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ISABELLA BANK Corp - Quarter Report: 2014 March (Form 10-Q)

Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
ý
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended March 31, 2014
or
¨
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: 0-18415
 
Isabella Bank Corporation
(Exact name of registrant as specified in its charter)
 
Michigan
 
38-2830092
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
 
401 N. Main St, Mt. Pleasant, MI
 
48858
(Address of principal executive offices)
 
(Zip code)
(989) 772-9471
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report)
 
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 period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    ý  Yes    ¨  No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    ý  Yes    ¨  No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
 
¨
 
Accelerated filer
 
ý
 
 
 
 
 
Non-accelerated filer
 
¨  (Do not check if a smaller reporting company)
 
Smaller reporting company
 
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     ¨  Yes    ý  No
The number of shares outstanding of the registrant’s Common Stock (no par value) was 7,735,097 as of May 5, 2014.


Table of Contents

ISABELLA BANK CORPORATION
QUARTERLY REPORT ON FORM 10-Q
Table of Contents
 
 
 
 
 
 
Item 1.
 
 
 
 
 
 
 
Item 2.
 
 
 
 
 
 
 
Item 3.
 
 
 
 
 
 
 
Item 4.
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 1.
 
 
 
 
 
 
 
Item 1A.
 
 
 
 
 
 
 
Item 2.
 
 
 
 
 
 
 
Item 6.
 
 
 
 
 
 
 
 
 
 

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Table of Contents

Forward Looking Statements
This report contains certain forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We intend 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 included in this statement for purposes of these safe harbor provisions. Forward looking statements, which are based on certain assumptions and describe future plans, strategies and expectations, are generally identifiable by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project,” or similar expressions. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations and future prospects include, but are not limited to, changes in: interest rates, general economic conditions, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the FRB, the quality or composition of the loan or investment portfolios, demand for loan products, fluctuation in the value of collateral securing our loan portfolio, deposit flows, competition, demand for financial services in our market area, and accounting principles, policies and guidelines. These risks and uncertainties should be considered in evaluating forward looking statements and undue reliance should not be placed on such statements. Further information concerning Isabella Bank Corporation and its business, including additional factors that could materially affect our financial results, is included in our filings with the SEC.
The acronyms and abbreviations identified below may be used throughout this Quarterly Report on Form 10-Q, or in our other filings. You may find it helpful to refer back to this page while reading this report.
AFS: Available-for-sale
 
GLB Act: Gramm-Leach-Bliley Act of 1999
ALLL: Allowance for loan and lease losses
 
IFRS: International Financial Reporting Standards
AOCI: Accumulated other comprehensive income (loss)
 
IRR: Interest rate risk
ASC: FASB Accounting Standards Codification
 
JOBS Act: Jumpstart our Business Startups Act
ASU: FASB Accounting Standards Update
 
LIBOR: London Interbank Offered Rate
ATM: Automated Teller Machine
 
Moody’s: Moody’s Investors Service, Inc.
BHC Act: Bank Holding Company Act of 1956
 
N/A: Not applicable
CFPB: Consumer Financial Protection Bureau
 
N/M: Not meaningful
CIK: Central Index Key
 
NASDAQ: NASDAQ Stock Market Index
CRA: Community Reinvestment Act
 
NASDAQ Banks: NASDAQ Bank Stock Index
DIF: Deposit Insurance Fund
 
NAV: Net asset value
DIFS: Department of Insurance and Financial Services
 
NOW: Negotiable order of withdrawal
Directors Plan: Isabella Bank Corporation and Related Companies Deferred Compensation Plan for Directors
 
NSF: Non-sufficient funds
Dividend Reinvestment Plan: Isabella Bank Corporation Stockholder Dividend Reinvestment Plan and Employee Stock Purchase Plan
 
OCI: Other comprehensive income (loss)
Dodd-Frank Act: Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
 
OMSRs: Originated mortgage servicing rights
ESOP: Employee stock ownership plan
 
OREO: Other real estate owned
Exchange Act: Securities Exchange Act of 1934
 
OTC: Over-the-Counter
FASB: Financial Accounting Standards Board
 
OTTI: Other-than-temporary impairment
FDI Act: Federal Deposit Insurance Act
 
PBO: Projected benefit obligation
FDIC: Federal Deposit Insurance Corporation
 
PCAOB: Public Company Accounting Oversight Board
FFIEC: Federal Financial Institutions Examinations Council
 
Rabbi Trust: A trust established to fund the Directors Plan
Fitch: Fitch Ratings
 
SEC: U.S. Securities & Exchange Commission
FRB: Federal Reserve Bank
 
SOX: Sarbanes-Oxley Act of 2002
FHLB: Federal Home Loan Bank
 
S&P: Standard & Poor's
Freddie Mac: Federal Home Loan Mortgage Corporation
 
TDR: Troubled debt restructuring
FTE: Fully taxable equivalent
 
XBRL: eXtensible Business Reporting Language
GAAP: U.S. generally accepted accounting principles
 
 

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Table of Contents

PART I – FINANCIAL INFORMATION
Item 1. Interim Condensed Consolidated Financial Statements (Unaudited)
INTERIM CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
 
March 31
2014
 
December 31
2013
ASSETS
 
 
 
Cash and cash equivalents
 
 
 
Cash and demand deposits due from banks
$
17,745

 
$
21,755

Interest bearing balances due from banks
922

 
19,803

Total cash and cash equivalents
18,667

 
41,558

Certificates of deposit held in other financial institutions
580

 
580

Trading securities
521

 
525

AFS securities (amortized cost of $555,176 in 2014 and $517,614 in 2013)
555,144

 
512,062

Mortgage loans AFS
489

 
1,104

Loans
 
 
 
Commercial
399,702

 
392,104

Agricultural
92,059

 
92,589

Residential real estate
284,586

 
289,931

Consumer
32,064

 
33,413

Gross loans
808,411

 
808,037

Less allowance for loan and lease losses
11,100

 
11,500

Net loans
797,311

 
796,537

Premises and equipment
26,009

 
25,719

Corporate owned life insurance policies
24,585

 
24,401

Accrued interest receivable
6,725

 
5,442

Equity securities without readily determinable fair values
18,965

 
18,293

Goodwill and other intangible assets
46,263

 
46,311

Other assets
18,112

 
20,605

TOTAL ASSETS
$
1,513,371

 
$
1,493,137

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Deposits
 
 
 
Noninterest bearing
$
158,241

 
$
158,428

NOW accounts
194,407

 
192,089

Certificates of deposit under $100 and other savings
469,955

 
455,547

Certificates of deposit over $100
243,332

 
237,702

Total deposits
1,065,935

 
1,043,766

Borrowed funds
272,536

 
279,326

Accrued interest payable and other liabilities
8,929

 
9,436

Total liabilities
1,347,400

 
1,332,528

Shareholders’ equity
 
 
 
Common stock — no par value 15,000,000 shares authorized; issued and outstanding 7,727,547 shares (including 5,263 shares held in the Rabbi Trust) in 2014 and 7,723,023 shares (including 12,761 shares held in the Rabbi Trust) in 2013
137,804

 
137,580

Shares to be issued for deferred compensation obligations
3,892

 
4,148

Retained earnings
26,835

 
25,222

Accumulated other comprehensive income (loss)
(2,560
)
 
(6,341
)
Total shareholders’ equity
165,971

 
160,609

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
1,513,371

 
$
1,493,137

See notes to interim condensed consolidated financial statements.

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Table of Contents

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands except per share amounts)

Three Months Ended 
 March 31
 
2014
 
2013
Interest income
 
 
 
Loans, including fees
$
9,751

 
$
10,330

AFS securities
 
 
 
Taxable
1,998

 
1,834

Nontaxable
1,457

 
1,234

Trading securities
5

 
14

Federal funds sold and other
153

 
116

Total interest income
13,364

 
13,528

Interest expense
 
 
 
Deposits
1,616

 
1,874

Borrowings
884

 
947

Total interest expense
2,500

 
2,821

Net interest income
10,864

 
10,707

Provision for loan losses
(242
)
 
300

Net interest income after provision for loan losses
11,106

 
10,407

Noninterest income
 
 
 
Service charges and fees
1,394

 
1,281

Net gain on sale of mortgage loans
115

 
358

Earnings on corporate owned life insurance policies
184

 
169

Net gains (losses) on sale of AFS securities

 
99

Other
556

 
540

Total noninterest income
2,249

 
2,447

Noninterest expenses
 
 
 
Compensation and benefits
5,486

 
5,445

Furniture and equipment
1,268

 
1,189

Occupancy
742

 
665

Other
1,990

 
1,892

Total noninterest expenses
9,486

 
9,191

Income before federal income tax expense
3,869

 
3,663

Federal income tax expense
560

 
576

NET INCOME
$
3,309

 
$
3,087

Earnings per share
 
 
 
Basic
$
0.43

 
$
0.40

Diluted
$
0.42

 
$
0.39

Cash dividends per basic share
$
0.22

 
$
0.21







See notes to interim condensed consolidated financial statements.

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Table of Contents

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Dollars in thousands)

Three Months Ended 
 March 31
 
2014
 
2013
Net income
$
3,309

 
$
3,087

Unrealized gains (losses) on AFS securities
 
 
 
Unrealized gains (losses) arising during the period
5,520

 
(1,961
)
Reclassification adjustment for net realized (gains) losses included in net income

 
(99
)
Net unrealized gains (losses)
5,520

 
(2,060
)
Tax effect (1)
(1,739
)
 
923

Other comprehensive income (loss), net of tax
3,781

 
(1,137
)
Comprehensive income (loss)
$
7,090

 
$
1,950

(1)
See “Note 12 – Accumulated Other Comprehensive Income (Loss)” for tax effect reconciliation.
























