudited)


	Three Months Ended
	March 31,
	2020		2019
Cash Flows from Operating Activities:
Net income	$	3,051	$	3,167
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		687		618
Provision for loan losses		100		100
Deferred tax expense, net		456		324
Gain on sale of loans sold in the secondary market		(447)		(258)
Origination of loans held for sale in the secondary market		(18,997)		(13,604)
Proceeds from sale of loans in the secondary market		16,900		13,862
Loss on sale of other real estate held for sale				28
Writedown of other real estate held for sale		3		—
Stock compensation		168		138
Change in other assets		2,090		(2,386)
Change in other liabilities		(667)		3,351
Net cash provided by operating activities		3,344		5,340

Cash Flows from Investing Activities:
Net decrease (increase) in loans		17,200		(9,291)
Net decrease in interest bearing deposits in other financial institutions		1,470		740
Purchase of securities available for sale		(17,873)		—
Proceeds from maturities, sales, calls or paydowns of securities available for sale		9,988		4,306
Capital expenditures		(1,584)		(346)
Proceeds from sale of other real estate, premises and fixed assets		67		415
Net cash (used in) provided by investing activities		9,268		(4,176)

Cash Flows from Financing Activities:
Net increase (decrease) in deposits		19,704		(289)
Net activity on line of credit		3,000		—
Net increase in fed funds purchased		16,565		3,875
New term debt issuance		10,000		—
Principal payments on borrowings		(10,431)		(10,658)
Repurchase of common stock		(2,729)		—
Dividend on common stock		(1,475)		(1,286)
Net cash provided by (used in) financing activities		34,634		(8,358)

Net (decrease) increase in cash and cash equivalents		47,246		(7,194)
Cash and cash equivalents at beginning of period		49,826		64,157

Cash and cash equivalents at end of period	$	97,072	$	56,963

Supplemental Cash Flow Information:
Cash paid during the year for:
Interest	$	2,242	$	2,523
Income taxes		—		—

Noncash Investing and Financing Activities:		155		298
Transfers of Foreclosures from Loans to Other Real Estate Held for Sale		—		—
Transfers of Other Real Estate Held for Sale to Fixed Assets

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MACKINAC FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The unaudited condensed consolidated financial statements of Mackinac Financial Corporation (the “Corporation”) have been prepared in accordance with generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three month periods ended March 31, 2020 are not necessarily indicative of the results that may be expected for the year ending December 31, 2020. The unaudited consolidated financial statements and footnotes thereto should be read in conjunction with the audited consolidated financial statements and footnotes thereto included in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2019.

In order to properly reflect some categories of other income and other expenses, reclassifications of expense and income items have been made to prior period numbers. The “net” other income and other expenses were unchanged by these reclassifications.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of investment securities, the valuation of foreclosed real estate, deferred tax assets, mortgage servicing rights, the assessment of goodwill for impairment, and the fair value of assets and liabilities acquired in business combinations.

Acquired Loans

Loans acquired with evidence of credit deterioration since inception and for which it is probable that all contractual payments will not be received are accounted for under ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”). These loans are recorded at fair value at the time of acquisition, with no carryover of the related allowance for loan losses. Fair value of acquired loans is determined using a discounted cash flow methodology based on assumptions about the amount and timing of principal and interest payments, principal prepayments and principal defaults and losses, and current market rates.

In recording the fair values of acquired impaired loans at acquisition date, management calculates a non-accretable difference (the credit component of the purchased loans) and an accretable difference (the yield component of the purchased loans).

Over the life of the acquired loans, management continues to estimate cash flows expected to be collected. We evaluate at each balance sheet date whether it is probable that we will be unable to collect all cash flows expected at acquisition and if so, recognize a provision for loan loss in our consolidated statement of operations. For any significant increases in cash flows expected to be collected, we adjust the amount of the accretable yield recognized on a prospective basis over the pool’s remaining life.

Performing acquired loans are accounted for under Financial Accounting Standards Board (“FASB”) Topic 310-20, Receivables – Nonrefundable Fees and Other Costs. Performance of certain loans may be monitored and based on management’s assessment of the cash flows and other facts available, portions of the accretable difference may be delayed or suspended if management deems appropriate. The Corporation’s policy for determining when to discontinue accruing interest on performing acquired loans and the subsequent accounting for such loans is essentially the same as the policy for originated loans.

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Allowance for Loan Losses

The allowance for loan losses includes specific allowances related to loans, when they have been judged to be impaired. A loan is impaired when, based on current information, it is probable that the Corporation will not collect all amounts due in accordance with the contractual terms of the loan agreement. These specific allowances are based on discounted cash flows of expected future payments using the loan’s initial effective interest rate or the fair value of the collateral if the loan is collateral dependent.

The Corporation also has an unallocated allowance for loan losses for loans not considered impaired. The allowance for loan losses is maintained at a level which management believes is adequate to provide for probable loan losses. Management periodically evaluates the adequacy of the allowance using the Corporation’s past loan loss experience, known and inherent risks in the portfolio, composition of the portfolio, current economic conditions, and other factors. The allowance does not include the effects of expected losses related to future events or future changes in economic conditions. This evaluation is inherently subjective since it requires material estimates that may be susceptible to significant change. Loans are charged against the allowance for loan losses when management believes the collectability of the principal is unlikely. In addition, various regulatory agencies periodically review the allowance for loan losses. These agencies may require additions to the allowance for loan losses based on their judgments of collectability.

In management’s opinion, the allowance for loan losses is adequate to cover probable losses relating to specifically identified loans, as well as probable losses inherent in the balance of the loan portfolio as of the balance sheet date.

Stock Compensation Plans

On May 22, 2012, the Corporation’s shareholders approved the Mackinac Financial Corporation 2012 Incentive Compensation Plan, under which current and prospective employees, non-employee directors and consultants may be awarded incentive stock options, non-statutory stock options, shares of restricted stock awards (“RSAs”), stock grants, or stock appreciation rights. The aggregate number of shares of the Corporation’s common stock issuable under the plan is 575,000. At March 31, 2020 there were 76,310 shares available for issuance under this plan. Awards are made to certain other senior officers at the discretion of the Corporation’s management. Compensation cost equal to the fair value of the award is recognized over the vesting period.

2.RECENT ACCOUNTING PRONOUNCEMENTS

In September 2016, the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"). ASU 2016-13 changes how entities will measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income.

ASU 2016-13 requires an entity to measure expected credit losses for financial assets over the estimated lifetime of expected credit loss and record an allowance that, when deducted from the amortized cost basis of the financial asset, presents the net amount expected to be collected on the financial asset. The standard includes the following core concepts in determining the expected credit loss. The estimate must: (a) be based on an asset’s amortized cost (including premiums or discounts, net deferred fees and costs, foreign exchange and fair value hedge accounting adjustments), (b) reflect losses expected over the remaining contractual life of an asset (considering the effect of voluntary prepayments), (c) consider available relevant information about the estimated collectability of cash flows (including information about past events, current conditions, and reasonable and supportable forecasts), and (d) reflect the risk of loss, even when that risk is remote.

ASU 2016-13 also amends the recording of purchased credit-deteriorated assets. Under the new guidance, an allowance will be recognized at acquisition through a gross-up approach whereby an entity will record as the initial amortized cost the sum of (a) the purchase price and (b) an estimate of credit losses as of the date of acquisition. In addition, the guidance also requires immediate recognition in earnings of any subsequent changes, both favorable and unfavorable, in expected cash flows by adjusting this allowance.

ASU 2016-13 also amends the impairment model for available-for-sale debt securities and requires entities to determine whether all or a portion of the unrealized loss on an available-for-sale debt security is a credit loss. Management may not use the length of time a security has been in an unrealized loss position as a factor in concluding whether a credit loss exists, as is currently permitted. In addition, an entity will recognize an allowance for credit losses on available-for-sale debt securities as a contra-account to the amortized cost basis rather than as a direct reduction of the amortized cost basis

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of the investment, as is currently required. As a result, entities will recognize improvements to credit losses on available-for-sale debt securities immediately in earnings rather than as interest income over time under current practice.

New disclosures required by ASU 2016-13 include: (a) for financial assets measured at amortized cost, an entity will be required to disclose information about how it developed its allowance, including changes in the factors that influenced management’s estimate of expected credit losses and the reasons for those changes, (b) for financial receivables and net investments in leases measured at amortized cost, an entity will be required to further disaggregate the information it currently discloses about the credit quality of these assets by year or the asset’s origination or vintage for as many as five annual periods, and (c) for available-for-sale debt securities, an entity will be required to provide a roll-forward of the allowance for credit losses and an aging analysis for securities that are past due.

Upon adoption of ASU 2016-13, a cumulative-effect adjustment to retained earnings will be recorded as of the beginning of the first reporting period in which the guidance is effective. The Corporation is currently evaluating the provisions of ASU 2016-13 to determine the potential impact on the Corporation's consolidated financial condition and results of operations. The Corporation has formed a cross-functional implementation team consisting of individuals from finance, credit and information systems. A project plan and timeline has been developed and the implementation team meets regularly to assess the project status to ensure adherence to the timeline. The implementation team has also been working with a software vendor to assist in implementing required changes to credit loss estimation models and proceses, and is finalizing the historical data collected to be utilized in the credit loss models. The Corporation expects to recognize a cumulative effect adjustment to the opening balance of retained earnings as of the beginning of the first reporting period in which ASU 2016-13 is effective. The Corporation has not yet determined the magnitude of any such one-time adjustment or the potential impact of ASU 2016-13 on its condensed consolidated financial statements. In October 2019 the Financial Accounting Standards Board (FASB) voted to defer the effective date of ASU 2016-13 to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years, for smaller reporting companies (as defined by the Securities Exchange Commission). As the Corporation qualifies as a smaller reporting company, management plans to delay the implementation of CECL beyond 2020 and adjust the timetable of the various CECL implementation tasks. Management believes that the Corporation will benefit from additional time to run parallel testing and refine credit loss estimation models.

3.EARNINGS PER SHARE

Diluted earnings per share, which reflects the potential dilution that could occur if stock awards were fully vested and resulted in the issuance of common stock that then shared in our earnings, is computed by dividing net income by the weighted average number of common shares outstanding and common stock equivalents, after giving effect for dilutive shares issued.

The following shows the computation of basic and diluted earnings per share for the three months ended March 31, 2020 and 2019 (dollars in thousands, except per share data):


	Three Months Ended March 31,
	2020		2019

(Numerator):
Net income	$	3,051	$	3,167

(Denominator):
Weighted average shares outstanding		10,717,967		10,720,127
Effect of restricted stock awards		96,824		3,794
Diluted weighted average shares outstanding		10,814,791		10,723,921
Income per common share:
Basic	$	0.28	$	0.30
Diluted	$	0.28	$	0.30

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4.INVESTMENT SECURITIES

At March 31, 2020 the Corporation had an investment security portfolio totaling $114.734 million, a increase of $6.762 million from the December 31, 2019 balance of $107.972 million. The amortized cost and estimated fair value of investment securities available for sale as of March 31, 2020 and December 31, 2019 are as follows (dollars in thousands):


			Gross		Gross
	Amortized		Unrealized		Unrealized		Estimated
	Cost		Gains		Losses		Fair Value

March 31, 2020

Corporate	$	20,265	$	78	$	(319)	$	20,024
US Agencies		9,457		154		—		9,611
US Agencies - MBS		36,743		788		(816)		36,715
Obligations of states and political subdivisions		48,078		518		(212)		48,384

Total securities available for sale	$	114,543	$	1,538	$	(1,347)	$	114,734

December 31, 2019

Corporate	$	20,779	$	160	$	(1)	$	20,938
US Agencies		14,450		47		(1)		14,496
US Agencies - MBS		34,063		492		(29)		34,526
Obligations of states and political subdivisions		37,382		630		—		38,012

Total securities available for sale	$	106,674	$	1,329	$	(31)	$	107,972

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The following table presents the amortized cost and estimated fair value of investment securities by contractual maturity as of March 31, 2020 and December 31, 2019 (dollars in thousands):


	March 31,				December 31,
	2020				2019
	Amortized		Estimated		Amortized		Estimated
	Cost		Fair Value		Cost		Fair Value
Available -for-sale securities
Under 1 year	$	15,383	$	15,398	$	21,532	$	21,575
After 1 year through five years		38,919		39,653		40,063		40,664
After 5 years through 10 years		11,898		11,281		10,019		10,189
After 10 years		11,600		11,687		997		1,018
Subtotal		77,800		78,019		72,611		73,446
US Agencies - MBS		36,743		36,715		34,063		34,526