See notes to interim condensed consolidated financial statements.

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Table of Contents

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(Dollars in thousands except per share amounts)
 
Common Stock
 
 
 
 
 
 
 
 

Shares
Outstanding
 
Amount
 
Shares to be
Issued for
Deferred
Compensation
Obligations
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Totals
Balance, January 1, 2013
7,671,846

 
$
136,580

 
$
3,734

 
$
19,168

 
$
5,007

 
$
164,489

Comprehensive income (loss)

 

 

 
3,087

 
(1,137
)
 
1,950

Issuance of common stock
37,591

 
902

 

 

 

 
902

Common stock issued for deferred compensation obligations

 

 

 

 

 

Common stock transferred from the Rabbi Trust to satisfy deferred compensation obligations

 
100

 
(100
)
 

 

 

Share-based payment awards under equity compensation plan

 

 
146

 

 

 
146

Common stock purchased for deferred compensation obligations

 
(90
)
 

 

 

 
(90
)
Common stock repurchased pursuant to publicly announced repurchase plan
(20,509
)
 
(480
)
 

 

 

 
(480
)
Cash dividends ($0.21 per share)

 

 

 
(1,609
)
 

 
(1,609
)
Balance, March 31, 2013
7,688,928

 
$
137,012

 
$
3,780

 
$
20,646

 
$
3,870

 
$
165,308

Balance, January 1, 2014
7,723,023

 
$
137,580

 
$
4,148

 
$
25,222

 
$
(6,341
)
 
$
160,609

Comprehensive income (loss)

 

 

 
3,309

 
3,781

 
7,090

Issuance of common stock
35,814

 
850

 

 

 

 
850

Common stock issued for deferred compensation obligations
6,125

 
143

 
(143
)
 

 

 

Common stock transferred from the Rabbi Trust to satisfy deferred compensation obligations

 
250

 
(250
)
 

 

 

Share-based payment awards under equity compensation plan

 

 
137

 

 

 
137

Common stock purchased for deferred compensation obligations

 
(126
)
 

 

 

 
(126
)
Common stock repurchased pursuant to publicly announced repurchase plan
(37,415
)
 
(893
)
 

 

 

 
(893
)
Cash dividends ($0.22 per share)

 

 

 
(1,696
)
 

 
(1,696
)
Balance, March 31, 2014
7,727,547

 
$
137,804

 
$
3,892

 
$
26,835

 
$
(2,560
)
 
$
165,971














See notes to interim condensed consolidated financial statements.

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Table of Contents

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)

Three Months Ended 
 March 31
 
2014
 
2013
OPERATING ACTIVITIES
 
 
 
Net income
$
3,309

 
$
3,087

Reconciliation of net income to net cash provided by operations:
 
 
 
Provision for loan losses
(242
)
 
300

Impairment of foreclosed assets
43

 
24

Depreciation
619

 
625

Amortization of OMSRs
68

 
204

Amortization of acquisition intangibles
48

 
57

Net amortization of AFS securities
457

 
578

Net (gains) losses on sale of AFS securities

 
(99
)
Net unrealized (gains) losses on trading securities
4

 
10

Net gain on sale of mortgage loans
(115
)
 
(358
)
Increase in cash value of corporate owned life insurance policies
(184
)
 
(169
)
Share-based payment awards under equity compensation plan
137

 
146

Origination of loans held-for-sale
(5,364
)
 
(21,587
)
Proceeds from loan sales
6,094

 
24,552

Net changes in operating assets and liabilities which provided (used) cash:
 
 
 
Accrued interest receivable
(1,283
)
 
(933
)
Other assets
(272
)
 
(385
)
Accrued interest payable and other liabilities
(507
)
 
(255
)
Net cash provided by (used in) operating activities
2,812

 
5,797

INVESTING ACTIVITIES
 
 
 
Net change in certificates of deposit held in other financial institutions

 
960

Activity in AFS securities
 
 
 
Sales

 
9,857

Maturities and calls
11,096

 
21,103

Purchases
(49,115
)
 
(50,420
)
Loan principal (originations) collections, net
(856
)
 
4,531

Proceeds from sales of foreclosed assets
567

 
1,194

Purchases of premises and equipment
(909
)
 
(610
)
Proceeds from redemption of corporate owned life insurance policies

 
123

Net cash provided by (used in) investing activities
(39,217
)
 
(13,262
)

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Table of Contents

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
(Dollars in thousands)
 
Three Months Ended 
 March 31
 
2014
 
2013
FINANCING ACTIVITIES
 
 
 
Net increase (decrease) in deposits
22,169

 
12,093

Increase (decrease) in borrowed funds
(6,790
)
 
(8,591
)
Cash dividends paid on common stock
(1,696
)
 
(1,609
)
Proceeds from issuance of common stock
850

 
902

Common stock repurchased
(893
)
 
(480
)
Common stock purchased for deferred compensation obligations
(126
)
 
(90
)
Net cash provided by (used in) financing activities
13,514

 
2,225

Increase (decrease) in cash and cash equivalents
(22,891
)
 
(5,240
)
Cash and cash equivalents at beginning of period
41,558

 
24,920

Cash and cash equivalents at end of period
$
18,667

 
$
19,680

SUPPLEMENTAL CASH FLOWS INFORMATION:
 
 
 
Interest paid
$
2,547

 
$
2,842

Federal income taxes paid
552

 
200

SUPPLEMENTAL NONCASH INFORMATION:
 
 
 
Transfers of loans to foreclosed assets
$
324

 
$
373





















See notes to interim condensed consolidated financial statements.

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Table of Contents

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands except per share amounts)
Note 1 – Basis of Presentation
As used in these notes as well as in Management's Discussion and Analysis of Financial Condition and Results of Operations, references to “Isabella,” “we,” “our,” “us,” and similar terms refer to the consolidated entity consisting of Isabella Bank Corporation and its subsidiaries. Isabella Bank Corporation refers solely to the parent holding company, and Isabella Bank refers to Isabella Bank Corporation’s subsidiary, Isabella Bank.
The accompanying unaudited interim condensed consolidated financial statements have been prepared in accordance with GAAP for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In our opinion, all adjustments considered necessary for a fair presentation have been included. Operating results for the three month period ended March 31, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2013.
Our accounting policies are materially the same as those discussed in Note 1 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2013.
Note 2 – Computation of Earnings Per Share
Basic earnings per share represents income available to common shareholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued relate solely to outstanding shares in the Directors Plan.
Earnings per common share have been computed based on the following:
 
Three Months Ended 
 March 31

2014
 
2013
Average number of common shares outstanding for basic calculation
7,721,254

 
7,677,009

Average potential effect of shares in the Directors Plan (1)
173,279

 
165,260

Average number of common shares outstanding used to calculate diluted earnings per common share
7,894,533

 
7,842,269

Net income
$
3,309

 
$
3,087

Earnings per share
 
 
 
Basic
$
0.43

 
$
0.40

Diluted
$
0.42

 
$
0.39

(1) 
Exclusive of shares held in the Rabbi Trust
Note 3 – Pending Accounting Standards Updates
ASU No. 2014-01: “Accounting for Investments in Qualified Affordable Housing Projects (a consensus of the FASB Emerging Issues Task Force)"
In January 2014, ASU No. 2014-01 amended ASC Topic 323, “Investments" to allow investors in low income housing tax credits to use the proportional amortization method if the following criteria are met:
It is probable that the tax credits allocable to the investor will be available.
The investor does not have the ability to exercise significant influence over the operating and financial policies of the limited liability entity.
Substantially all of the projected benefits are from tax credits and other tax benefits (e.g., operating losses).
The investor’s projected yield is based solely on the cash flows from the tax credits and other tax benefits are positive.
The investor is a limited liability investor in the limited liability entity for both legal and tax purposes, and the investor’s liability is limited to its capital investment.

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Table of Contents

Investors that do not meet the above criteria must utilize the cost method or equity method in accordance with previously issued authoritative accounting guidance. The new authoritative guidance is effective for interim and annual periods beginning after December 15, 2014 and is not expected to have a significant impact on our operations.
ASU No. 2014-04: “Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (a consensus of the FASB Emerging Issues Task Force)"
In January 2014, ASU No. 2014-04 amended ASC Topic 310, "Receivables" to reduce diversity by clarifying when an in substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. The new authoritative guidance is effective for interim and annual periods beginning after December 15, 2014 and is not expected to have a significant impact on our operations.
Note 4 – AFS Securities
The amortized cost and fair value of AFS securities, with gross unrealized gains and losses, are as follows at:
 
March 31, 2014

Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Government sponsored enterprises
$
24,775

 
$
5

 
$
897

 
$
23,883

States and political subdivisions
215,038

 
6,493

 
1,887

 
219,644

Auction rate money market preferred
3,200

 

 
445

 
2,755

Preferred stocks
6,800

 

 
747

 
6,053

Mortgage-backed securities
159,767

 
877

 
2,788

 
157,856

Collateralized mortgage obligations
145,596

 
1,241

 
1,884

 
144,953

Total
$
555,176

 
$
8,616

 
$
8,648


$
555,144

 
December 31, 2013

Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Government sponsored enterprises
$
24,860

 
$
7

 
$
1,122

 
$
23,745

States and political subdivisions
200,323

 
5,212

 
3,547

 
201,988

Auction rate money market preferred
3,200

 

 
623

 
2,577

Preferred stocks
6,800

 
20

 
993

 
5,827

Mortgage-backed securities
147,292

 
657

 
3,834

 
144,115

Collateralized mortgage obligations
135,139

 
1,016

 
2,345

 
133,810

Total
$
517,614

 
$
6,912

 
$
12,464

 
$
512,062

The amortized cost and fair value of AFS securities by contractual maturity at March 31, 2014 are as follows:
 
Maturing
 
Securities with Variable Monthly Payments or Noncontractual Maturities
 
 

Due in
One Year
or Less
 
After One
Year But
Within
Five Years
 
After Five
Years But
Within
Ten Years
 
After
Ten Years
 
 
Total
Government sponsored enterprises
$

 
$
72

 
$
24,703

 
$

 
$

 
$
24,775

States and political subdivisions
13,067

 
44,403

 
102,328

 
55,240

 

 
215,038

Auction rate money market preferred

 

 

 

 
3,200

 
3,200

Preferred stocks

 

 

 

 
6,800

 
6,800

Mortgage-backed securities

 

 

 

 
159,767

 
159,767

Collateralized mortgage obligations

 

 

 

 
145,596

 
145,596

Total amortized cost
$
13,067

 
$
44,475

 
$
127,031

 
$
55,240

 
$
315,363

 
$
555,176

Fair value
$
13,170


$
46,153


$
128,612


$
55,592


$
311,617

 
$
555,144


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Expected maturities for government sponsored enterprises and states and political subdivisions may differ from contractual maturities because issuers may have the right to call or prepay obligations.
As the auction rate money market preferred and preferred stocks have continual call dates, they are not reported by a specific maturity group. Because of their variable monthly payments, mortgage-backed securities and collateralized mortgage obligations are not reported by a specific maturity group.
A summary of the activity related to sales of AFS securities was as follows for the three month periods ended March 31:
 
2014
 
2013
Proceeds from sales of AFS securities
$


$
9,857

Gross realized gains (losses)
$


$
99

Applicable income tax expense (benefit)
$


$
34

The cost basis used to determine the realized gains or losses of AFS securities sold was the amortized cost of the individual investment security as of the trade date.
Information pertaining to AFS securities with gross unrealized losses at March 31, 2014 and December 31, 2013, respectively, aggregated by investment category and length of time that individual securities have been in a continuous loss position, follows:
 
March 31, 2014
 
Less Than Twelve Months
 
Twelve Months or More
 
 

Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Total
Unrealized
Losses
Government sponsored enterprises
$
897

 
$
23,098

 
$

 
$

 
$
897

States and political subdivisions
1,025

 
35,389

 
862

 
9,302

 
1,887

Auction rate money market preferred

 

 
445

 
2,755

 
445

Preferred stocks
6

 
2,995

 
741

 
3,059

 
747

Mortgage-backed securities
1,664

 
60,711

 
1,124

 
21,435

 
2,788

Collateralized mortgage obligations
1,238

 
61,690

 
646

 
13,159

 
1,884

Total
$
4,830

 
$
183,883

 
$
3,818

 
$
49,710

 
$
8,648

Number of securities in an unrealized loss position:
 
 
152

 
 
 
39

 
191

 
December 31, 2013
 
Less Than Twelve Months
 
Twelve Months or More
 
 

Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Total
Unrealized
Losses
Government sponsored enterprises
$
1,122

 
$
22,873

 
$

 
$

 
$
1,122

States and political subdivisions
2,566

 
42,593

 
981

 
6,115

 
3,547

Auction rate money market preferred

 

 
623

 
2,577

 
623

Preferred stocks

 

 
993

 
2,807

 
993

Mortgage-backed securities
2,424

 
101,816

 
1,410

 
21,662

 
3,834

Collateralized mortgage obligations
2,345

 
84,478

 

 

 
2,345

Total
$
8,457

 
$
251,760

 
$
4,007

 
$
33,161

 
$
12,464

Number of securities in an unrealized loss position:
 
 
182

 
 
 
19

 
201

As of March 31, 2014 and December 31, 2013, we conducted an analysis to determine whether any securities currently in an unrealized loss position should be other-than-temporarily impaired. Such analyses considered, among other factors, the following criteria:
Has the value of the investment declined more than what is deemed to be reasonable based on a risk and maturity adjusted discount rate?
Is the investment credit rating below investment grade?
Is it probable the issuer will be unable to pay the amount when due?

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Table of Contents

Is it more likely than not that we will have to sell the security before recovery of its cost basis?
Has the duration of the investment been extended?
Based on our analysis using the above criteria, the fact that we have asserted that we do not have the intent to sell AFS securities in an unrealized loss position, and considering it is unlikely that we will have to sell AFS securities in an unrealized loss position before recovery of their cost basis, we do not believe that the values of any AFS securities are other-than-temporarily impaired as of March 31, 2014, or December 31, 2013.
Note 5 – Loans and ALLL
We grant commercial, agricultural, residential real estate, and consumer loans to customers situated primarily in Clare, Gratiot, Isabella, Mecosta, Midland, Montcalm, and Saginaw counties in Michigan. The ability of the borrowers to honor their repayment obligations is often dependent upon the real estate, agricultural, light manufacturing, retail, gaming, tourism, higher education, and general economic conditions of this region. Substantially all of our consumer and residential real estate loans are secured by various items of property, while commercial loans are secured primarily by real estate, business assets, and personal guarantees; a portion of loans are unsecured.
Loans that we have the intent and ability to hold in our portfolio are reported at their outstanding principal balance adjusted for any charge-offs, the ALLL, and any deferred fees or costs. Interest income on loans is accrued over the term of the loan based on the principal amount outstanding. Loan origination fees and certain direct loan origination costs are capitalized and recognized as a component of interest income over the term of the loan using the level yield method.
The accrual of interest on commercial, agricultural, and residential real estate loans is typically discontinued at the time the loan is 90 days or more past due unless the credit is well-secured and in the process of collection. Consumer loans are typically charged-off no later than 180 days past due. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.
For loans that are placed on nonaccrual status or charged-off, all interest accrued in the current calendar year, but not collected, is reversed against interest income while interest accrued in prior calendar years, but not collected, is charged against the ALLL. Loans are typically returned to accrual status after six months of continuous performance. For impaired loans not classified as nonaccrual, interest income continues to be accrued over the term of the loan based on the principal amount outstanding.
Commercial and agricultural loans include loans for commercial real estate, commercial operating loans, farmland and agricultural production, and states and political subdivisions. Repayment of these loans is often dependent upon the successful operation and management of a business. We minimize our risk by limiting the amount of credit exposure to any one borrower to $12,500. Borrowers with credit needs of more than $12,500 are serviced through the use of loan participations with other commercial banks. Commercial and agricultural real estate loans generally require loan-to-value limits of less than 80%. Depending upon the type of loan, past credit history, and current operating results, we may require the borrower to pledge accounts receivable, inventory, and property and equipment. Personal guarantees are generally required from the owners of closely held corporations, partnerships, and sole proprietorships. In addition, we require annual financial statements, prepare cash flow analyses, and review credit reports as deemed necessary.
We offer adjustable rate mortgages, construction loans, and fixed rate mortgage loans which typically have amortization periods up to a maximum of 30 years. Fixed rate loans with an amortization of greater than 15 years are generally sold upon origination to Freddie Mac. Fixed rate residential real estate loans with an amortization of 15 years or less may be held in our portfolio, held for future sale, or sold upon origination. We consider the direction of interest rates, the sensitivity of our balance sheet to changes in interest rates, and overall loan demand to determine whether or not to sell these loans to Freddie Mac.
Our lending policies generally limit the maximum loan-to-value ratio on residential real estate loans to 95% of the lower of the appraised value of the property or the purchase price, with the condition that private mortgage insurance is required on loans with loan-to-value ratios in excess of 80%. Substantially all loans upon origination have a loan to value ratio of less than 80%. Underwriting criteria for residential real estate loans include: evaluation of the borrower’s ability to make monthly payments, the value of the property securing the loan, ensuring the payment of principal, interest, taxes, and hazard insurance does not exceed 28% of a borrower’s gross income, all debt servicing does not exceed 36% of income, acceptable credit reports, verification of employment, income, and financial information. Appraisals are performed by independent appraisers and reviewed internally. All mortgage loan requests are reviewed by our mortgage loan committee or through a secondary market automated underwriting system; loans in excess of $400 require the approval of our Internal Loan Committee, the Board of Directors’ Loan Committee, or the Board of Directors.