Total available -for-sale securities	$	114,543	$	114,734	$	106,674	$	107,972

The following is information pertaining to securities with gross unrealized losses at March 31, 2020 and December 31, 2019 (dollars in thousands):


	Less Than Twelve Months						Over Twelve Months						Total
	Number				Gross		Number				Gross		Number				Gross
	of		Fair		Unrealized		of		Fair		Unrealized		of		Fair		Unrealized
March 31, 2020	Securities		Value		Loss		Securities		Value		Loss		Securities		Value		Loss
Corporate		6	$	14,504	$	(319)		—	$	—	$	—		6	$	14,504	$	(319)
US Agencies		—		—		—		—		—		—		—		—		—
US Agencies - MBS		17		16,017		(814)		3		39		(2)		20		16,056		(816)
Obligations of states and political subdivisions		46		9,474		(212)		—		—		—		46		9,474		(212)
Total		69	$	39,995	$	(1,345)		3	$	39	$	(2)		72	$	40,034	$	(1,347)


	Less Than Twelve Months						Over Twelve Months						Total
	Number				Gross		Number				Gross		Number				Gross
	of		Fair		Unrealized		of		Fair		Unrealized		of		Fair		Unrealized
December 31, 2019	Securities		Value		Loss		Securities		Value		Loss		Securities		Value		Loss
Corporate		1	$	2,502	$	(1)		—	$	—	$	—		1	$	2,502	$	(1)
US Agencies		—		—		—		1		500		(1)		1		500		(1)
US Agencies - MBS		10		6,966		(9)		13		1,233		(19)		23		8,199		(28)
Obligations of states and political subdivisions		—		—		—		1		115		(1)		1		115		(1)
Total		11	$	9,468	$	(10)		15	$	1,848	$	(21)		26	$	11,316	$	(31)

The Corporation has evaluated gross unrealized losses that exist within the portfolio and considers them temporary in nature. The Corporation has both the ability and the intent to hold the investment securities until their respective maturities and therefore does not anticipate the realization of the temporary losses.

The amortized cost and estimated fair value of investment securities pledged to secure FHLB borrowings and customer relationships were $25.327 million and $25.884 million, respectively, at March 31, 2020.

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5.LOANS

The composition of loans is as follows (dollars in thousands):


	March 31,		December 31,
	2020		2019

Commercial real estate	$	522,659	$	514,394
Commercial, financial, and agricultural		207,727		211,023
Commercial construction		29,971		40,107
One to four family residential real estate		244,059		253,918
Consumer		20,375		21,238
Consumer construction		19,386		18,096

Total loans	$	1,044,177	$	1,058,776

The Corporation completed the acquisition of Peninsula Financial Corporation (“PFC”) on December 5, 2014, The First National Bank of Eagle River (“Eagle River”) on April 29, 2016, Niagara Bancorporation (“Niagara”) on August 31, 2016, First Federal of Northern Michigan Bancorp (“FFNM”) on May 18, 2018 and Lincoln Community Bank (“Lincoln”) on October 1, 2018. The PFC acquired impaired loans totaled $13.290 million, the Eagle River acquired impaired loans totaled $3.401 million, the Niagara acquired impaired loans totaled $2.105 million, the FFNM acquired impaired loans totaled $5.440 million, and the Lincoln acquired impaired loans totaled $1.901 million.

The table below details the outstanding balances of the PFC acquired portfolio and the fair value adjustments at acquisition date (dollars in thousands):


	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total
Loans acquired - contractual payments	$	13,290	$	53,849	$	67,139
Nonaccretable difference		(2,234)		—		(2,234)
Expected cash flows		11,056		53,849		64,905
Accretable yield		(744)		(2,100)		(2,844)
Carrying balance at acquisition date	$	10,312	$	51,749	$	62,061

The table below details the outstanding balances of the Eagle River acquired portfolio and the fair value adjustments at acquisition date (dollars in thousands):


	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total
Loans acquired - contractual payments	$	3,401	$	80,737	$	84,138
Nonaccretable difference		(1,172)		—		(1,172)
Expected cash flows		2,229		80,737		82,966
Accretable yield		(391)		(1,700)		(2,091)
Carrying balance at acquisition date	$	1,838	$	79,037	$	80,875

The table below details the outstanding balances of the Niagara acquired portfolio and the fair value adjustments at acquisition date (dollars in thousands):


	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total
Loans acquired - contractual payments	$	2,105	$	30,555	$	32,660
Nonaccretable difference		(265)		—		(265)
Expected cash flows		1,840		30,555		32,395
Accretable yield		(88)		(600)		(688)
Carrying balance at acquisition date	$	1,752	$	29,955	$	31,707

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The table below details the outstanding balances of the FFNM acquired portfolio and the fair value adjustments at acquisition date (dollars in thousands):


	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total
Loans acquired - contractual payments	$	5,440	$	187,302	$	192,742
Nonaccretable difference		(2,100)		—		(2,100)
Expected cash flows		3,340		187,302		190,642
Accretable yield		(700)		(4,498)		(5,198)
Carrying balance at acquisition date	$	2,640	$	182,804	$	185,444

The table below details the outstanding balances of the Lincoln acquired portfolio and the fair value adjustments at acquisition date (dollars in thousands):


	Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total
Loans acquired - contractual payments	$	1,901	$	37,700	$	39,601
Nonaccretable difference		(421)		—		(421)
Expected cash flows		1,480		37,700		39,180
Accretable yield		(140)		(493)		(633)
Carrying balance at acquisition date	$	1,340	$	37,207	$	38,547

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The table below presents a rollforward of the accretable yield on acquired loans for the three months ended March 31, 2020 (dollars in thousands):


	PFC						Eagle River
	Acquired		Acquired		Acquired		Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total		Impaired		Non-impaired		Total

Balance, December 31, 2019	$	105	$	—	$	105	$	209	$	—	$	209
Accretion		(90)		—		(90)		(77)		—		(77)
Reclassification from nonaccretable difference		52		—		52		58		—		58
Balance, March 31, 2020	$	67	$	—	$	67	$	190	$	—	$	190

	Niagara						First Federal Northern Michigan
	Acquired		Acquired		Acquired		Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total		Impaired		Non-impaired		Total

Balance, December 31, 2019	$	19	$	—	$	19	$	518	$	1,953	$	2,471
Accretion		(4)		—		(4)		(237)		(310)		(547)
Reclassification from nonaccretable difference		3		—		3		177		—		177
Balance, March 31, 2020	$	18	$	—	$	18	$	458	$	1,643	$	2,101

	Lincoln Community Bank						Total
	Acquired		Acquired		Acquired		Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total		Impaired		Non-impaired		Total

Balance, December 31, 2019	$	108	$	264	$	372	$	959	$	2,217	$	3,176
Accretion		(3)		(38)		(41)		(411)		(348)		(759)
Reclassification from nonaccretable difference		3		—		3		293		—		293
Balance, March 31, 2020	$	108	$	226	$	334	$	841	$	1,869	$	2,710

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The table below presents a rollforward of the accretable yield on acquired loans for the three months ended March 31, 2019 (dollars in thousands):


	PFC						Eagle River
	Acquired		Acquired		Acquired		Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total		Impaired		Non-impaired		Total

Balance, December 31, 2018	$	128	$	—	$	128	$	213	$	16	$	229
Acquisition		—		—		—		—		—		—
Accretion		—		—		—		—		(16)		(16)
Reclassification from nonaccretable difference		—		—		—		—		—		—
Balance, March 31, 2019	$	128	$	—	$	128	$	213	$	—	$	213

	Niagara						First Federal Northern Michigan
	Acquired		Acquired		Acquired		Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total		Impaired		Non-impaired		Total

Balance, December 31, 2018	$	26	$	69	$	95	$	571	$	3,446	$	4,017
Acquisition		—		—		—		—		—		—
Accretion		—		(51)		(51)		—		(410)		(410)
Reclassification from nonaccretable difference		—		—		—		—		—		—
Balance, March 31, 2019	$	26	$	18	$	44	$	571	$	3,036	$	3,607

	Lincoln Community Bank						Total
	Acquired		Acquired		Acquired		Acquired		Acquired		Acquired
	Impaired		Non-impaired		Total		Impaired		Non-impaired		Total

Balance, December 31, 2018	$	140	$	442	$	582	$	1,078	$	3,973	$	5,051
Acquisition		—		—		—		—		—		—
Accretion		(15)		(49)		(64)		(15)		(526)		(541)
Reclassification from nonaccretable difference		12		—		12		12		—		12
Balance, March 31, 2019	$	137	$	393	$	530	$	1,075	$	3,447	$	4,522

Allowance for Loan Losses

An analysis of the allowance for loan losses for the three months ended March 31, 2020 and March 31, 2019 is as follows (dollars in thousands):


	March 31,		March 31,
	2020		2019

Balance, January 1	$	5,308	$	5,183
Recoveries on loans previously charged off		29		32
Loans charged off		(145)		(161)
Provision		100		100

Balance at end of period	$	5,292	$	5,154

In the first three months of 2020, net charge-offs were $116,000, compared to net charge-offs of $129,000 in the same period in 2019. In the first three months of 2020, the Corporation recorded a provision for loan loss of $100,000 compared to a $100,000 provision for loan losses in the first three months of 2019. The Corporation’s allowance for loan loss reserve policy calls for a measurement of the adequacy of the reserve at each quarter end. This process includes an analysis of the loan portfolio to take into account increases in loans outstanding and portfolio composition, historical loss rates, and specific reserve requirements of nonperforming loans.

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A breakdown of the allowance for loan losses and recorded balances in loans at March 31, 2020 is as follows (dollars in thousands):


			Commercial,				One to four
	Commercial		financial and		Commercial		family residential		Consumer
	real estate		agricultural		construction		real estate		construction		Consumer		Unallocated		Total
Allowance for loan loss reserve:
Beginning balance ALLR	$	1,189	$	1,197	$	71	$	148	$	11	$	13	$	2,679	$	5,308
Charge-offs		—		(66)		—		(22)		(8)		(49)		—		(145)
Recoveries		6		—		—		10		—		13		—		29
Provision		623		502		27		291		7		33		(1,383)		100
Ending balance ALLR	$	1,818	$	1,633	$	98	$	427	$	10	$	10	$	1,296	$	5,292

Loans:
Ending balance	$	522,659	$	207,727	$	29,971	$	244,059	$	19,386	$	20,375	$	—	$	1,044,177
Ending balance ALLR		(1,818)		(1,633)		(98)		(427)		(10)		(10)		(1,296)		(5,292)
Net loans	$	520,841	$	206,094	$	29,873	$	243,632	$	19,376	$	20,365	$	(1,296)	$	1,038,885

Ending balance ALLR:
Individually evaluated	$	913	$	476	$	—	$	—	$	—	$	—	$	—	$	1,389
Collectively evaluated		905		1,157		98		427		10		10		1,296		3,903
Total	$	1,818	$	1,633	$	98	$	427	$	10	$	10	$	1,296	$	5,292

Ending balance Loans:
Individually evaluated	$	2,278	$	1,454	$	—	$	—	$	—	$	—	$	—	$	3,732
Collectively evaluated		518,642		203,857		29,604		243,251		19,386		20,374		—		1,035,114
Acquired with deteriorated credit quality		1,739		2,416		367		808		—		1		—		5,331
Total	$	522,659	$	207,727	$	29,971	$	244,059	$	19,386	$	20,375	$	—	$	1,044,177

Impaired loans, by definition, are individually evaluated.

In the first quarter of 2020, the Corporation booked a provision for loan losses of $100,000 as a result of changes in environmental factors. Furthermore, a portion of the unallocated reserve was allocated due to a modification in the methodology for calculating the environmental factors.