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Table of Contents

Consumer loans include secured and unsecured personal loans and overdraft protection related loans. Loans are amortized for a period of up to 12 years based on the age and value of the underlying collateral. The underwriting emphasis is on a borrower’s perceived intent and ability to pay rather than collateral value. No consumer loans are sold to the secondary market.
The ALLL is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the ALLL when we believe the uncollectability of the loan balance is confirmed. Subsequent recoveries, if any, are credited to the ALLL.
The ALLL is evaluated on a regular basis and is based upon a periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The primary factors behind the determination of the level of the ALLL are specific allocations for impaired loans, historical loss percentages, as well as unallocated components. Specific allocations for impaired loans are primarily determined based on the difference between the net realizable value of the loan’s underlying collateral or the net present value of the projected payment stream and our recorded investment. Historical loss allocations were calculated at the loan class and segment levels based on a migration analysis of the loan portfolio over the preceding five years. An unallocated component is maintained to cover uncertainties that we believe affect our estimate of probable losses based on qualitative factors. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
A summary of changes in the ALLL and the recorded investment in loans by segments follows:
 
Allowance for Loan Losses
 
Three Months Ended March 31, 2014

Commercial
 
Agricultural
 
Residential Real Estate
 
Consumer
 
Unallocated
 
Total
January 1, 2014
$
6,048

 
$
434

 
$
3,845

 
$
639

 
$
534

 
$
11,500

Loans charged-off
(192
)
 
(31
)
 
(113
)
 
(114
)
 

 
(450
)
Recoveries
214

 

 
36

 
42

 

 
292

Provision for loan losses
(1,256
)
 
22

 
959

 
63

 
(30
)
 
(242
)
March 31, 2014
$
4,814

 
$
425

 
$
4,727

 
$
630

 
$
504

 
$
11,100

 
Allowance for Loan Losses and Recorded Investment in Loans
 
March 31, 2014

Commercial
 
Agricultural
 
Residential Real Estate
 
Consumer
 
Unallocated
 
Total
ALLL
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
$
1,911

 
$
29

 
$
2,353

 
$
1

 
$

 
$
4,294

Collectively evaluated for impairment
2,903

 
396

 
2,374

 
629

 
504

 
6,806

Total
$
4,814

 
$
425

 
$
4,727

 
$
630

 
$
504

 
$
11,100

Loans
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
$
14,034

 
$
1,780

 
$
13,329

 
$
61

 
 
 
$
29,204

Collectively evaluated for impairment
385,668

 
90,279

 
271,257

 
32,003

 
 
 
779,207

Total
$
399,702

 
$
92,059

 
$
284,586

 
$
32,064

 
 
 
$
808,411


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Table of Contents

 
Allowance for Loan Losses
 
Three Months Ended March 31, 2013

Commercial
 
Agricultural
 
Residential Real Estate
 
Consumer
 
Unallocated
 
Total
January 1, 2013
$
6,862

 
$
407

 
$
3,627

 
$
666

 
$
374

 
$
11,936

Loans charged-off
(211
)
 

 
(190
)
 
(121
)
 

 
(522
)
Recoveries
57

 

 
53

 
85

 

 
195

Provision for loan losses
189

 
(86
)
 
144

 
102

 
(49
)
 
300

March 31, 2013
$
6,897

 
$
321

 
$
3,634

 
$
732

 
$
325

 
$
11,909

 
Allowance for Loan Losses and Recorded Investment in Loans
 
December 31, 2013

Commercial
 
Agricultural
 
Residential Real Estate
 
Consumer
 
Unallocated
 
Total
ALLL
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
$
2,035

 
$
30

 
$
2,287

 
$

 
$

 
$
4,352

Collectively evaluated for impairment
4,013

 
404

 
1,558

 
639

 
534

 
7,148

Total
$
6,048

 
$
434

 
$
3,845

 
$
639

 
$
534

 
$
11,500

Loans
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
$
13,816

 
$
1,538

 
$
14,302

 
$
119

 
 
 
$
29,775

Collectively evaluated for impairment
378,288

 
91,051

 
275,629

 
33,294

 
 
 
778,262

Total
$
392,104


$
92,589

 
$
289,931

 
$
33,413

 
 
 
$
808,037


15

Table of Contents

The following table displays the credit quality indicators for commercial and agricultural credit exposures based on internally assigned credit ratings as of:
 
March 31, 2014
 
Commercial
 
Agricultural

Real Estate
 
Other
 
Total
 
Real Estate
 
Other
 
Total
Rating
 
 
 
 
 
 
 
 
 
 

2 - High quality
$
16,016

 
$
15,907

 
$
31,923

 
$
5,093

 
$
3,319

 
$
8,412

3 - High satisfactory
94,147

 
38,980

 
133,127

 
24,021

 
13,018

 
37,039

4 - Low satisfactory
161,906

 
41,820

 
203,726

 
28,708

 
12,924

 
41,632

5 - Special mention
10,753

 
1,677

 
12,430

 
1,738

 
574

 
2,312

6 - Substandard
15,532

 
306

 
15,838

 
2,260

 
97

 
2,357

7 - Vulnerable
2,410

 
125

 
2,535

 
82

 
225

 
307

8 - Doubtful
107

 
16

 
123

 

 

 

Total
$
300,871

 
$
98,831

 
$
399,702

 
$
61,902

 
$
30,157

 
$
92,059

 
December 31, 2013
 
Commercial
 
Agricultural

Real Estate
 
Other
 
Total
 
Real Estate
 
Other
 
Total
Rating
 
 
 
 
 
 
 
 
 
 
 
2 - High quality
$
18,671

 
$
14,461

 
$
33,132

 
$
3,527

 
$
3,235

 
$
6,762

3 - High satisfactory
91,323

 
39,403

 
130,726

 
26,015

 
17,000

 
43,015

4 - Low satisfactory
149,921

 
43,809

 
193,730

 
26,874

 
10,902

 
37,776

5 - Special mention
13,747

 
1,843

 
15,590

 
1,609

 
922

 
2,531

6 - Substandard
16,974

 
473

 
17,447

 
1,232

 
1,273

 
2,505

7 - Vulnerable
1,041

 
238

 
1,279

 

 

 

8 - Doubtful
183

 
17

 
200

 

 

 

Total
$
291,860

 
$
100,244

 
$
392,104

 
$
59,257

 
$
33,332

 
$
92,589

Internally assigned risk ratings are reviewed, at a minimum, when loans are renewed or when management has knowledge of improvements or deterioration of the credit quality of individual credits. Descriptions of the internally assigned risk ratings for commercial and agricultural loans are as follows:
1. EXCELLENT – Substantially Risk Free
Credit has strong financial condition and solid earnings history, characterized by:
High liquidity, strong cash flow, low leverage.
Unquestioned ability to meet all obligations when due.
Experienced management, with management succession in place.
Secured by cash.
2. HIGH QUALITY – Limited Risk
Credit with sound financial condition and has a positive trend in earnings supplemented by:
Favorable liquidity and leverage ratios.
Ability to meet all obligations when due.
Management with successful track record.
Steady and satisfactory earnings history.
If loan is secured, collateral is of high quality and readily marketable.
Access to alternative financing.
Well defined primary and secondary source of repayment.
If supported by guaranty, the financial strength and liquidity of the guarantor(s) are clearly evident.

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Table of Contents

3. HIGH SATISFACTORY – Reasonable Risk
Credit with satisfactory financial condition and further characterized by:
Working capital adequate to support operations.
Cash flow sufficient to pay debts as scheduled.
Management experience and depth appear favorable.
Loan performing according to terms.
If loan is secured, collateral is acceptable and loan is fully protected.
4. LOW SATISFACTORY – Acceptable Risk
Credit with bankable risks, although some signs of weaknesses are shown:
Would include most start-up businesses.
Occasional instances of trade slowness or repayment delinquency – may have been 10-30 days slow within the past year.
Management’s abilities are apparent, yet unproven.
Weakness in primary source of repayment with adequate secondary source of repayment.
Loan structure generally in accordance with policy.
If secured, loan collateral coverage is marginal.
Adequate cash flow to service debt, but coverage is low.
To be classified as less than satisfactory, only one of the following criteria must be met.
5. SPECIAL MENTION – Criticized
Credit constitutes an undue and unwarranted credit risk but not to the point of justifying a classification of substandard. The credit risk may be relatively minor yet constitute an unwarranted risk in light of the circumstances surrounding a specific loan:
Downward trend in sales, profit levels, and margins.
Impaired working capital position.
Cash flow is strained in order to meet debt repayment.
Loan delinquency (30-60 days) and overdrafts may occur.
Shrinking equity cushion.
Diminishing primary source of repayment and questionable secondary source.
Management abilities are questionable.
Weak industry conditions.
Litigation pending against the borrower.
Collateral or guaranty offers limited protection.
Negative debt service coverage, however the credit is well collateralized and payments are current.
6. SUBSTANDARD – Classified
Credit where the borrower’s current net worth, paying capacity, and value of the collateral pledged is inadequate. There is a distinct possibility that we will implement collection procedures if the loan deficiencies are not corrected. In addition, the following characteristics may apply:
Sustained losses have severely eroded the equity and cash flow.
Deteriorating liquidity.
Serious management problems or internal fraud.
Original repayment terms liberalized.
Likelihood of bankruptcy.
Inability to access other funding sources.
Reliance on secondary source of repayment.
Litigation filed against borrower.
Collateral provides little or no value.
Requires excessive attention of the loan officer.
Borrower is uncooperative with loan officer.