A breakdown of the allowance for loan losses and recorded balances in loans at March 31, 2019 is as follows (dollars in thousands):


			Commercial,				One to four
	Commercial		financial and		Commercial		family residential		Consumer
	real estate		agricultural		construction		real estate		construction		Consumer		Unallocated		Total
Allowance for loan loss reserve:
Beginning balance ALLR	$	1,682	$	648	$	101	$	199	$	6	$	8	$	2,539	$	5,183
Charge-offs		(20)		(19)		—		(63)		—		(59)		—		(161)
Recoveries		12		4		—		5		—		11		—		32
Provision		(109)		372		(1)		60		—		49		(271)		100
Ending balance ALLR	$	1,565	$	1,005	$	100	$	201	$	6	$	9	$	2,268	$	5,154

Loans:
Ending balance	$	498,471	$	201,089	$	33,118	$	281,104	$	12,022	$	19,624	$	—	$	1,045,428
Ending balance ALLR		(1,565)		(1,005)		(100)		(201)		(6)		(9)		(2,268)		(5,154)
Net loans	$	496,906	$	200,084	$	33,018	$	280,903	$	12,016	$	19,615	$	(2,268)	$	1,040,274

Ending balance ALLR:
Individually evaluated	$	467	$	648	$	—	$	—	$	—	$	—	$	—	$	1,115
Collectively evaluated		1,098		357		100		201		6		9		2,268		4,039
Total	$	1,565	$	1,005	$	100	$	201	$	6	$	9	$	2,268	$	5,154

Ending balance Loans:
Individually evaluated	$	2,138	$	1,245	$	—	$	—	$	—	$	—	$	—	$	3,383
Collectively evaluated		493,570		198,425		32,753		279,943		11,809		19,585		—		1,036,085
Acquired with deteriorated credit quality		2,763		1,419		365		1,161		213		39		—		5,960
Total	$	498,471	$	201,089	$	33,118	$	281,104	$	12,022	$	19,624	$	—	$	1,045,428

Table of Contents

As part of the management of the loan portfolio, risk ratings are assigned to all commercial loans. Through the loan review process, ratings are modified as believed to be appropriate to reflect changes in the credit. Our ability to manage credit risk depends in large part on our ability to properly identify and manage problem loans.

To do so, we operate a credit risk rating system under which our credit management personnel assign a credit risk rating to each loan at the time of origination and review loans on a regular basis to determine each loan’s credit risk rating on a scale of 1 through 8, with higher scores indicating higher risk. The credit risk rating structure used is shown below.

In the context of the credit risk rating structure, the term Classified is defined as a problem loan which may or may not be in a nonaccrual status, dependent upon current payment status and collectability.

Strong (1)

Borrower is not vulnerable to sudden economic or technological changes. They have “strong” balance sheets and are within an industry that is very typical for our markets or type of lending culture. Borrowers also have “strong” financial and cash flow performance and excellent collateral (low loan to value or readily available to liquidate collateral) in conjunction with an impeccable repayment history.

Good (2)

Borrower shows limited vulnerability to sudden economic change. These borrowers have “above average” financial and cash flow performance and a very good repayment history. The balance sheet of the company is also very good as compared to peer and the company is in an industry that is familiar to our markets or our type of lending. The collateral securing the deal is also very good in terms of its type, loan to value, and other relevant characteristics.

Average (3)

Borrower is typically a well-seasoned business, however may be susceptible to unfavorable changes in the economy, and could be somewhat affected by seasonal factors. The borrowers within this category exhibit financial and cash flow performance that appear “average” to “slightly above average” when compared to peer standards and they show an adequate payment history. Collateral securing this type of credit is good, exhibiting above average loan to values, and other relevant characteristics.

Acceptable (4)

A borrower within this category exhibits financial and cash flow performance that appear adequate and satisfactory when compared to peer standards and they show a satisfactory payment history. The collateral securing the request is within supervisory limits and overall is acceptable. Borrowers rated acceptable could also be newer businesses that are typically susceptible to unfavorable changes in the economy, and more than likely could be affected by seasonal factors.

Acceptable Watch (44)

The borrower may have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Acceptable Watch assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. Examples of this type of credit include a start-up company fully based on projections, a documentation issue that needs to be corrected or a general market condition that the borrower is working through to get corrected.

Substandard (6)

Substandard loans are classified assets exhibiting a number of well-defined weaknesses that jeopardize normal repayment. The assets are no longer adequately protected due to declining net worth, lack of earning capacity, or insufficient collateral offering the distinct possibility of the loss of a portion of the loan principal. Loans classified as substandard clearly represent troubled and deteriorating credit situations requiring constant supervision.

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Doubtful (7)

Loans in this category exhibit the same, if not more pronounced weaknesses used to describe the substandard credit. Loans are frozen with collection improbable. Such loans are not yet rated as Charge-off because certain actions may yet occur which would salvage the loan.

Charge-off/Loss (8)

Loans in this category are largely uncollectible and should be charged against the loan loss reserve immediately.

General Reserves:

For loans with a credit risk rating of 44 or better and any loans with a risk rating of 6 or 7 not considered impaired, reserves are established based on the type of loan collateral, if any, and the assigned credit risk rating.

Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogenous loans based on historical loss experience, and consideration of current environmental factors and economic trends, all of which may be susceptible to significant change.

Using a historical average loss by loan type as a base, each loan graded as higher risk is assigned a specific percentage. The residential real estate and consumer loan portfolios are assigned a loss percentage as a homogenous group. If, however, on an individual loan the projected loss based on collateral value and payment histories is in excess of the computed allowance, the allocation is increased for the higher anticipated loss. These computations provide the basis for the allowance for loan losses as recorded by the Corporation.

Below is a breakdown of loans by risk category as of March 31, 2020 (dollars in thousands):


	(1)		(2)		(3)		(4)		(44)		(6)		(7)		Rating
	Strong		Good		Average		Acceptable		Acceptable Watch		Substandard		Doubtful		Unassigned		Total

Commercial real estate	$	14,737	$	18,108	$	227,628	$	253,746	$	3,865	$	4,575	$	—	$	—	$	522,659
Commercial, financial and agricultural		17,609		9,053		64,182		111,434		759		4,690		—		—		207,727
Commercial construction		—		278		8,768		16,474		596		398		—		3,457		29,971
One-to-four family residential real estate		40		2,217		5,119		15,187		617		2,556		—		218,323		244,059
Consumer construction		—		—		—		—		—		—		—		19,386		19,386
Consumer		—		130		252		473		—		85		—		19,435		20,375

Total loans	$	32,386	$	29,786	$	305,949	$	397,314	$	5,837	$	12,304	$	—	$	260,601	$	1,044,177

Below is a breakdown of loans by risk category as of December 31, 2019 (dollars in thousands):


	(1)		(2)		(3)		(4)		(44)		(6)		(7)		Rating
	Strong		Good		Average		Acceptable		Acceptable Watch		Substandard		Doubtful		Unassigned		Total

Commercial real estate	$	9,979	$	17,516	$	228,962	$	248,177	$	4,468	$	5,292	$	—	$	—	$	514,394
Commercial, financial and agricultural		15,126		4,510		70,748		115,229		930		4,480		—		—		211,023
Commercial construction		—		292		6,390		28,893		400		607		—		3,525		40,107
One-to-four family residential real estate		40		2,145		4,937		15,168		634		2,632		—		228,362		253,918
Consumer construction		—		—		—		—		—		—		—		18,096		18,096
Consumer		—		158		250		640		—		41		—		20,149		21,238

Total loans	$	25,145	$	24,621	$	311,287	$	408,107	$	6,432	$	13,052	$	—	$	270,132	$	1,058,776

Impaired Loans

Impaired loans are those which are contractually past due 90 days or more as to interest or principal payments, on nonaccrual status, or loans, the terms of which have been renegotiated to provide a reduction or deferral on interest or principal.

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Loans are considered impaired when, based on current information and events, it is probable the Corporation will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

The following is a summary of impaired loans and their effect on interest income (dollars in thousands):


	Impaired Loans		Impaired Loans		Total		Unpaid		Related
	with No Related		with Related		Impaired		Principal		Allowance for
	Allowance		Allowance		Loans		Balance		Loan Losses
March 31, 2020

Commercial real estate	$	1,739	$	2,278	$	4,017	$	7,061	$	913
Commercial, financial and agricultural		2,416		1,454		3,870		3,870		476
Commercial construction		367		—		367		373		—
One to four family residential real estate		808		—		808		2,450		—
Consumer construction		—		—		—		—		—
Consumer		1		—		1		1		—
Total	$	5,331	$	3,732	$	9,063	$	13,755	$	1,389

December 31, 2019
Commercial real estate	$	4,318	$	2,374	$	6,692	$	7,937	$	497
Commercial, financial and agricultural		2,354		1,475		3,829		4,892		770
Commercial construction		373		—		373		386		—
One to four family residential real estate		1,920		—		1,920		2,881		—
Consumer construction		—		—		—		—		—
Consumer		9		—		9		33		—
Total	$	8,974	$	3,849	$	12,823	$	16,129	$	1,267


	Individually Evaluated Impaired Loans
	March 31, 2020				December 31, 2019
	Average		Interest Income		Average		Interest Income
	Balance for		Recognized for		Balance for		Recognized for
	the Period		the Period		the Period		the Period
Commercial real estate	$	7,841	$	65	$	8,374	$	301
Commercial, financial and agricultural		1,597		—		1,144		2
Commercial construction		21		1		396		—
One to four family residential real estate		2,665		39		3,508		219
Consumer construction		—		—		—		—
Consumer		17		1		44		2
Total	$	12,141	$	106	$	13,466	$	524

A summary of past due loans at March 31, 2020 and December 31, 2019 is as follows (dollars in thousands):


	March 31,								December 31,
	2020								2019
	30-89 days		90+ days						30-89 days		90+ days
	Past Due		Past Due						Past Due		Past Due
	(accruing)		(accruing)		Nonaccrual		Total		(accruing)		(accruing)		Nonaccrual		Total

Commercial real estate	$	1,621	$	—	$	959	$	2,580	$	1,055	$	—	$	671	$	1,726
Commercial, financial and agricultural		1,538		—		816		2,354		829		—		527		1,356
Commercial construction		128		—		99		227		59		—		105		164
One to four family residential real estate		3,321		—		4,479		7,800		4,357		11		3,850		8,218
Consumer construction		—		—		—		—		—		—		—		—
Consumer		156		—		63		219		83		—		19		102

Total past due loans	$	6,764	$	—	$	6,416	$	13,180	$	6,383	$	11	$	5,172	$	11,566

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Troubled Debt Restructuring

Troubled debt restructurings (“TDR”) are determined on a loan-by-loan basis. Generally restructurings are related to interest rate reductions, loan term extensions and short term payment forbearance as a means to maximize collectability of troubled credits. If a portion of the TDR loan is uncollectible (including forgiveness of principal), the uncollectible amount will be charged off against the allowance at the time of the restructuring. In general, a borrower must make at least six consecutive timely payments before the Corporation would consider a return of a restructured loan to accruing status in accordance with FDIC guidelines regarding restoration of credits to accrual status. More recent regulatory guidelines and accounting standards indicate that loan modifications or forbearances related to the COVID-19 pandemic will generally not be considered TDRs.

The Corporation has, in accordance with generally accepted accounting principles and applicable accounting standard updates, evaluated all loan modifications to determine the fair value impact of the underlying asset. The carrying amount of the loan is compared to the expected payments to be received, discounted at the loan’s original rate, or for collateral dependent loans, to the fair value of the collateral.

There were 3 TDR’s that occurred during the three months ended March 31, 2020 and 3 TDR during the three months ended March 31, 2019. The three restructured loans as of March 31, 2020, included only modifications to the repayment schedules. The balance of these restructured loans pre-modification was $.504 million. Post-modification balances as of March 31, 2020 were $.493 million. The three TDR’s are not COVID-19 related.

Insider Loans

The Bank, in the ordinary course of business, grants loans to the Corporation’s executive officers and directors, including their families and firms in which they are principal owners. Activity in such loans is summarized below (dollars in thousands):


	Three Months Ended		Three Months Ended
	March 31,		March 31,
	2020		2019
Loans outstanding, January 1	$	12,196	$	9,817
New loans		—		1,872
Net activity on revolving lines of credit		(354)		358
Repayment		(100)		(96)
Loans outstanding at end of period	$	11,742	$	11,951

There were no loans to related parties classified substandard as of March 31, 2020 or March 31, 2019. In addition to the outstanding balances above, there were unfunded commitments of $.355 million to related parties at March 31, 2020.

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6.GOODWILL AND OTHER INTANGIBLE ASSETS

The Corporation through the acquisition of Peninsula in 2014, Eagle River and Niagara in 2016, and FFNM and Lincoln in 2018, has recorded goodwill and core deposit intangibles as presented below (dollars in thousands):


			Deposit Based
	Goodwill		Intangible
	Balance		Initial Balance
Peninsula	$	3,805	$	1,206
Eagle River		1,839		993
Niagara		50		300
FFNM		12,628		2,894
Lincoln		1,252		1,353
Total	$	19,574	$	6,746


	Deposit Based
	Intangible		March 31, 2020		Future Annual
	March 31, 2020		Amortization		Amortization
	Balance		Expense		Expense
Peninsula	$	564	$	30	$	121
Eagle River		604		25		99
Niagara		192		8		30
FFNM		2,364		72		290
Lincoln		1,150		34		135
Total	$	4,874	$	169	$	675


	Deposit Based
	Intangible		2019
	December 31, 2019		Amortization
	Balance		Expense
Peninsula	$	594	$	121
Eagle River		629		99
Niagara		200		30
FFNM		2,436		299
Lincoln		1,184		128
Total	$	5,043	$	677

The deposit based intangible asset is reported net of accumulated amortization at $4.874 million at March 31, 2020. Amortization expense in the first three months of 2020 is $.169 million. Amortization expense for the next five years is expected to be at $.675 million per year.

The Corporation, in accordance with GAAP, evaluates it goodwill annually for impairment. As a result of the current economic uncertainty and volatility surrounding COVID-19, the Corporation may need to perform this evaluation prior to the annual measurement date.

7.SERVICING RIGHTS

Mortgage Loans

Mortgage servicing rights (“MSRs”) are recorded when loans are sold in the secondary market with servicing retained. As of March 31, 2020, the Corporation had obligations to service approximately $246.370 million of residential first mortgage loans. The valuation of MSRs is based upon the net present value of the projected revenues over the expected life of the loans being serviced, as reduced by estimated internal costs to service these loans. On a quarterly basis, management evaluates the MSRs for impairment. The key economic assumptions used in determining the fair value of the MSRs include an annual constant prepayment speed of 13.65% and a discount rate of 8.66% as of March 31, 2020.

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The following table summarizes MSRs capitalized and amortized (dollars in thousands):


	March 31,		March 31,
	2020		2019
Balance at beginning of period	$	1,499	$	1,144
Additions from loans sold with servicing retained		—		500
Amortization		(35)		(60)

Balance at end of period	$	1,464	$	1,584
Balance of loan servicing portfolio	$	246,370	$	288,687
Mortgage servicing rights as % of portfolio		.59%		.55%
Fair value of servicing rights		2,159		2,898

Commercial Loans

The Corporation periodically retains the servicing on certain commercial loans that have been sold. These loans were originated and underwritten under the SBA and USDA government guarantee programs, in which the guaranteed portion of the loan was sold to a third party with servicing retained. The balance of these sold loans with servicing retained at March 31, 2020 was approximately $41 million. The Corporation valued these servicing rights at $42,000 as of March 31, 2020 and at $80,000 as of March 31, 2019. This valuation was established in consideration of the discounted cash flow of net expected servicing income over the life of the loans.

8.BORROWINGS

Borrowings consist of the following at March 31, 2020 and December 31, 2019 (dollars in thousands):


	March 31,		December 31,
	2020		2019
Federal Home Loan Bank fixed rate advances	$	63,717	$	64,148
Correspondent bank line of credit		3,000		—
USDA Rural Development note		403		403
	$	67,120	$	64,551

The Federal Home Loan Bank borrowings bear a weighted average rate of 1.67% and mature at various dates through 2026. They are collateralized at March 31, 2020 by the following: a collateral agreement on the Corporation’s one to four family residential real estate loans with a book value of approximately $50.310 million; mortgage related and municipal securities with an amortized cost and estimated fair value of $20.051 million and $20.655 million, respectively; and Federal Home Loan Bank stock owned by the Bank totaling $4.924 million. Prepayment of the advances is subject to the provisions and conditions of the credit policy of the Federal Home Loan Bank of Indianapolis in effect as of March 31, 2020.

The Corporation currently has one correspondent banking borrowing relationship. As of March 31, 2020 the relationship consisted of a $15.0 million revolving line of credit, which had a balance of $3.0 million. The line of credit bears an interest rate of LIBOR plus 2.00%, with a floor rate of 3.00% and a ceiling of 22%. The line of credit expired on April 30, 2020, and has since been renewed with a new expiration date of April 30, 2022. LIBOR at March 31, 2020 was 1.45%. This relationship is secured by all of the outstanding mBank stock.

The USDA Rural Development borrowing bears an interest rate of 1.00% and matures in August, 2024. It is collateralized by an assignment of a demand deposit account held by the Corporation’s wholly owned subsidiary, First Rural Relending, in the amount of $.456 million, and guaranteed by the Corporation.

9.DEFINED BENEFIT PENSION PLAN

The Corporation acquired the Peninsula Financial Corporation noncontributory defined benefit pension plan in 2014. Effective December 31, 2005, the plan was amended to freeze participation in the plan; therefore, no additional employees are eligible to become participants in the plan. The benefits are based on years of service and the employee’s

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compensation at the time of retirement. The Plan was amended effective December 31, 2010, to freeze benefit accrual for all participants. Expected contributions to the Plan in 2020 are $139,000.

The anticipated distributions over the next five years and through December 31, 2029 are detailed in the table below (dollars in thousands):


2020	$	131
2021		129
2022		137
2023		143
2024		141
2025-2029		869
Total	$	1,550

The Corporation receives a valuation of the Plan annually. As such, at March 31, 2020, the plan’s assets had a fair value of $2.259 million and the Corporation had a net unfunded liability of $1.188 million. The accumulated benefit obligation at March 31, 2020 was $3.447 million.

Assumptions in the actuarial valuation are:


	2020	2019
Weighted average discount rate	2.92%	2.92%
Rate of increase in future compensation levels	N/A	N/A
Expected long-term rate of return on plan assets	8.00%	8.00%

The expected long-term rate of return on plan assets reflects management’s expectations of long-term average rates of return on funds invested to provide for benefits included in the projected benefit obligation. The expected return is based on the outlook for inflation, fixed income returns and equity returns, while also considering historical returns, asset allocation and investment strategy. The discount rate assumption is based on investment yields available on AA rated long-term corporate bonds.

The primary investment objective is to maximize growth of the pension plan assets to meet the projected obligations to the beneficiaries over a long period of time, and to do so in a manner that is consistent with the Corporation’s risk tolerance. The intention of the plan sponsor is to invest the plan assets in mutual funds with the following asset allocation; which was in place at both March 31, 2020 and December 31, 2019.


	Target	Actual
	Allocation	Allocation
Equity securities	50% to 70%	60%
Fixed income securities	30% to 50%	40%

10.STOCK COMPENSATION PLANS

Restricted Stock Awards

The Corporation’s restricted stock awards are service-based and awarded based on performance. Each award has a vesting period of four years. Compensation expense is recognized on a straight-line basis over the vesting period. Shares are subject to certain restrictions and risk of forfeiture by the participants.

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The Corporation has historically granted RSAs to members of the Board of Directors and management. Awards granted are set to vest equally over their award terms and are issued at no cost to the recipient. The table below summarizes each of the grant awards:


		Market Value at
Date of Award	Units Granted	grant date	Vesting Term
February, 2017	28,427	13.39	4 years
February, 2018	18,643	16.30	4 years
April, 2018	8,000	16.00	Immediate
February, 2019	27,790	15.70	4 years
October, 2019	8,000	15.40	Immediate
February, 2020	132,000	15.46	4 years

In the first three months of 2020, the Corporation issued 25,521 shares of its common stock for vested RSAs. In the first three months of 2019, the Corporation issued 27,967 shares of its common stock for vested RSAs.

A summary of changes in our nonvested shares for the period follows:


		Weighted Average
	Number	Grant Date
	Outstanding	Fair Value
Nonvested balance at January 1, 2020	69,145	$	14.52
Granted during the period	132,000		15.46
Vested during the period	(25,521)		14.99
Nonvested balance at March 31, 2020	175,624	$	15.16

11.INCOME TAXES

The Corporation has reported deferred tax assets of $3.154 million at March 31, 2020.

A valuation allowance is provided against deferred tax assets when it is more likely than not that some or all of the deferred tax asset will not be realized. The Corporation, as of March 31, 2020 had a net operating loss carryforwards for tax purposes of approximately $10.2 million. As a result of the repeal of the corporate alternative minimum tax in the Tax Cuts and Jobs Act, any outstanding alternative minimum tax credits are believed to be utilized or refundable as of December 31, 2019. Therefore, the $1.6 million of alternative minimum tax credits, was reclassified to a current tax receivable incuded in other assets during 2018. The net operating loss carryforwards expire twenty years from the date they originated. These carryforwards, if not utilized, will begin to expire in the year 2023. A portion of the NOL and credit carryforwards are subject to the limitations for utilization as set forth in Section 382 of the Internal Revenue Code. The annual limitation is $2.0 million for the NOL and the equivalent value of tax credits, which is approximately $.420 million. These limitations for use were established in conjunction with the recapitalization of the Corporation in December 2004. The Corporation will continue to evaluate the future benefits from these carryforwards in order to determine if any adjustment to the deferred tax asset is warranted.

The Corporation recognized a federal income tax expense of approximately $.811 million for the three months ended March 31, 2020 and $.842 million for the three months ended March 31, 2019.

12.FAIR VALUE MEASUREMENTS

Fair value estimates, methods, and assumptions are set forth below for the Corporation’s financial instruments.

Cash, cash equivalents, and interest-bearing deposits - The carrying values approximate the fair values for these assets.

Securities - Fair values are based on quoted market prices where available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

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Federal Home Loan Bank stock – Federal Home Loan Bank stock is carried at cost, which is its redeemable value and approximates its fair value, since the market for this stock is limited.

Loans - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, residential mortgage, and other consumer. The fair value of loans is calculated by discounting scheduled cash flows using discount rates reflecting the credit and interest rate risk inherent in the loan.

The methodology in determining fair value of nonaccrual loans is to average them into the blended interest rate at 0% interest. This has the effect of decreasing the carrying amount below the risk-free rate amount and, therefore, discounts the estimated fair value.

Impaired loans are measured at the estimated fair value of the expected future cash flows at the loan’s effective interest rate or the fair value of the collateral for loans which are collateral dependent. Therefore, the carrying values of impaired loans approximate the estimated fair values for these assets.

Deposits - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits and savings, is equal to the amount payable on demand at the reporting date. The fair value of time deposits is based on the discounted value of contractual cash flows applying interest rates currently being offered on similar time deposits.

Borrowings - Rates currently available for debt with similar terms and remaining maturities are used to estimate the fair value of existing debt. The fair value of borrowed funds due on demand is the amount payable at the reporting date.

Accrued interest - The carrying amount of accrued interest approximates fair value.

Off-balance-sheet instruments - The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the current interest rates, and the present creditworthiness of the counterparties. Since the differences in the current fees and those reflected to the off-balance-sheet instruments at year-end are immaterial, no amounts for fair value are presented.

The following table presents information for financial instruments at March 31, 2020 and December 31, 2019 (dollars in thousands):


		March 31, 2020				December 31, 2019
	Level in Fair	Carrying		Estimated		Carrying		Estimated
	Value Hierarchy	Amount		Fair Value		Amount		Fair Value

Financial assets:
Cash and cash equivalents	Level 1	$	97,072	$	97,072	$	49,826	$	49,826
Interest-bearing deposits	Level 2		8,825		8,825		10,295		10,295
Securities available for sale	Level 2		113,331		113,331		106,569		106,569
Securities available for sale	Level 3		1,403		1,403		1,403		1,403
Federal Home Loan Bank stock	Level 2		4,924		4,924		4,924		4,924
Net loans	Level 3		1,038,885		1,042,604		1,053,468		1,055,985
Accrued interest receivable	Level 3		4,047		4,047		3,751		3,751

Total financial assets		$	1,268,487	$	1,272,206	$	1,230,236	$	1,232,753

Financial liabilities:
Deposits	Level 2	$	1,095,381	$	1,095,819	$	1,075,677	$	1,044,267
Borrowings	Level 2		67,120		64,952		64,551		64,403
Accrued interest payable	Level 3		595		595		569		569

Total financial liabilities		$	1,163,096	$	1,161,366	$	1,140,797	$	1,109,239

Limitations - Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Corporation’s entire holdings of a particular financial instrument. Because no

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market exists for a significant portion of the Corporation’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on-and off-balance-sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. Significant assets and liabilities that are not considered financial assets or liabilities include premises and equipment, other assets, and other liabilities. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.

The following is information about the Corporation’s assets and liabilities measured at fair value on a recurring basis at March 31, 2020, and the valuation techniques used by the Corporation to determine those fair values.