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Table of Contents

7. VULNERABLE – Classified
Credit is considered “Substandard” and warrants placing on nonaccrual. Risk of loss is being evaluated and exit strategy options are under review. Other characteristics that may apply:
Insufficient cash flow to service debt.
Minimal or no payments being received.
Limited options available to avoid the collection process.
Transition status, expect action will take place to collect loan without immediate progress being made.
8. DOUBTFUL – Workout
Credit has all the weaknesses inherent in a “Substandard” loan with the added characteristic that collection and/or liquidation is pending. The possibility of a loss is extremely high, but its classification as a loss is deferred until liquidation procedures are completed, or reasonably estimable. Other characteristics that may apply:
Normal operations are severely diminished or have ceased.
Seriously impaired cash flow.
Original repayment terms materially altered.
Secondary source of repayment is inadequate.
Survivability as a “going concern” is impossible.
Collection process has begun.
Bankruptcy petition has been filed.
Judgments have been filed.
Portion of the loan balance has been charged-off.
Our primary credit quality indicator for residential real estate and consumer loans is the individual loan’s past due aging. The following tables summarize the past due and current loans as of:
 
March 31, 2014
 
Accruing Interest
and Past Due:
 
 
 
Total Past Due and Nonaccrual
 
 
 
 

30-59
Days
 
60-89
Days
 
90 Days
or More
 
Nonaccrual
 
 
Current
 
Total
Commercial
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial real estate
$
1,086

 
$
21

 
$
330

 
$
2,495

 
$
3,932

 
$
296,939

 
$
300,871

Commercial other
116

 
96

 

 
125

 
337

 
98,494

 
98,831

Total commercial
1,202

 
117

 
330

 
2,620

 
4,269

 
395,433

 
399,702

Agricultural
 
 
 
 
 
 
 
 
 
 
 
 
 
Agricultural real estate
115

 

 
295

 
82

 
492

 
61,410

 
61,902

Agricultural other

 

 

 
225

 
225

 
29,932

 
30,157

Total agricultural
115

 

 
295

 
307

 
717

 
91,342

 
92,059

Residential real estate
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior liens
3,610

 
541

 
268

 
1,232

 
5,651

 
225,650

 
231,301

Junior liens
615

 
54

 

 
15

 
684

 
12,378

 
13,062

Home equity lines of credit
388

 
174

 

 
170

 
732

 
39,491

 
40,223

Total residential real estate
4,613

 
769

 
268

 
1,417

 
7,067

 
277,519

 
284,586

Consumer
 
 
 
 
 
 
 
 
 
 
 
 
 
Secured
69

 
27

 

 

 
96

 
27,552

 
27,648

Unsecured
16

 

 

 
1

 
17

 
4,399

 
4,416

Total consumer
85

 
27

 

 
1

 
113

 
31,951

 
32,064

Total
$
6,015

 
$
913

 
$
893

 
$
4,345

 
$
12,166

 
$
796,245

 
$
808,411


18

Table of Contents

 
December 31, 2013
 
Accruing Interest
and Past Due:
 
 
 
Total Past Due and Nonaccrual
 
 
 
 

30-59
Days
 
60-89
Days
 
90 Days
or More
 
Nonaccrual
 
 
Current
 
Total
Commercial
 
 
 
 
 
 
 
 
 
 
 
 
 
Commercial real estate
$
1,226

 
$
296

 
$

 
$
1,136

 
$
2,658

 
$
289,202

 
$
291,860

Commercial other
368

 
15

 
13

 
238

 
634

 
99,610

 
100,244

Total commercial
1,594

 
311

 
13

 
1,374

 
3,292

 
388,812

 
392,104

Agricultural
 
 
 
 
 
 
 
 
 
 
 
 
 
Agricultural real estate
34

 
295

 

 

 
329

 
58,928

 
59,257

Agricultural other

 

 

 

 

 
33,332

 
33,332

Total agricultural
34

 
295

 

 

 
329

 
92,260

 
92,589

Residential real estate
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior liens
3,441

 
986

 
129

 
1,765

 
6,321

 
229,865

 
236,186

Junior liens
408

 
44

 

 
29

 
481

 
13,074

 
13,555

Home equity lines of credit
181

 

 

 
25

 
206

 
39,984

 
40,190

Total residential real estate
4,030

 
1,030

 
129

 
1,819

 
7,008

 
282,923

 
289,931

Consumer
 
 
 
 
 
 
 
 
 
 
 
 
 
Secured
167

 
11

 

 
50

 
228

 
28,444

 
28,672

Unsecured
25

 
5

 

 
1

 
31

 
4,710

 
4,741

Total consumer
192

 
16

 

 
51

 
259

 
33,154

 
33,413

Total
$
5,850

 
$
1,652

 
$
142

 
$
3,244

 
$
10,888

 
$
797,149

 
$
808,037

Impaired Loans
Loans may be classified as impaired if they meet one or more of the following criteria:
1.
There has been a charge-off of its principal balance (in whole or in part),
2.
The loan has been classified as a TDR, or
3.
The loan is in nonaccrual status.
Impairment is measured on a loan-by-loan basis for commercial and agricultural loans by comparing the loan’s outstanding balance to the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral, less cost to sell, if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Impairment is measured on a loan-by-loan basis for residential real estate and consumer loans by comparing the loan’s outstanding balance to the present value of expected future cash flows discounted at the loan’s effective interest rate.

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Table of Contents

We do not recognize interest income on impaired loans in nonaccrual status. For impaired loans not in nonaccrual status, interest income is recognized daily, as earned, according to the terms of the loan agreement. The following is a summary of information pertaining to impaired loans as of:
 
March 31, 2014
 
December 31, 2013

Outstanding Balance
 
Unpaid Principal Balance
 
Valuation Allowance
 
Outstanding Balance
 
Unpaid Principal Balance
 
Valuation Allowance
Impaired loans with a valuation allowance
 
 
 
 
 
 
 
 
 
 
 
Commercial real estate
$
6,775

 
$
7,012

 
$
1,864

 
$
6,748

 
$
6,888

 
$
1,915

Commercial other
1,074

 
1,074

 
47

 
521

 
521

 
120

Agricultural real estate
89

 
89

 
29

 
90

 
90

 
30

Residential real estate senior liens
13,117

 
14,239

 
2,336

 
14,061

 
15,315

 
2,278

Residential real estate junior liens
43

 
63

 
10

 
48

 
64

 
9

Home equity lines of credit
169

 
469

 
7

 

 

 

Consumer secured
61

 
68

 
1

 

 

 

Total impaired loans with a valuation allowance
21,328

 
23,014

 
4,294

 
21,468

 
22,878

 
4,352

Impaired loans without a valuation allowance
 
 
 
 
 
 
 
 
 
 
 
Commercial real estate
5,929

 
6,655

 
 
 
5,622

 
6,499

 
 
Commercial other
256

 
366

 
 
 
925

 
1,035

 
 
Agricultural real estate
1,448

 
1,448

 
 
 
1,370

 
1,370

 
 
Agricultural other
243

 
388

 
 
 
78

 
198

 
 
Home equity lines of credit

 

 
 
 
193

 
493

 
 
Consumer secured

 

 
 
 
119

 
148

 
 
Total impaired loans without a valuation allowance
7,876

 
8,857

 
 
 
8,307

 
9,743

 
 
Impaired loans
 
 
 
 
 
 
 
 
 
 
 
Commercial
14,034

 
15,107

 
1,911

 
13,816

 
14,943

 
2,035

Agricultural
1,780

 
1,925

 
29

 
1,538

 
1,658

 
30

Residential real estate
13,329

 
14,771

 
2,353

 
14,302

 
15,872

 
2,287

Consumer
61

 
68

 
1

 
119

 
148

 

Total impaired loans
$
29,204

 
$
31,871

 
$
4,294

 
$
29,775

 
$
32,621

 
$
4,352


20

Table of Contents

The following is a summary of information pertaining to impaired loans for the three month periods ended:
 
March 31, 2014
 
March 31, 2013

Average Outstanding Balance
 
Interest Income Recognized
 
Average Outstanding Balance
 
Interest Income Recognized
Impaired loans with a valuation allowance
 
 
 
 
 
 
 
Commercial real estate
$
6,762

 
$
94

 
$
8,178

 
$
119

Commercial other
798

 
18

 
1,100

 
1

Agricultural real estate
90

 
1

 
91

 
1

Agricultural other

 

 
210

 

Residential real estate senior liens
13,589

 
138

 
10,454

 
99

Residential real estate junior liens
46

 

 
86

 

Home equity lines of credit
85

 
1

 

 

Consumer secured
90

 
1

 

 

Total impaired loans with a valuation allowance
21,460

 
253

 
20,119

 
220

Impaired loans without a valuation allowance
 
 
 
 
 
 
 
Commercial real estate
5,776

 
102

 
3,626

 
73

Commercial other
591

 
6

 
1,233

 
40

Agricultural real estate
1,409

 
16

 
67

 
2

Agricultural other
161

 
28

 
388

 
7

Home equity lines of credit
97

 

 
183

 
4

Consumer secured

 

 
74

 
1

Total impaired loans without a valuation allowance
8,034

 
152

 
5,571

 
127

Impaired loans
 
 
 
 
 
 
 
Commercial
13,927

 
220

 
14,137

 
233

Agricultural
1,660

 
45

 
756

 
10

Residential real estate
13,817

 
139

 
10,723

 
103

Consumer
90

 
1

 
74

 
1

Total impaired loans
$
29,494

 
$
405

 
$
25,690

 
$
347

As of March 31, 2014 and December 31, 2013, we had committed to advance $93 and $134, respectively, in connection with impaired loans, which include TDRs.
Troubled Debt Restructurings
Loan modifications are considered to be TDRs when the modification includes terms outside of normal lending practices to a borrower who is experiencing financial difficulties.
Typical concessions granted include, but are not limited to:
1.
Agreeing to interest rates below prevailing market rates for debt with similar risk characteristics.
2.
Extending the amortization period beyond typical lending guidelines for debt with similar risk characteristics.
3.
Forbearance of principal.
4.
Forbearance of accrued interest.
To determine if a borrower is experiencing financial difficulties, we consider if:
1.
The borrower is currently in default on any of their debt.
2.
The borrower would likely default on any of their debt if the concession was not granted.
3.
The borrower’s cash flow was insufficient to service all of their debt if the concession was not granted.
4.
The borrower has declared, or is in the process of declaring, bankruptcy.
5.
The borrower is unlikely to continue as a going concern (if the entity is a business).