Level 1:	In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that the Corporation has the ability to access.

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

Level 3:	Level 3 inputs are unobservable inputs, including inputs available in situations where there is little, if any, market activity for the related asset or liability.

The fair value of all investment securities at March 31, 2020 and December 31, 2019 were based on level 2 and level 3 inputs. There are no other assets or liabilities measured on a recurring basis at fair value. For additional information regarding investment securities, please refer to “Note 4 - Investment Securities.”

The table below shows investment securities measured at fair value on a recurring basis (dollars in thousands):


			Quoted Prices		Significant		Significant		Total (Gains)
			in Active Markets		Other Observable		Unobservable		Losses for
	Balance at		for Identical Assets		Inputs		Inputs		Three Months Ended
(dollars in thousands)	March 31, 2020		(Level 1)		(Level 2)		(Level 3)		March 31, 2020
Assets

Corporate	$	20,024	$	—	$	19,524	$	500	$	—
US Agencies		9,611		—		9,611		—		—
US Agencies - MBS		36,715		—		36,715		—		—
Obligations of state and political subdivisions		48,384		—		40,874		903		—
	$	114,734							$	—


			Quoted Prices		Significant		Significant
			in Active Markets		Other Observable		Unobservable		Total (Gains) Losses for
	Balance at		for Identical Assets		Inputs		Inputs		Twelve months ended
(dollars in thousands)	December 31, 2019		(Level 1)		(Level 2)		(Level 3)		December 31, 2019
Assets

Corporate	$	20,938	$	—	$	20,438	$	500	$	—
US Agencies		14,496		—		14,496		—		—
US Agencies - MBS		34,526		—		34,526		—		—
Obligations of state and political subdivisions		38,012		—		37,024		903		—
	$	107,972							$	—

The Corporation had no Level 3 assets or liabilities measured at fair value on a recurring basis as of March 31, 2020, or December 31, 2019 other than as described above.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Corporation’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset or liability.

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The Corporation also has assets that under certain conditions are subject to measurement at fair value on a non-recurring basis. These assets include certain impaired loans and other real estate owned. The Corporation has estimated the fair values of these assets using Level 3 inputs, specifically discounted cash flow projections.

Assets Measured at Fair Value on a Nonrecurring Basis at March 31, 2020


			Quoted Prices		Significant		Significant		Total (Gains)
			in Active Markets		Other Observable		Unobservable		Losses for
	Balance at		for Identical Assets		Inputs		Inputs		Three Months Ended
(dollars in thousands)	March 31, 2020		(Level 1)		(Level 2)		(Level 3)		March 31, 2020
Assets

Impaired loans	$	9,063	$	—	$	—	$	9,063	$	48
Other real estate owned		2,228		—		—		2,228		3
									$	51

Assets Measured at Fair Value on a Nonrecurring Basis at December 31, 2019


			Quoted Prices		Significant		Significant
			in Active Markets		Other Observable		Unobservable		Total Losses for
	Balance at		for Identical Assets		Inputs		Inputs		Twelve months ended
(dollars in thousands)	December 31, 2019		(Level 1)		(Level 2)		(Level 3)		December 31, 2019
Assets

Impaired loans	$	12,823	$	—	$	—	$	12,823	$	280
Other real estate held for sale		2,194		—		—		2,194		212
									$	492

Impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Corporation estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals).

13.SHAREHOLDERS’ EQUITY

The Corporation currently has two share repurchase programs. The program is conducted under authorizations by the Board of Directors. The Corporation repurchased 1,661 shares in 2020, 14,000 shares in 2016, 102,455 shares in 2015, 13,700 shares in 2014 and 55,594 shares in 2013. The share repurchases were conducted under Board authorizations made and publically announced of $.600 million on February 27, 2013, $.600 million on December 17, 2013 and an additional $.750 million on April 28, 2015. None of these authorizations has an expiration date.

Total shares repurchased under stock repurchase plans in the first quarter of 2020 were 240,644.

On August 28, 2019, the Corporation, under the authorization of the Board of Directors announced a new common stock repurchase program. Under the Repurchase Program, the Company is authorized to repurchase up to approximately 5% of the Company’s outstanding common stock. During the first quarter of 2020, the Corporation repurchased 238,983 shares under this plan.

14.COMMITMENTS, CONTINGENCIES AND CREDIT RISK

Financial Instruments With Off-Balance-Sheet Risk

The Corporation is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

The Corporation’s exposure to credit loss, in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit, is represented by the contractual amount of those

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instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. These commitments are as follows (dollars in thousands):


	March 31,		December 31,
	2020		2019
Commitments to extend credit:
Variable rate	$	116,961	$	106,278
Fixed rate		78,776		50,796
Standby letters of credit - Variable rate		8,322		5,441
Credit card commitments - Fixed rate		6,186		5,841

	$	210,245	$	168,356

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The commitments are structured to allow for 100% collateralization on all standby letters of credit.

Credit card commitments are commitments on credit cards issued by the Corporation’s subsidiary and serviced by other companies. These commitments are unsecured.

Legal Proceedings and Contingencies

In the normal course of business, the Corporation is involved in various legal proceedings. For an expanded discussion on the Corporation’s legal proceedings, see Part II, Item 1, “Legal Proceedings” in this report.

Concentration of Credit Risk

The Bank grants commercial, residential, agricultural, and consumer loans throughout Michigan and Northeastern Wisconsin. The Bank’s most prominent concentration in the loan portfolio relates to commercial real estate loans to operators of nonresidential buildings. This concentration at March 31, 2020 represents $136.477 million, or 17.95%, compared to $141.965 million, or 18.54%, of the commercial loan portfolio on December 31, 2019. The remainder of the commercial loan portfolio is diversified in such categories as hospitality and tourism, real estate agents and managers, new car dealers, gas stations and convenience stores, petroleum, forestry, agriculture and construction. Due to the diversity of the Bank’s locations, the ability of debtors of residential and consumer loans to honor their obligations is not tied to any particular economic sector.

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MACKINAC FINANCIAL CORPORATION

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward Looking Statements/Risk Factors

This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Corporation intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and is including this statement for purposes of these safe harbor provisions. Forward-looking statements which are based on certain assumptions and describe future plans, strategies, or expectations of the Corporation, are generally identifiable by use of the words “believe”, “expect”, “intend”, “anticipate”, “estimate”, “project”, or similar expressions. The Corporation’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that could cause actual results to differ from the results in forward-looking statements include, but are not limited to:

RISK FACTORS

Risks Related to our Lending and Credit Activities

The outbreak of the COVID-19 pandemic, including the severity, magnitude, duration and businesses’ and governments’ responses thereto, may have a negative impact on the Corportion’s operations and personnel, as well as on activity and demand across the customers it serves.

Our business may be adversely affected by conditions in the financial markets and economic conditions generally, as our borrowers’ ability to repay loans and the value of the collateral securing our loans decline.

Weakness in the markets for residential or commercial real estate, including the secondary residential mortgage loan markets, could reduce our net income and profitability.

As a community banking organization, the Corporation’s success depends upon local and regional economic conditions and the Corporation has different lending risks than larger banks.

We manage our credit exposure through careful monitoring of loan applicants and loan concentrations in particular industries and through loan approval and review procedures. We have established an evaluation process designed to determine the adequacy of our allowance for loan losses. While this evaluation process uses historical and other objective information, the classification of loans and the establishment of loan losses is estimated based on experience, judgment and expectations regarding borrowers and economic conditions, as well as regulator judgments. We can make no assurance that our loan loss reserves will be sufficient to absorb future loan losses or prevent a material adverse effect on our business, profitability or financial condition.

Our allowance for loan losses may be insufficient.

Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans, and other factors, both within and outside of our control, may require an increase in our allowance for loan losses.

Risks Related to Our Operations

We are subject to interest rate risk.

Our earnings and cash flows are largely dependent upon our net interest income, which is the difference between interest income on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. There are many factors which influence interest rates that are beyond our control, including but not limited to general economic conditions and governmental policy, in particular, the policies of the FRB.

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Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition.

We may not realize the expected benefits of our recent acquisitions of First Federal of Northern Michigan or Lincoln Community Bank.

Our controls and procedures may fail or be circumvented.

Impairment of deferred income tax assets could require charges to earnings, which could result in an adverse impact on our results of operations.

In assessing the realizability of deferred income tax assets, management considers whether it is more likely than not that some allowance requires management to evaluate all available evidence, both negative and positive. Positive evidence necessary to overcome the negative evidence includes whether future taxable income in sufficient amounts and character within the carry back and carry forward periods is available under the tax law, including the use of tax planning strategies. When negative evidence (e.g. cumulative losses, history of operating loss or tax credit carry forwards expiring unused) exists, more positive evidence than negative evidence will be necessary. At March 31, 2020, net deferred tax assets were approximately $3.154 million. If a valuation allowance becomes necessary with respect to such balance, it could have a material adverse effect on our business, results of operations and financial condition.

Our information systems may experience an interruption or breach in security.

Risks Related to Legal and Regulatory Compliance

We operate in a highly regulated environment, which could increase our cost structure or have other negative impacts on our operations.

Strategic Risks

Maintaining or increasing our market share may depend on lowering prices and market acceptance of new products and services.

Future growth or operating results may require us to raise additional capital but that capital may not be available.

Reputation Risks

Unauthorized disclosure of sensitive or confidential client or customer information, whether through a breach of our computer system or otherwise, could severely harm our business.

Liquidity Risks

We could experience an unexpected inability to obtain needed liquidity.

The ability of a financial institution to meet its current financial obligations is a function of its balance sheet structure, its ability to liquidate assets and its access to alternative sources of funds. We seek to ensure our funding needs are met by maintaining an appropriate level of liquidity through asset/liability management.

Risks Related to an Investment in Our Common Stock

Limited trading activity for shares of our common stock may contribute to price volatility.

Our securities are not an insured deposit.

You may not receive dividends on your investment in common stock.

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Our ability to pay dividends is dependent upon our receipt of dividends from the Bank, which is subject to regulatory restrictions. Such restrictions, which govern state-chartered banks, generally limit the payment of dividends on bank stock to the bank’s undivided profits after all payments of all necessary expenses, provided that the bank’s surplus equals or exceeds its capital.

These risks and uncertainties should be considered in evaluating forward-looking statements. Further information concerning the Corporation and its business, including additional factors that could materially affect the Corporation’s financial results, is included in the Corporation’s filings with the Securities and Exchange Commission. All forward-looking statements contained in this report are based upon information presently available and the Corporation assumes no obligation to update any forward-looking statements.

The following discussion covers results of operations, asset quality, financial position, liquidity, interest rate sensitivity, and capital resources for the periods indicated. The information included in this discussion is intended to assist readers in their analysis of, and should be read in conjunction with, the consolidated financial statements, the related notes, and other supplemental information presented elsewhere in this report. It should be noted that there may be non-GAAP disclosures presented within this discussion to further assist readers in their analysis of the financial condition of the Corporation. This discussion should also be read in conjunction with the consolidated financial statements and footnotes contained in the Corporation’s Annual Report and Form 10-K for the year-ended December 31, 2019. Throughout this discussion and elsewhere in this report, the term “Bank” refers to mBank, the principal banking subsidiary of the Corporation.

FINANCIAL OVERVIEW

The Corporation recorded first quarter 2020 net income of $3.051 million, or $.28 per share, compared to net income of $3.167 million, or $.30 per share for the first quarter of 2019.

Weighted average shares outstanding for the three month period in 2020 totaled 10,717,967, compared to 10,720,127 shares in the same period of 2019.

The net interest income and net interest margin for the first quarter of 2020 was $13.397 million, or 4.60%, respectively, compared to $13.236 million, or 4.55%, respectively, for the first quarter of 2019.

Total assets of the Corporation at March 31, 2020 were $1.356 billion, up by $36.312 million, or 2.75%, from the $1.320 billion in total assets reported at year-end 2019.

As of the end of the first quarter of 2020, the Corporation had experienced no material adverse systemic issues or material deterioration in its loan portfolio prior to the COVID-19 pandemic. At the onset of COVID-19, the Corporation began to actively work to identify potential heightened industry and consumer exposure within the portfolio based on its footprint. The Corporation does expect that COVID-19 will unavoidably impact many of its customer’s businesses and will be prepared to assist these customers with appropriate relief using the regulatory guidance provided, particularly for industries experiencing negative environmental factors and risk trends. The Corporation will continue to refine these measures and continually assess is financial reporting and loan loss reserves as the Corporation and its customers work through the pandemic crisis in the upcoming quarters.

FINANCIAL CONDITION

Cash and Cash Equivalents

Cash and cash equivalents increased $47.246 million during the first three months of 2020, compared to 2019 year end. See further discussion of the change in cash and cash equivalents in the Liquidity section of this Quarterly Report on Form 10-Q.

Investment Securities

Securities available for sale decreased $6.762 million from December 31, 2019 to March 31, 2020, with the balance on March 31, 2020 totaling $114.734 million. Investment securities are increased or decreased as appropriate as a result of

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managing interest rate risk and liquidity. As of March 31, 2020, investment securities with an estimated fair value of $25.884 million were pledged against borrowings at the FHLB and certain customer relationships.

Loans

Through the first three months of 2020, loan balances decreased by $14.599 million from December 31, 2019 balances of $1.059 billion. During the first three months of 2020, the Bank had total loan production of $66.880 million, which included $18.997 million of secondary market loan production. The loan production, however, was partially offset by loan amortization and payoffs.

Management believes a properly positioned loan portfolio provides the most attractive earning asset yield available to the Corporation and, with a diligent loan approval process and exception reporting, management can effectively manage the risk in the loan portfolio. Management intends to continue to pursue loan growth within its markets for mortgage, consumer, and commercial loan products while concentrating on loan quality, industry concentration issues, and competitive pricing. The Corporation is highly competitive in structuring loans to meet borrowing needs, while maintaining strong underwriting requirements.

Following is a summary of the loan portfolio at March 31, 2020 and December 31, 2019 (dollars in thousands):


	March 31,		Percent of	December 31,		Percent of
	2020		Total	2019		Total

Commercial real estate	$	522,659	50.06%	$	508,332	47.96%
Commercial, financial, and agricultural		207,727	19.89		209,872	19.80
Commercial construction		29,971	2.87		34,511	3.26
One to four family residential real estate		244,059	23.37		268,333	25.32
Consumer		20,375	1.95		20,214	1.91
Consumer construction		19,386	1.86		18,680	1.75
Total loans	$	1,044,177	100.00%	$	1,059,942	100.00%

Following is a table showing the significant industry types in the commercial loan portfolio as of March 31, 2020 and December 31, 2019 (dollars in thousands).


	March 31, 2020				December 31, 2019
	Outstanding		Percent of	Percent of	Outstanding		Percent of	Percent of
	Balance		Loans	Capital	Balance		Loans	Capital

Real estate - operators of nonresidential buildings		136,477	17.95%	85.27%		142,176	18.89%	88.77%
Hospitality and tourism		94,734	12.46	59.19		94,143	12.51	58.78
Lessors of residential buildings		48,529	6.38	30.32		50,891	6.76	31.77
Gasoline stations and convenience stores		26,495	3.48	16.55		24,917	3.31	15.56
Logging		21,380	2.81	13.36		22,725	3.02	14.19
Commercial construction		29,971	3.94	18.72		34,511	4.58	21.55
Other		402,771	52.97	251.64		383,352	50.93	239.35
Total Commercial Loans	$	760,357	100.00%		$	752,715	100.00%

Management recognizes that additional risks presented by concentration in certain segments of the portfolio. Management does not believe that its current portfolio composition has increased such risk related to any specific industry concentration as of March 31, 2020. The current concentration of commercial real estate-related loans represents a broad customer base composed of a high percentage of owner-occupied developments. The company will, and has, slowed growth and origination of certain industry concentrations where internal limits have been reached.

Our residential real estate portfolio predominantly includes one to four family adjustable rate mortgages that have repricing terms generally from one to three years, construction loans to individuals and bridge financing loans for qualifying customers. As of March 31, 2020, our residential loan portfolio totaled $263.445 million, or 25.23%, of our total outstanding loans.

Due to the seasonal nature of many of the Corporation’s commercial loan customers, our loan payment terms provide flexibility by structuring payments to coincide with our customers’ business cycles. The lending staff evaluates the collectability of past due loans based on documented collateral values and payment history. The Corporation

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discontinues the accrual of interest on loans when, in the opinion of management, there is an indication that the borrower may be unable to meet the payments as they become due. Upon such discontinuance, all unpaid accrued interest is reversed. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Credit Quality

The table below shows period end balances of nonperforming assets (dollars in thousands):


	March 31,		December 31,
	2020		2019

Nonperforming Assets:
Nonaccrual loans	$	6,416	$	5,172
Loans past due 90 days or more		—		11
Restructured loans on nonaccrual		—		—
Total nonperforming loans		6,416		5,183
Other real estate owned		2,228		2,194
Total nonperforming assets	$	8,644	$	7,377
Nonperforming loans as a % of loans		0.61%		0.49%
Nonperforming assets as a % of assets		0.64%		0.56%
Reserve for Loan Losses:
At period end	$	5,292	$	5,308
As a % of outstanding loans		.51%		.51%
As a % of nonperforming loans		82.48%		102.41%
As a % of nonaccrual loans		82.48%		102.63%
Texas Ratio		6.13%		4.41%

The following ratios provide additional information relative to the Corporation’s credit quality (dollars in thousands):


	At Period End
	March 31, 2020		December 31, 2019

Total loans, at period end	$	1,044,177		1,058,776
Average loans for the period	$	1,047,144	$	1,047,437

	For the Period Ended
	Three Months Ended		Twelve Months Ended
	March 31, 2020		December 31, 2019

Net charge-offs during the period	$	116		260
Net charge-offs to average loans, annualized	.04%		.02%

Management seeks to address market issues, if any, impacting its loan customer base. In conjunction with the Corporation’s senior lending staff and bank regulatory examinations, management reviews the Corporation’s loans, related collateral evaluations, and the overall lending process. The Corporation also utilizes an outside loan consultant to perform a review of the loan portfolio. The opinion of this consultant upon completion of the 2019 independent review provided findings similar to management’s findings with respect to credit quality. In 2020, the Corporation is once again utilizing a consultant for loan review.

During the first quarter of 2020, the Corporation recorded a provision for loan losses of $100,000. As a result of COVID-19, the qualitative factors for economic conditions were adjusted within the allowance for loan losses calculation and methodology. The Corporation is not yet subject to the requirements of CECL and management will actively refine the provision and loan reserves as client impact and broader economic data from the pandemic become more clear in the second quarter and beyond.

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As of March 31, 2020, the allowance for loan losses represented .51% of total loans. At March 31, 2020, the allowance included specific reserves in the amount of $1.389 million, as compared to specific reserves of $1.266 million at December 31, 2019. In management’s opinion, the allowance for loan losses is adequate to cover probable losses related to specifically identified loans, as well as probable losses inherent in the balance of the loan portfolio. Purchased impaired credits do not have an effect on the allowance for loan losses, in accordance with ASC 310-30.

As part of the process of resolving problem credits, the Corporation may acquire ownership of collateral which secured such credits. The Corporation carries this collateral in other real estate on the balance sheet.

The following table represents the activity in other real estate for the periods indicated (dollars in thousands):


	Three Months Ended		Year Ended
	March 31, 2020		December 31, 2019

Balance at beginning of period	$	2,194	$	3,119
Other real estate transferred from loans due to foreclosure		174		1,629
Proceeds from sale of other real estate		(137)		(1,329)
Transfer to premise and equipment		—		(1,013)
Writedowns on other real estate held for sale		(3)		(181)
Loss on other real estate held for sale		—		(31)

Balance at end of period	$	2,228	$	2,194

During the first three months of 2020, the Corporation received real estate in lieu of loan payments of $.174 million. In determining the carrying value of other real estate held for sale, the Corporation generally starts with a third party appraisal of the underlying collateral and then deducts estimated selling costs to arrive at a net asset value. After the initial receipt, management periodically re-evaluates the recorded balances and records any additional reductions in the fair value as a write-down of other real estate held for sale.

Deposits

The Corporation had an increase in deposits in the first three months of 2020. Total deposits increased by $19.704 million, or 1.83%, in the first three months of 2020. The increase in deposits for the first three months of 2020 is composed of a decrease in core deposits of $19.344 million and an increase in noncore deposits of $39.048 million. Management utilizes brokered deposits as a funding source, which provides flexibility in managing interest rate risk for fixed rate longer term loan fundings.

Management continues to monitor existing deposit products in order to stay competitive, both as to terms and pricing, which will remain important as we move through the current rate cycle to protect our margin. This focus on deposits has become especially important with changing client banking habits and demographics, as well as customer desire for more electronic and mobile based banking products and services, particularly in light of the pandemic. It is the intent of management to focus on growing core deposit levels, as the comparatively inexpensive deposits, in relation to wholesale deposit sources, will continue to prove valuable as rates continue to increase.

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The following table represents detail of deposits at the end of the periods indicated (dollars in thousands):


	March 31,			December 31,
	2020		% of Total	2019		% of Total

Noninterest bearing	$	278,191	25.40%	$	287,611	26.74%
NOW, money market, checking		369,003	33.69		373,165	34.69%
Savings		109,818	10.03		109,548	10.18%
Certificates of Deposit <$250,000		227,924	20.81		233,956	21.75%
Total core deposits		984,936	89.92		1,004,280	93.36%

Certificates of Deposit >$250,000		14,152	1.29		12,775	1.19%
Brokered CDs		96,293	8.79		58,622	5.45%
Total non-core deposits		110,445	10.08		71,397	6.64%

Total deposits	$	1,095,381	100.00%	$	1,075,677	100.00%

Borrowings

The Corporation also utilizes FHLB borrowings as a source of funding. At March 31, 2020, this source of funding totaled $64 million and the Corporation secured this funding by pledging loans and investments. The $64 million of FHLB borrowings have a weighted average maturity of 2.63 years and a weighted average interest rate of 1.67% at March 31, 2020. The Corporation also has a USDA Rural Development loan held by its wholly owned subsidiary, First Rural Relending, that has an outstanding balance of $.403 million, with a fixed interest rate of 1% that matures in August 2024.

Shareholders’ Equity

Total shareholders’ equity decreased $1.859 million from December 31, 2019 to March 31, 2020. Contributing to the change in shareholders’ equity was net income of $3.051 million, offset by a reduction for cash dividends on common stock of $1.475 million, an increase due to stock compensation of $.168 million, and a decrease in the market value of securities of $.874 million and a decrease due to share repurchases of $2.729 million.

RESULTS OF OPERATIONS

Summary

The Corporation recorded first quarter 2020 net income of $3.051 million, or $.28 per share, compared to net income of $3.167 million or $.30 per share for the first quarter of 2019.

Net Interest Income

Net interest income is the Corporation’s primary source of core earnings. Net interest income represents the difference between the average yield earned on interest earning assets and the average rate paid on interest bearing obligations. Net interest income is impacted by economic and competitive factors that influence rates, loan demand, and the availability of funding.

Net interest income and net interest margin on a fully taxable equivalent basis amounted to $13.481 million, 4.63% of average earning assets, respectively in the first three months of 2020, compared to $13.304 million, 4.57% of average earning assets, respectively in the first three months of 2019.

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The following table presents the amount of interest income from average interest-earning assets and the yields earned on those assets, as well as the interest expense on average interest-bearing obligations and the rates paid on those obligations. All average balances are daily average balances.