21

Table of Contents

The following is a summary of information pertaining to TDRs granted in the:
 
Three Months Ended March 31, 2014
 
Three Months Ended March 31, 2013

Number of Loans
 
Pre-Modification Recorded Investment
 
Post-Modification Recorded Investment
 
Number of Loans
 
Pre-Modification Recorded Investment
 
Post-Modification Recorded Investment
Commercial other
4

 
$
355

 
$
355

 

 
$

 
$

Agricultural other

 

 

 
1

 
134

 
134

Residential real estate senior liens
9

 
490

 
490

 
8

 
799

 
783

Consumer unsecured
1

 
1

 
1

 

 

 

Total
14

 
$
846

 
$
846

 
9

 
$
933

 
$
917

The following tables summarize concessions we granted to borrowers in financial difficulty for the:
 
Three Months Ended March 31, 2014
 
Three Months Ended March 31, 2013

Below Market Interest Rate
 
Below Market Interest Rate and Extension of Amortization Period
 
Below Market Interest Rate
 
Below Market Interest Rate and Extension of Amortization Period
 
Number of Loans
 
Pre-Modification Recorded Investment
 
Number of Loans
 
Pre-Modification Recorded Investment
 
Number of Loans
 
Pre-Modification Recorded Investment
 
Number of Loans
 
Pre-Modification Recorded Investment
Commercial other
4

 
$
355

 

 
$

 

 
$

 

 
$

Agricultural other

 

 

 

 
1

 
134

 

 

Residential real estate senior liens
2

 
49

 
7

 
441

 
3

 
209

 
5

 
590

Consumer unsecured
1

 
1

 

 

 

 

 

 

Total
7

 
$
405

 
7

 
$
441

 
4

 
$
343

 
5

 
$
590

We did not restructure any loans through the forbearance of principal or accrued interest in the three month periods ended March 31, 2014 or 2013.
Based on our historical loss experience, losses associated with TDRs are not significantly different than other impaired loans within the same loan segment. As such, TDRs, including TDRs that have been modified in the past 12 months that subsequently defaulted, are analyzed in the same manner as other impaired loans within their respective loan segment.
We had no loans that defaulted in the three month periods ended March 31, 2014 or 2013, which were modified within 12 months prior to the default date.
The following is a summary of TDR loan balances as of:
 
March 31, 2014
 
December 31, 2013
TDRs
$
25,633

 
$
25,865

Note 6 – Equity Securities Without Readily Determinable Fair Values
Included in equity securities without readily determinable fair values are restricted securities, which are carried at cost, and investments in unconsolidated entities accounted for under the equity method of accounting.
Equity securities without readily determinable fair values consist of the following as of:

March 31
2014
 
December 31
2013
FHLB Stock
$
8,850

 
$
8,100

Corporate Settlement Solutions, LLC
6,895

 
6,970

FRB Stock
1,879

 
1,879

Valley Financial Corporation
1,000

 
1,000

Other
341

 
344

Total
$
18,965

 
$
18,293


22

Table of Contents

Note 7 – Borrowed Funds
Borrowed funds consist of the following obligations as of:
 
March 31
2014
 
December 31
2013

Amount
 
Rate
 
Amount
 
Rate
FHLB advances
$
162,000

 
2.02
%
 
$
162,000

 
2.02
%
Securities sold under agreements to repurchase without stated maturity dates
94,741

 
0.13
%
 
106,025

 
0.13
%
Securities sold under agreements to repurchase with stated maturity dates
1,195

 
4.27
%
 
11,301

 
3.30
%
Federal funds purchased
14,600

 
0.39
%
 

 

Total
$
272,536

 
1.29
%
 
$
279,326

 
1.35
%
The FHLB advances are collateralized by a blanket lien on all qualified 1-4 family residential real estate loans and certain mortgage-backed securities and collateralized mortgage obligations. Advances are also secured by our holdings of FHLB stock.
The following table lists the maturity and weighted average interest rates of FHLB advances as of:
 
March 31
2014
 
December 31
2013

Amount
 
Rate
 
Amount
 
Rate
Fixed rate advances due 2014
$
10,000

 
0.48
%
 
$
10,000

 
0.48
%
Fixed rate advances due 2015
32,000

 
0.84
%
 
32,000

 
0.84
%
Fixed rate advances due 2016
10,000

 
2.15
%
 
10,000

 
2.15
%
Fixed rate advances due 2017
30,000

 
1.95
%
 
30,000

 
1.95
%
Fixed rate advances due 2018
40,000

 
2.35
%
 
40,000

 
2.35
%
Fixed rate advances due 2019
20,000

 
3.11
%
 
20,000

 
3.11
%
Fixed rate advances due 2020
10,000

 
1.98
%
 
10,000

 
1.98
%
Fixed rate advances due 2023
10,000

 
3.90
%
 
10,000

 
3.90
%
Total
$
162,000

 
2.02
%
 
$
162,000

 
2.02
%
Securities sold under agreements to repurchase are classified as secured borrowings. Securities sold under agreements to repurchase without stated maturity dates generally mature within one to four days from the transaction date. Securities sold under agreements to repurchase are reflected at the amount of cash received in connection with the transaction. The securities underlying the agreements have a carrying value and a fair value of $145,481 and $148,930 at March 31, 2014 and December 31, 2013, respectively. Such securities remain under our control. We may be required to provide additional collateral based on the fair value of underlying securities.
The following table lists the maturity and weighted average interest rates of securities sold under agreements to repurchase with stated maturity dates as of:
 
March 31
2014
 
December 31
2013
 
Amount
 
Rate
 
Amount
 
Rate
Repurchase agreements due 2014
$
766

 
4.85
%
 
$
10,876

 
3.30
%
Repurchase agreements due 2015
429

 
3.25
%
 
425

 
3.25
%
Total
$
1,195

 
4.27
%
 
$
11,301

 
3.30
%
Securities sold under repurchase agreements without stated maturity dates, federal funds purchased, and FRB Discount Window advances generally mature within one to four days from the transaction date. The following table provides a summary

23

Table of Contents

of short-term borrowings for the three month periods ended:
 
March 31
2014
 
March 31
2013
 
Maximum Month End Balance
 
Average Balance
 
Weighted Average Interest Rate During the Period
 
Maximum Month End Balance
 
Average Balance
 
Weighted Average Interest Rate During the Period
Securities sold under agreements to repurchase without stated maturity dates
$
94,741


$
94,362


0.13
%

$
64,527


$
63,573


0.15
%
Federal funds purchased
15,000


5,755


0.47
%

4,400


1,215


0.50
%
We had pledged trading securities, AFS securities, and 1-4 family residential real estate loans in the following amounts at:

March 31
2014
 
December 31
2013
Pledged to secure borrowed funds
$
304,146

 
$
320,173

Pledged to secure repurchase agreements
145,481

 
148,930

Pledged for public deposits and for other purposes necessary or required by law
20,559

 
20,922

Total
$
470,186

 
$
490,025

As of March 31, 2014, we had the ability to borrow up to an additional $109,677, based on assets pledged as collateral. We had no investment securities that are restricted to be pledged for specific purposes.
Note 8 – Other Noninterest Expenses
A summary of expenses included in other noninterest expenses is as follows for the:
 
Three Months Ended 
 March 31

2014
 
2013
Marketing and community relations
$
243

 
$
242

FDIC insurance premiums
202

 
272

Directors fees
195

 
199

Audit and related fees
138

 
139

Education and travel
121

 
122

Postage and freight
108

 
99

Printing and supplies
102

 
86

Loan underwriting fees
95

 
116

Consulting fees
91

 
72

All other
695

 
545

Total other
$
1,990

 
$
1,892


24

Table of Contents

Note 9 – Federal Income Taxes
The reconciliation of the provision for federal income taxes and the amount computed at the federal statutory tax rate of 34% of income before federal income tax expense is as follows for the:
 
Three Months Ended 
 March 31

2014
 
2013
Income taxes at 34% statutory rate
$
1,315

 
$
1,245

Effect of nontaxable income
 
 
 
Interest income on tax exempt municipal securities
(469
)
 
(401
)
Earnings on corporate owned life insurance policies
(63
)
 
(57
)
Other
(236
)
 
(228
)
Total effect of nontaxable income
(768
)
 
(686
)
Effect of nondeductible expenses
13

 
17

Federal income tax expense
$
560

 
$
576

Note 10 – Defined Benefit Pension Plan
We maintain a noncontributory defined benefit pension plan, which was curtailed effective March 1, 2007. As a result of the curtailment, future salary increases are no longer considered (the projected benefit obligation is equal to the accumulated benefit obligation), and plan benefits are based on years of service and the individual employee’s five highest consecutive years of compensation out of the last ten years of service through March 1, 2007. We contributed $0 and $215 to the plan during the three month periods ended March 31, 2014 and 2013, respectively. We do not anticipate any contributions to the plan in 2014.
Following are the components of net periodic benefit cost for the:
 
Three Months Ended 
 March 31

2014
 
2013
Interest cost on benefit obligation
$
122

 
$
113

Expected return on plan assets
(154
)
 