	Three Months Ended
													2020-2019
	Average Balances						Average Rates		Interest				Income/						Rate/
	March 31,				Increase/		March 31,		March 31,				Expense		Volume		Rate		Volume
(dollars in thousands)	2020		2019		(Decrease)		2020	2019	2020		2019		Variance		Variance		Variance		Variance

Loans (1,2,3)	$	1,047,144	$	1,046,740	$	404	5.66%	5.69%	$	14,749	$	14,684	$	65	$	5	$	(63)	$	123
Taxable securities		93,577		97,973		(4,396)	2.66	2.91		620		703		(83)		(32)		(60)		9
Nontaxable securities (2)		14,917		17,023		(2,106)	2.99	295.00		111		124		(13)		(15)		2		1
Federal funds sold		1,044		1,110		(66)	1.67	2.54		4		7		(3)		(1)		(2)		—
Other interest-earning assets		14,869		18,143		(3,274)	7.18	8.46		265		378		(113)		(69)		(58)		13
Total earning assets		1,171,551		1,180,989		(9,438)	5.41	5.46		15,749		15,896		(147)		(112)		(181)		146
Reserve for loan losses		(5,269)		(5,180)		(89)
Cash and due from banks		66,967		59,738		7,229
Fixed Assets		24,171		22,679		1,492
Other Real Estate		2,180		2,803		(623)
Other assets		61,534		59,051		2,483
Total assets	$	1,321,134	$	1,320,080	$	1,054

NOW and money market deposits	$	284,315	$	263,185	$	21,130	.42	0.57	$	296	$	370	$	(74)	$	30	$	(99)	$	(5)
Interest checking		93,922		113,664		(19,742)	.07	0.20		17		56		(39)		(10)		(36)		6
Savings deposits		110,351		109,910		441	.87	0.26		238		71		167		—		165		2
Certificates of deposit		242,882		250,527		(7,645)	1.82	1.76		1,101		1,087		14		(33)		40		8
Brokered deposits		60,059		128,111		(68,052)	1.84	2.44		275		770		(495)		(412)		(190)		107
Borrowings		72,911		53,224		19,687	1.88	1.81		341		238		103		89		9		5
Total interest-bearing liabilities		864,440		918,621		(54,181)	1.06	1.14		2,268		2,592		(324)		(336)		(111)		123
Demand deposits		284,677		235,247		49,430
Other liabilities		9,356		12,523		(3,167)
Shareholders’ equity		162,661		153,689		8,972
Total liabilities and shareholders’ equity	$	1,321,134	$	1,320,080	$	1,054
Rate spread							4.35%	4.32%
Net interest margin/revenue							4.63%	4.57%	$	13,481	$	13,304	$	177	$	224	$	(70)	$	23

(1)

For purposes of these computations, nonaccruing loans are included in the daily average loan amounts outstanding.

(2)

The amount of interest income on loans and nontaxable securities has been adjusted to a tax equivalent basis, using a 21% tax rate.

(3)

Interest income on loans includes fees.

The Corporation continues to reprice a significant portion of its loan portfolio. Management has been diligent when repricing maturing or new loans in establishing interest rate floors in order to maintain our interest rate spread. The Corporation is anticipating some margin pressure in future periods as we continue to see extremely competitive pricing on new and renewable loans.

Provision for Loan Losses

The Corporation records a provision for loan losses when it believes it is necessary to adjust the allowance for loan losses to maintain an adequate level after considering factors such as loan charge-offs and recoveries, changes in identified levels of risk in the loan portfolio, changes in the mix of loans in the portfolio, loan growth, and other economic factors. During the first three months of 2020, the Corporation recorded a loan loss provision of $100,000, compared to $100,000 in the first three months of 2019. There were net charge-offs of $116,000 in the first three months of 2020, compared to net charge-offs of $129,000 for the same period in 2019. There was no provision for loan losses for acquired loans as a result of acquisition fair value adjustments.

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Other Income

Other income was $1.937 million in the first quarter of 2020, compared to $1.117 million in the same period in 2019. The increase year over year was largely a result of increased income from income from loans sold in the secondary market and loans sold to the SBA. Management continues to evaluate deposit products and services for ways to better serve its customer base and also enhance service fee income through a broad array of products that price services based on income contribution and cost attributes.

The following table details other income for the three months ended March 31, 2020 and 2019 (dollars in thousands):


	Three Months Ended
	March 31,
					Increase/(Decrease)
	2020		2019		Dollars		Percent

Deposit service fees	$	403	$	406	$	(3)	-0.74%
Income from loans sold in the secondary market		538		312		226	72.44
SBA/USDA loan sale gains		710		125		585	468.00
Net mortgage servicing (amortization) income		259		120		139	115.83
Other noninterest income		27		154		(127)	(82.47)

Total other income	$	1,937	$	1,117	$	820	73.41%

Other Expense

For the first three months of 2020, the Corporation recorded other expenses of $11.372 million, compared to $10.244 million in 2019, an increase of $1.128 million. The increase in salaries and benefits and other customary operating expenses were related to our efforts to ensure our platform infrastructure keeps pace with our growing asset base and the associated regulatory and risk management needs.

The following table details other expense for the three months ended March 31, 2020 and 2019 (dollars in thousands):


	Three Months Ended
	March 31,
					Increase/(Decrease)
	2020		2019		Dollars		Percentage

Salaries and employee benefits	$	6,051	$	5,435	$	616	11.33%
Occupancy		1,124		1,081		43	3.98
Furniture and equipment		802		718		84	11.70
Data processing		825		709		116	16.36
Advertising		212		309		(97)	(31.39)
Professional service fees		498		434		64	14.75
Loan origination expenses and deposit and card related fees		381		179		202	112.85
Writedowns and losses on other real estate held for sale		3		28		(25)	(89.29)
FDIC insurance assessment		150		134		16	11.94
Communications		213		228		(15)	(6.58)
Other		1,113		989		124	12.54
Total other expense	$	11,372	$	10,244	$	1,128	11.01%

Federal Income Taxes

The Corporation recognized a federal income tax expense for the three months ended March 31, 2020 of $.811 million, compared to $.842 million a year earlier.

The Corporation has reported deferred tax assets of $3.154 million at March 31, 2020. A valuation allowance is provided against deferred tax assets when it is more likely than not that some or all of the deferred tax asset will not be realized. The Corporation, as of March 31, 2020 had a net operating loss carryforwards for tax purposes of

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approximately $10.2 million. As a result of the repeal of the corporate alternative minimum tax in the Tax Cuts and Jobs Act, any outstanding alternative minimum tax credits are believed to be utilized or refundable as of December 31, 2019. Therefore, the $1.6 million of alternative minimum tax credits, was reclassified to a current tax receivable incuded in other assets during 2018. The net operating loss carryforwards expire twenty years from the date they originated. These carryforwards, if not utilized, will begin to expire in the year 2023. A portion of the NOL and credit carryforwards are subject to the limitations for utilization as set forth in Section 382 of the Internal Revenue Code. The annual limitation is $2.0 million for the NOL and the equivalent value of tax credits, which is approximately $.420 million. These limitations for use were established in conjunction with the recapitalization of the Corporation in December 2004. The Corporation will continue to evaluate the future benefits from these carryforwards in order to determine if any adjustment to the deferred tax asset is warranted.

LIQUIDITY

We define liquidity as the ability to generate cash at a reasonable cost to fulfill lending commitments and support asset growth, while satisfying the withdrawal demands of customers and making payments on any existing borrowing commitments. The Bank’s principal sources of liquidity are core deposits and loan and investment payments and prepayments. Providing a secondary source of liquidity is the available for sale investment portfolio, FHLB borrowings and brokered deposits. As a final source of liquidity, the Bank can exercise existing credit arrangements.

Current balance sheet liquidity consists of $97.072 million in cash and cash equivalents and $88.850 million of unpledged investment securities. Although current liquidity is deemed adequate, management has the ability to increase on hand liquidity by acquiring brokered CDs in order to fund any anticipated loan growth.

During the first three months of 2020, the Corporation increased cash and cash equivalents by $47.246 million. The management of bank liquidity for funding of loans and deposit maturities and withdrawals includes monitoring projected loan fundings and scheduled prepayments and deposit maturities within a 30 day period, a 30- to 90- day period and from 90 days until the end of the year. This funding forecast model is completed weekly.

The Corporation’s primary source of liquidity on a stand-alone basis is dividends from the Bank. During the first three months of 20209, the Bank paid dividends of $4.5 million to the Corporation. Bank capital remains strong and above the “well-capitalized” level for regulatory purposes as of March 31, 2020. The Corporation also has a line of credit with a correspondent bank that had borrowing availability at March 31, 2020 of $15 million. The Corporation’s current plan for dividends from the Bank are dependent upon the profitability of the Bank, growth of assets at the Bank and the level of capital needed to stay “adequately capitalized.” The Corporation will continue to explore opportunities for longer term sources of liquidity and permanent equity to support projected asset growth.

Liquidity is managed by the Corporation through its Asset and Liability Committee (“ALCO”). The ALCO Committee meets regularly to discuss asset and liability management in order to address liquidity and funding needs to provide a process to seek the best alternatives for investments of assets, funding costs, and risk management. The liquidity position of the Bank is managed daily, thus enabling the Bank to adapt its position according to market fluctuations. Core deposits are important in maintaining a strong liquidity position as they represent a stable and relatively low cost source of funds. The Bank’s liquidity is best illustrated by the mix in the Bank’s core and noncore funding dependence ratio, which explains the degree of reliance on noncore liabilities to fund long-term assets.

Core deposits are herein defined as demand deposits, NOW (negotiable order withdrawals), money markets, savings and certificates of deposit under $250,000. Noncore funding consists of certificates of deposit greater than $250,000, brokered deposits, and FHLB, Farmers’ Home Administration and other borrowings. At March 31, 2020, the Bank’s core deposits in relation to total funding were 83.10% compared to 87.60% at December 31, 2019. These ratios indicate that at March 31, 2020, that the Bank had slightly increased its reliance on noncore deposits and borrowings to fund the Bank’s long-term assets, namely loans and investments. This increase is the direct result of the Bank taking precautionary measures to augment its cash position at the onset of the COVID-19 pandemic. The Bank believes that by maintaining adequate volumes of short-term investments and implementing competitive pricing strategies on deposits, it can ensure adequate liquidity to support future growth. The Bank also has correspondent lines of credit available to meet unanticipated short-term liquidity needs. As of March 31, 2020, the Bank had $106 million of unsecured lines available and additional funding sources available if secured. The Bank believes that its liquidity position remains strong to meet both present and future financial obligations and commitments, events or uncertainties that have resulted or are

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reasonably likely to result in material changes with respect to the Bank’s liquidity, including any additional liquidity pressure that may stem from the effects of the COVID-19 pandemic.

From a long-term perspective, the Corporation’s strategy is to increase core deposits in the Corporation’s local markets. Management continually evaluates deposit products it offers in order to remain competitive in its goal of increasing core deposits. The Corporation also has the ability to augment local deposit growth efforts with wholesale CD funding.

REGULATORY CAPITAL

The Corporation is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory—and possibly additional discretionary—actions by regulators that, if undertaken, could have a direct material effect on the Corporation’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation must meet specific capital guidelines that involve quantitative measures of the Corporation’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Corporation’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Corporation to maintain minimum amounts and ratios (set forth in the table below) of total, Tier 1 capital and Common Equity Tier 1 Capital to risk-weighted assets and of Tier 1 capital to average assets. Management has determined that, as of March 31, 2020, the Corporation is well-capitalized.

In order to be “well-capitalized” under the current guidelines, a depository institution must maintain a Common Equity Tier 1 Capital ratio of 6.5% or more; an Additional Tier 1 Capital ratio of 8% or more; a Total Capital ratio of 10% or more; and a leverage ratio of 5% or more.

The Corporation’s and the Bank’s actual capital and ratios compared to generally applicable regulatory requirements as of March 31, 2020 are as follows (dollars in thousands):


	Actual				Adequacy Purposes					Well-Capitalized
	Amount		Ratio		Amount			Ratio		Amount			Ratio

Total capital to risk weighted assets:
Consolidated	$	138,009	13.4%	>	$	82,360	>	8.0%	>	$	N/A	>	N/A
mBank	$	136,209	13.2%	>	$	82,345	>	8.0%	>	$	102,931	>	10.0%

Tier 1 capital to risk weighted assets:
Consolidated	$	132,717	12.9%	>	$	61,770	>	6.0%	>	$	N/A	>	N/A
mBank	$	130,958	12.7%	>	$	61,758	>	6.0%	>	$	82,345	>	8.0%

Common equity Tier 1 capital to risk weighted assets
Consolidated	$	132,717	12.9%	>	$	56,328	>	4.5%	>	$	N/A	>	N/A
mBank	$	130,958	12.7%	>	$	46,319	>	4.5%	>	$	66,905	>	6.5%

Tier 1 capital to average assets:
Consolidated	$	132,717	10.2%	>	$	52,048	>	4.0%	>	$	N/A	>	N/A
mBank	$	130,958	10.1%	>	$	52,048	>	4.0%	>	$	65,060	>	5.0%

Regulatory capital is not the same as shareholders’ equity reported in the accompanying condensed consolidated financial statements. Certain assets cannot be considered assets for regulatory purposes, such as acquisition intangibles and noncurrent deferred tax benefits.

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MACKINAC FINANCIAL CORPORATION

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

INTEREST RATE RISK

In general, the Corporation attempts to manage interest rate risk by investing in a variety of assets which afford it an opportunity to reprice assets and increase interest income at a rate equal to or greater than the interest expense associated with repricing liabilities.