(143
)
Amortization of unrecognized actuarial net loss
42

 
83

Net periodic benefit cost
$
10

 
$
53


25

Table of Contents

Note 11 – Fair Value
Following is a description of the valuation methodologies, key inputs, and an indication of the level of the fair value hierarchy in which the assets or liabilities are classified.
Cash and cash equivalents: The carrying amounts of cash and short term investments, including Federal funds sold, approximate fair values. As such, we classify cash and demand deposits due from banks as Level 1.
Certificates of deposit held in other financial institutions: Interest bearing balances held in unaffiliated financial institutions include certificates of deposit and other short term interest bearing balances that mature within 3 years. Fair value is determined using prices for similar assets with similar characteristics. As such, we classify certificates of deposits held in other financial institutions as Level 2.
AFS and trading securities: AFS and trading securities are recorded at fair value on a recurring basis. Level 1 fair value measurement is based upon quoted prices for identical instruments. Level 2 fair value measurement is based upon quoted prices for similar instruments. If quoted prices are not available, fair values are measured using independent pricing models or other model based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss and liquidity assumptions. The values for Level 1 and Level 2 investment securities are generally obtained from an independent third party. On a quarterly basis, we compare the values provided to alternative pricing sources.
Mortgage loans AFS: Mortgage loans AFS are carried at the lower of cost or fair value. The fair value of Mortgage loans AFS are based on what price secondary markets are currently offering for portfolios with similar characteristics. As such, we classify Mortgage loans AFS subject to nonrecurring fair value adjustments as Level 2.
Loans: For variable rate loans with no significant change in credit risk, fair values are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The resulting amounts are adjusted to estimate the effect of changes in the credit quality of borrowers since the loans were originated. As such, we classify loans as Level 3 assets.
We do not record loans at fair value on a recurring basis. However, from time-to-time, loans are classified as impaired and a specific allowance for loan losses may be established. Loans for which it is probable that payment of interest and principal will be significantly different than the contractual terms of the original loan agreement are considered impaired. Once a loan is identified as impaired, we measure the estimated impairment. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, or liquidation value. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans.
We review the net realizable values of the underlying collateral for collateral dependent impaired loans on at least a quarterly basis for all loan types. To determine the collateral value, we utilize independent appraisals, broker price opinions, or internal evaluations. We review these valuations to determine whether an additional discount should be applied given the age of market information that may have been considered as well as other factors such as costs to carry and sell an asset if it is determined that the collateral will be liquidated in connection with the ultimate settlement of the loan. We use these valuations to determine if any charge-offs or specific reserves are necessary. We may obtain new valuations in certain circumstances, including when there has been significant deterioration in the condition of the collateral, if the foreclosure process has begun, or if the existing valuation is deemed to be outdated.
The following tables list the quantitative fair value information about impaired loans as of:

March 31, 2014
Valuation Techniques
Fair Value
Unobservable Input
 
Range
 
 
Discount applied to collateral appraisal:
 
 
 
 
Real Estate
 
20% - 50%
 
 
Equipment
 
30% - 75%
 
 
Cash crop inventory
 
40%
Discounted appraisal value
$14,220
Other inventory
 
50%
 
 
Accounts receivable
 
50%
 
 
Stocks and brokerage accounts
 
30%
 
 
Liquor license
 
75%

26

Table of Contents


December 31, 2013
Valuation Techniques
Fair Value
Unobservable Input
 
Range
 
 
Discount applied to collateral appraisal:
 
 
 
 
Real Estate
 
20% - 30%
 
 
Equipment
 
50%
Discounted appraisal value
$13,902
Livestock
 
50%
 
 
Cash crop inventory
 
50%
 
 
Other inventory
 
75%
 
 
Accounts receivable
 
75%
Discount factors with ranges are based on the age of the independent appraisal, broker price opinion, or internal evaluations.
Accrued interest receivable: The carrying amounts of accrued interest receivable approximate fair value. As such, we classify accrued interest receivable as Level 1.
Equity securities without readily determinable fair values: Included in equity securities without readily determinable fair values are FHLB stock and FRB stock as well as our ownership interests in Corporate Settlement Solutions, LLC and Valley Financial Corporation. The investment in Corporate Settlement Solutions, LLC, a title insurance company, was made in the first quarter 2008. We are not the managing entity of Corporate Settlement Solutions, LLC, and therefore, we account for our investment under the equity method of accounting. Valley Financial Corporation is the parent company of 1st State Bank in Saginaw, Michigan, which is a community bank that opened in 2005. We made investments in Valley Financial Corporation in 2004 and in 2007.
The lack of an active market, or other independent sources to validate fair value estimates coupled with the impact of future capital calls and transfer restrictions, is an inherent limitation in the valuation process. As the fair values of these investments are not readily determinable, they are not disclosed under a specific fair value hierarchy; however, they are reviewed quarterly for impairment. If we were to record an impairment adjustment related to these securities, it would be classified as a nonrecurring Level 3 fair value adjustment. During 2014 and 2013, there were no impairments recorded on equity securities without readily determinable fair values.
Foreclosed assets: Upon transfer from the loan portfolio, foreclosed assets (which are included in other assets) are adjusted to and subsequently carried at the lower of carrying value or fair value less costs to sell. Net realizable value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral. Due to the inherent level of estimation in the valuation process, we record foreclosed assets as nonrecurring Level 3.
The table below lists the quantitative fair value information related to foreclosed assets as of:
 
March 31, 2014
Valuation Techniques
Fair Value
 
Unobservable Input
 
Range
 
 
 
Discount applied to collateral appraisal:
 
 
Discounted appraisal value
$
1,126

 
Real Estate
 
20% - 50%
 
December 31, 2013
Valuation Techniques
Fair Value
 
Unobservable Input
 
Range
 
 
 
Discount applied to collateral appraisal:
 
 
Discounted appraisal value
$
1,412

 
Real Estate
 
20% - 30%
Discount factors with ranges are based on the age of the independent appraisal, broker price opinion, or internal evaluations.
Goodwill and other intangible assets: Acquisition intangibles and goodwill are evaluated for potential impairment on at least an annual basis. Acquisition intangibles and goodwill are typically qualitatively evaluated to determine if it is more likely than not that the carrying balance is impaired. If it is determined that the carrying balance of acquisition intangibles or goodwill is more likely than not to be impaired, we perform a cash flow valuation to determine the extent of the potential impairment. If the testing resulted in impairment, we would classify goodwill and other acquisition intangibles subjected to nonrecurring fair

27

Table of Contents

value adjustments as Level 3. During 2014 and 2013, there were no impairments recorded on goodwill and other acquisition intangibles.
OMSRs: OMSRs (which are included in other assets) are subject to impairment testing. To test for impairment, we utilize a discounted cash flow analysis using interest rates and prepayment speed assumptions currently quoted for comparable instruments and discount rates. If the valuation model reflects a value less than the carrying value, OMSRs are adjusted to fair value through a valuation allowance as determined by the model. As such, we classify OMSRs subject to nonrecurring fair value adjustments as Level 2.
Deposits: The fair value of demand, savings, and money market deposits are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts), and are classified as Level 1. Fair values for variable rate certificates of deposit approximate their recorded carrying value. Fair values for fixed rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits. As such, fixed rate certificates of deposit are classified as Level 2.
Borrowed funds: The carrying amounts of federal funds purchased, borrowings under overnight repurchase agreements, and other short-term borrowings maturing within ninety days approximate their fair values. The fair values of other borrowed funds are estimated using discounted cash flow analyses based on current incremental borrowing arrangements. As such, borrowed funds are classified as Level 2.
Accrued interest payable: The carrying amounts of accrued interest payable approximate fair value. As such, we classify accrued interest payable as Level 1.
Commitments to extend credit, standby letters of credit, and undisbursed loans: Our commitments to extend credit, standby letters of credit, and undisbursed funds have no carrying amount and are estimated to have no realizable fair value. Historically, a majority of the unused commitments to extend credit have not been drawn upon and, generally, we do not receive fees in connection with these commitments other than standby letter of credit fees, which are not significant.
The preceding methods described may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Although we believe our valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement.
Estimated Fair Values of Financial Instruments Not Recorded at Fair Value in their Entirety on a Recurring Basis
Disclosure of the estimated fair values of financial instruments, which differ from carrying values, often requires the use of estimates. In cases where quoted market values in an active market are not available, we use present value techniques and other valuation methods to estimate the fair values of our financial instruments. These valuation methods require considerable judgment and the resulting estimates of fair value can be significantly affected by the assumptions made and methods used.

28

Table of Contents

The carrying amount and estimated fair value of financial instruments not recorded at fair value in their entirety on a recurring basis on our consolidated balance sheets are as follows as of:
 
March 31, 2014
 
Carrying
Value
 
Estimated
Fair Value
 
(Level 1)
 
(Level 2)
 
(Level 3)
ASSETS
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
18,667

 
$
18,667

 
$
18,667

 
$

 
$

Certificates of deposit held in other financial institutions
580

 
580

 

 
580

 

Mortgage loans AFS
489

 
493

 

 
493

 

Total loans
808,411

 
808,077

 

 

 
808,077

Less allowance for loan and lease losses
11,100

 
11,100

 

 

 
11,100

Net loans
797,311

 
796,977

 

 

 
796,977

Accrued interest receivable
6,725

 
6,725

 
6,725

 

 

Equity securities without readily determinable fair values (1)
18,965

 
18,965

 

 

 

OMSRs
2,645

 
2,787

 

 
2,787

 

LIABILITIES
 
 
 
 
 
 
 
 
 
Deposits without stated maturities
614,092

 
614,092

 
614,092

 

 

Deposits with stated maturities
451,843

 
453,980

 

 
453,980

 

Borrowed funds
272,536

 
276,357

 

 
276,357

 

Accrued interest payable
586

 
586

 
586

 

 

 
December 31, 2013
 
Carrying
Value
 
Estimated
Fair Value
 
(Level 1)
 
(Level 2)
 
(Level 3)
ASSETS
 
 
 
 
 
 
 
 
 
Cash and cash equivalents
$
41,558

 
$
41,558

 
$
41,558

 
$

 
$

Certificates of deposit held in other financial institutions
580

 
582

 

 
582

 

Mortgage loans AFS
1,104

 
1,123

 

 
1,123

 

Total loans
808,037

 
808,246

 

 

 
808,246

Less allowance for loan and lease losses
11,500

 
11,500

 

 

 
11,500

Net loans
796,537

 
796,746

 

 

 
796,746

Accrued interest receivable
5,442

 
5,442

 
5,442

 

 

Equity securities without readily determinable fair values (1)
18,293

 
18,293

 

 

 

OMSRs
2,555

 
2,667

 

 
2,667

 

LIABILITIES
 
 
 
 
 
 
 
 
 
Deposits without stated maturities
593,754

 
593,754

 
593,754

 

 

Deposits with stated maturities
450,012

 
452,803

 

 
452,803

 

Borrowed funds
279,326

 
283,060

 

 
283,060

 

Accrued interest payable
633

 
633

 
633

 

 

(1) 
Due to the characteristics of equity securities without readily determinable fair values, they are not disclosed under a specific fair value hierarchy. If we were to record an impairment adjustment related to these securities, such amount would be classified as a nonrecurring Level 3 fair value adjustment.