Interest rate risk is the exposure of the Corporation to adverse movements in interest rates. The Corporation derives its income primarily from the excess of interest collected on its interest-earning assets over the interest paid on its interest-bearing obligations. The rates of interest the Corporation earns on its assets and owes on its obligations generally are established contractually for a period of time. Since market interest rates change over time, the Corporation is exposed to lower profitability if it cannot adapt to interest rate changes. Accepting interest rate risk can be an important source of profitability and shareholder value; however, excess levels of interest rate risk could pose a significant threat to the Corporation’s earnings and capital base. Accordingly, effective risk management that maintains interest rate risk at prudent levels is essential to the Corporation’s safety and soundness.

Loans are the Corporation’s most significant earning asset. Management offers commercial and real estate loans priced at interest rates which fluctuate with various indices such as the prime rate or rates paid on various government issued securities. In addition, the Corporation prices the majority of its fixed rate loans so it has an opportunity to reprice the loan within 12 to 60 months.

As of March 31, 2020, the Corporation had established interest rate floors on approximately $105.585 million of its variable rate commercial loans. Historically these interest rate floors would result in a “lag” on the repricing of these variable rate loans when and if interest rates increased in future periods. However, the majority of these loans have surpassed their floors and will now reprice with each interest rate move.

The Corporation also has $114.734 million of securities providing for scheduled monthly principal and interest payments as well as unanticipated prepayments of principal as of March 31, 2020. These cash flows are then reinvested into other earning assets at current market rates. The Corporation also has federal funds sold to correspondent banks as well as other interest-bearing deposits with correspondent banks. These funds are generally repriced on a daily basis.

The Corporation offers deposit products with a variety of terms ranging from deposits whose interest rates can change on a weekly basis to certificates of deposit with repricing terms of up to five years. Longer term deposits generally include penalty provisions for early withdrawal.

Management can mitigate interest rate risk by managing the maturity periods of securities purchased, selling securities available for sale, and borrowing funds with targeted maturity periods, among other strategies. Also, the rate of interest rate changes can impact the actions taken since the rate environment affects borrowers and depositors differently.

Exposure to interest rate risk is reviewed on a regular basis. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect of interest rate changes on net interest income and to structure the composition of the balance sheet to minimize interest rate risk and at the same time maximize income.

Management realizes certain interest rate risks are inherent in the business of banking and that the goal is to identify and minimize the risks. Tools used by management include maturity and repricing analysis and interest rate sensitivity analysis. The Bank has regular asset/liability meetings with an outside consultant to review its current position and strategize about future opportunities on risks relative to pricing and positioning of assets and liabilities.

The difference between repricing assets and liabilities for a specific period is referred to as the gap. An excess of repricable assets over liabilities is referred to as a positive gap. An excess of repricable liabilities over assets is referred to as a negative gap. The cumulative gap is the summation of the gap for all periods to the end of the period for which the cumulative gap is being measured.

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Assets and liabilities scheduled to reprice are reported in the following time frames. Those instruments with a variable interest rate tied to an index and considered immediately repricable are reported in the 1- to 90-day time frame. The estimates of principal amortization and prepayments are assigned to the following time frames.

The following is the Corporation’s repricing opportunities at March 31, 2020 (dollars in thousands):


	1-90		91-365		>1-5		Over 5
	Days		Days		Years		Years		Total
Interest-earning assets:
Loans	$	265,399		350,787		410,843		17,148	$	1,044,177
Securities		23,977		12,459		50,085		28,213		114,734
Other (1)		5,668		5,157		2,677		247		13,749

Total interest-earning assets		295,044		368,403		463,605		45,608		1,172,660

Interest-bearing obligations:
NOW, money market, savings and interest checking		478,821		—		—		—		478,821
Time deposits		35,560		133,930		71,908		678		242,076
Brokered CDs		30,811		52,131		13,351		—		96,293
Borrowings		3,227		10,362		50,531		3,000		67,120

Total interest-bearing obligations		548,419		196,423		135,790		3,678		884,310

Gap	$	(253,375)	$	171,980	$	327,815	$	41,930	$	288,350

Cumulative gap	$	(253,375)	$	(81,395)	$	246,420	$	288,350

(1)

Includes Federal Home Loan Bank Stock.

The above analysis indicates that at March 31, 2020, the Corporation had a cumulative liability sensitivity gap position of $81.395 million within the one-year time frame. The Corporation’s cumulative liability sensitive gap suggests that if market interest rates were to increase in the next twelve months, the Corporation has the potential to earn less net interest income. This is because more liabilities would reprice at higher rates than assets. Conversely, if market interest rates decrease in the next twelve months, the above gap position suggests the Corporation’s net interest income would increase. A limitation of the traditional gap analysis is that it does not consider the timing or magnitude of non-contractual repricing or expected prepayments. In addition, the gap analysis treats savings, NOW, and money market accounts as repricing within 90 days, while experience suggests that these categories of deposits are actually comparatively resistant to rate sensitivity.

At December 31, 2019, the Corporation had a cumulative liability sensitivity gap position of $46.031 million within the one-year time frame.

The borrowings in the gap analysis include $64 million of FHLB advances that have a weighted average maturity of 2.63 years and a weighted average rate of 1.67%.

The Corporation’s primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk and foreign exchange risk. The Corporation has no market risk sensitive instruments held for trading purposes. The Corporation has limited agricultural-related loan assets and therefore has minimal significant exposure to changes in commodity prices. Any impact that changes in foreign exchange rates and commodity prices would have on interest rates are assumed to be insignificant.

Evaluating the exposure to changes in interest rates includes assessing both the adequacy of the process used to control interest rate risk and the quantitative level of exposure. The Corporation’s interest rate risk management process seeks to ensure that appropriate policies, procedures, management information systems, and internal controls are in place to maintain interest rate risk at prudent levels with consistency and continuity. In evaluating the quantitative level of

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interest rate risk, the Corporation assesses the existing and potential future effects of changes in interest rates on its financial condition, including capital adequacy, earnings, liquidity, and asset quality.

In addition to changes in interest rates, the level of future net interest income is also dependent on a number of variables, including: the growth, composition and levels of loans, deposits, and other earning assets and interest-bearing obligations, and economic and competitive conditions; potential changes in lending, investing, and deposit strategies; customer preferences; and other factors.

FOREIGN EXCHANGE RISK

In addition to managing interest rate risk, management also actively manages risk associated with foreign exchange. The Corporation has decided to curtail its foreign exchange services for customers, and accordingly, management believes the exposure to short-term foreign exchange risk is minimal.

OFF-BALANCE-SHEET RISK

Derivative financial instruments include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. The Corporation currently does not enter into futures, forwards, swaps, or options. However, the Corporation is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit and involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the condensed consolidated balance sheets. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower if deemed necessary by the Corporation. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions.

Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Corporation until the instrument is exercised.

IMPACT OF INFLATION AND CHANGING PRICES

The accompanying condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and results of operations in historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Corporation’s operations. Nearly all the assets and liabilities of the Corporation are financial, unlike industrial or commercial companies. As a result, the Corporation’s performance is directly impacted by changes in interest rates, which are indirectly influenced by inflationary expectations. The Corporation’s ability to match the interest sensitivity of its financial assets to the interest sensitivity of its financial liabilities tends to minimize the effect of changes in interest rates on the Corporation’s performance. Changes in interest rates do not necessarily move to the same extent as changes in the price of goods and services.

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MACKINAC FINANCIAL CORPORATION

ITEM 4 CONTROLS AND PROCEDURES

As of March 31, 2020, we carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934. Our management, which includes our principal executive officer and our principal financial officer, does not expect that our disclosure controls and procedures will prevent all errors and all fraud.

A control system, no matter how well conceived and operated, can provide only reasonable, but not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints; additionally, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Corporation have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is also based, in part, upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate due to changes in conditions; also the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Our principal executive officer and principal accounting officer have concluded, based on our evaluation of our disclosure controls and procedures, that our disclosure controls and procedures, as defined under Rule 13a-15 of the Securities Exchange Act of 1934, are effective as of March 31, 2020.

Changes in Internal Control Over Financial Reporting

There were no changes in the Corporation’s internal control over financial reporting that occurred during the quarter ended March 31, 2020 that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

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MACKINAC FINANCIAL CORPORATION

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The Corporation and its subsidiaries are subject to routine litigation incidental to the business of banking. Although the results of litigation and claims cannot be predicted, management believes there are no legal proceedings, the outcome of which, if determined adversely to the Corporation, would individually or in the aggregate be reasonably expected to have a material adverse effect on the Corporation’s results of operations.

Item 1A. Risk Factors

The recent global COVID-19 outbreak could harm the Corporation’s business and results of operations.

In December 2019, a COVID-19 outbreak was reported in China, and, in March 2020, the World Health Organization declared it a pandemic. Since that time, the COVID-19 has spread throughout the United States, including in the regions and communities in which the Company operates. In response, many state and local governments, including the states of Michigan and Wisconsin, have instituted emergency restrictions that have substantially limited the operation of non-essential businesses and the activities of individuals. These restrictions could result in the significant adverse effects on the Bank’s borrowers and many different types of small and mid-sized businesses within the Corporation’s client base, particularly those in the tourism, hospitality and food and beverage industries, among many others, and has resulted in a significant number of layoffs and furloughs of employees nationwide and in the regions and communities in which the Corporation operates. The ultimate effect of COVID-19 on the local or broader economy is not known nor is the ultimate length of the restrictions described and any accompanying effects. Moreover, the Federal Reserve has taken action to lower the Federal Funds rate, which may negatively affect interest income and, therefore, earnings, financial condition and results of operation of the Company. In addition, the economic effects of the crisis generally and the negative effect on the Corporation’s stock price may lead to future impairments of goodwill.

The effect of COVID-19 and related events, including those described above and those not yet known or knowable, has had a negative effect on the stock price, business prospects, financial condition and results of operations of the Corporation, including as a result of quarantines, market volatility, market downturns, changes in consumer behavior, business closures, deterioration in the credit quality of borrowers or the potential inability of borrowers to satisfy their obligations to the Corporation (and any related forebearances or restructurings that may be implemented), declines in the value of collateral securing outstanding loans, branch or office closures and business interruptions. The bank regulatory agencies and various governmental authorities are urging financial institutions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations because of the effects of COVID-19. Further, demand for laons and other products and services that the Corporation offers and whose success it relies on to drive growth, is highly dependent upon the business environment in the primary markets in which the Coporation operates and in the United States as a whole. The ongoing pandemic may also have the effect of heightening many of the other risks described in the section entitled Risk Factors in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2019.

There have been no other material changes to the Corporation’s risk factors contained in its Annual Report on Form 10-K for the year ended December 31, 2019.

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

On August 28, 2019, the Corporation, under the authorization of the Board of Directors announced a common stock repurchase program (“the Repurchase Program”). Under the Repurchase Program, the Company is authorized to repurchase up to approximately 5% of the Corporation’s outstanding common stock. The Repurchase Program has no expiration date.


				Total number of
				shares purchased	Maximum
				as part of a	number of
				publically	shares that
	Total number of	Average price		announced	may yet be
Period of purchases	shares purchased	paid per share		plan or program	purchased

January 1, 2020 to January 31, 2020	—	$	—	—		537,036
February 1, 2020 to February 29, 2020	3,626	$	14.89	3,626		533,410
March 1, 2020 to March 31, 2020	237,018	$	11.28	237,018		296,392

Total First Quarter 2020	240,644	$	11.34	240,644

Item 6. Exhibits


(a)	Exhibits:


	Exhibit 31.1	Rule 13a-14(a) Certification of Chief Executive Officer.

	Exhibit 31.2	Rule 13a-14(a) Certification of Chief Financial Officer.

	Exhibit 32.1	Section 1350 Certification of Chief Executive Officer.

	Exhibit 32.2	Section 1350 Certification of Chief Financial Officer.

	101.INS	XBRL 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 Labels Linkbase Document.

	101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document.

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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.


	MACKINAC FINANCIAL CORPORATION
	(Registrant)


Date: May 11, 2020	By:	/s/ Paul D. Tobias
		PAUL D. TOBIAS,
		CHAIRMAN AND CHIEF EXECUTIVE OFFICER
		(principal executive officer)


	By:	/s/ Jesse A. Deering
		JESSE A. DEERING
		EVP/CHIEF FINANCIAL OFFICER
		(principal financial and accounting officer)

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