29

Table of Contents

Financial Instruments Recorded at Fair Value
The table below presents the recorded amount of assets and liabilities measured at fair value on:
 
March 31, 2014
 
December 31, 2013

Total
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
Total
 
(Level 1)
 
(Level 2)
 
(Level 3)
Recurring items
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Trading securities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
States and political subdivisions
$
521

 
$

 
$
521

 
$

 
$
525

 
$

 
$
525

 
$

AFS securities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Government-sponsored enterprises
23,883

 

 
23,883

 

 
23,745

 

 
23,745

 

States and political subdivisions
219,644

 

 
219,644

 

 
201,988

 

 
201,988

 

Auction rate money market preferred
2,755

 

 
2,755

 

 
2,577

 

 
2,577

 

Preferred stocks
6,053

 
6,053

 

 

 
5,827

 
5,827

 

 

Mortgage-backed securities
157,856

 

 
157,856

 

 
144,115

 

 
144,115

 

Collateralized mortgage obligations
144,953

 

 
144,953

 

 
133,810

 

 
133,810

 

Total AFS securities
555,144

 
6,053

 
549,091

 

 
512,062

 
5,827

 
506,235

 

Nonrecurring items
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Impaired loans (net of the ALLL)
14,220

 

 

 
14,220

 
13,902

 

 

 
13,902

Foreclosed assets
1,126

 

 

 
1,126

 
1,412

 

 

 
1,412

Total
$
571,011

 
$
6,053

 
$
549,612

 
$
15,346

 
$
527,901

 
$
5,827

 
$
506,760

 
$
15,314

Percent of assets and liabilities measured at fair value
 
 
1.06
%
 
96.25
%
 
2.69
%
 
 
 
1.10
%
 
96.00
%
 
2.90
%
The following table provides a summary of the changes in fair value of assets and liabilities recorded at fair value through earnings on a recurring basis and changes in assets and liabilities recorded at fair value on a nonrecurring basis, for which gains or losses were recognized in the:
 
Three Months Ended March 31
 
2014
 
2013

Trading
Losses
 
Other Gains
(Losses)
 
Total
 
Trading
Losses
 
Other Gains
(Losses)
 
Total
Recurring items
 
 
 
 
 
 
 
 
 
 
 
Trading securities
$
(4
)
 
$

 
$
(4
)
 
$
(10
)
 
$

 
$
(10
)
Nonrecurring items
 
 
 
 
 
 
 
 
 
 

Foreclosed assets

 
(43
)
 
(43
)
 

 
(24
)
 
(24
)
Total
$
(4
)
 
$
(43
)
 
$
(47
)
 
$
(10
)
 
$
(24
)
 
$
(34
)

30

Table of Contents

Note 12 – Accumulated Other Comprehensive Income (Loss)
The following table summarizes the changes in AOCI by component for the:
 
Three Months Ended March 31
 
2014
 
2013

Unrealized
Holding Gains
(Losses) on
AFS
Securities
 
Defined
Benefit
Pension Plan
 
Total
 
Unrealized
Holding Gains
(Losses) on
AFS
Securities
 
Defined
Benefit
Pension Plan
 
Total
Balance, January 1
$
(4,207
)
 
$
(2,134
)
 
$
(6,341
)
 
$
8,678

 
$
(3,671
)
 
$
5,007

OCI before reclassifications
5,520

 

 
5,520

 
(1,961
)
 

 
(1,961
)
Amounts reclassified from AOCI

 

 

 
(99
)
 

 
(99
)
Subtotal
5,520

 

 
5,520

 
(2,060
)
 

 
(2,060
)
Tax effect
(1,739
)
 

 
(1,739
)
 
923

 

 
923

OCI, net of tax
3,781

 

 
3,781

 
(1,137
)
 

 
(1,137
)
Balance, March 31
$
(426
)
 
$
(2,134
)
 
$
(2,560
)
 
$
7,541

 
$
(3,671
)
 
$
3,870

Included in OCI for the three month periods ended March 31, 2014 and 2013 are changes in unrealized holding gains and losses related to auction rate money market preferred and preferred stocks. For federal income tax purposes, these securities are considered equity investments. As such, no deferred federal income taxes related to unrealized holding gains or losses are expected or recorded.
A summary of the components of unrealized holding gains on AFS securities included in OCI follows for the:
 
Three Months Ended March 31
 
2014
 
2013

Auction Rate Money Market Preferred and Preferred Stocks
 
All Other AFS Securities
 
Total
 
Auction Rate Money Market Preferred and Preferred Stocks
 
All Other AFS Securities
 
Total
Unrealized gains (losses) arising during the period
$
25

 
$
5,495

 
$
5,520

 
$
658

 
$
(2,619
)
 
$
(1,961
)
Reclassification adjustment for net realized (gains) losses included in net income

 

 

 

 
(99
)
 
(99
)
Net unrealized gains (losses)
25

 
5,495

 
5,520

 
658

 
(2,718
)
 
(2,060
)
Tax effect

 
(1,739
)
 
(1,739
)
 

 
923

 
923

Unrealized gains (losses), net of tax
$
25

 
$
3,756

 
$
3,781

 
$
658

 
$
(1,795
)
 
$
(1,137
)
The following table details reclassification adjustments and the related affected line items on our interim condensed consolidated statements of income for the noted periods:
Details about AOCI components
Amount
Reclassified from
AOCI
 
Affected Line Item in the
Interim Condensed Consolidated
Statements of Income

Three Months Ended March 31
 
 
 
2014
 
2013
 
 
Unrealized holding gains (losses) on AFS securities
 
 
 
 
 
 
$

 
$
99

 
Net gains (losses) on sale of AFS securities
 

 
99

 
Income before federal income tax expense
 

 
34

 
Federal income tax expense
 
$

 
$
65

 
Net income

31

Table of Contents

Note 13 – Parent Company Only Financial Information
Interim Condensed Balance Sheets

March 31
2014
 
December 31
2013
ASSETS
 
 
 
Cash on deposit at the Bank
$
330

 
$
529

AFS securities
3,514

 
3,542

Investments in subsidiaries
116,295

 
110,192

Premises and equipment
1,988

 
2,013

Other assets
54,136

 
54,223

TOTAL ASSETS
$
176,263

 
$
170,499

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Other liabilities
$
10,292

 
$
9,890

Shareholders' equity
165,971

 
160,609

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
176,263

 
$
170,499

Interim Condensed Statements of Income
 
Three Months Ended 
 March 31

2014
 
2013
Income
 
 
 
Dividends from subsidiaries
$
1,500

 
$
1,500

Interest income
39

 
43

Management fee and other
506

 
508

Total income
2,045

 
2,051

Expenses
 
 
 
Compensation and benefits
832

 
712

Occupancy and equipment
114

 
111

Audit and related fees
71

 
65

Other
268

 
204

Total expenses
1,285

 
1,092

Income before income tax benefit and equity in undistributed earnings of subsidiaries
760

 
959

Federal income tax benefit
254

 
189

Income before equity in undistributed earnings of subsidiaries
1,014

 
1,148

Undistributed earnings of subsidiaries
2,295

 
1,939

Net income
$
3,309

 
$
3,087



32

Table of Contents

Interim Condensed Statements of Cash Flows
 
Three Months Ended 
 March 31

2014
 
2013
Operating activities
 
 
 
Net income
$
3,309

 
$
3,087

Adjustments to reconcile net income to cash provided by operations
 
 
 
Undistributed earnings of subsidiaries
(2,295
)
 
(1,939
)
Undistributed earnings of equity securities without readily determinable fair values
78

 
(6
)
Share-based payment awards
137

 
146

Depreciation
33

 
36

Net amortization of AFS securities

 
1

Changes in operating assets and liabilities which provided (used) cash
 
 
 
Other assets
9

 
(137
)
Accrued interest and other liabilities
153

 
(271
)
Net cash provided by (used in) operating activities
1,424

 
917

Investing activities
 
 
 
Purchases of premises and equipment
(8
)
 
(86
)
Advances to subsidiaries, net of repayments

 
101

Net cash provided by (used in) investing activities
(8
)
 
15

Financing activities
 
 
 
Net increase (decrease) in borrowed funds
250

 
900

Cash dividends paid on common stock
(1,696
)
 
(1,609
)
Proceeds from the issuance of common stock
850

 
902

Common stock repurchased
(893
)
 
(480
)
Common stock purchased for deferred compensation obligations
(126
)
 
(90
)
Net cash provided by (used in) financing activities
(1,615
)
 
(377
)
Increase (decrease) in cash and cash equivalents
(199
)
 
555

Cash and cash equivalents at beginning of period
529

 
332

Cash and cash equivalents at end of period
$
330

 
$
887

Note 14 – Operating Segments
Our reportable segments are based on legal entities that account for at least 10% of net operating results. The operations of the Bank as of March 31, 2014 and 2013 and each of the three month periods then ended, represent approximately 90% or more of our consolidated total assets and operating results. As such, no additional segment reporting is presented.

33

Table of Contents

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
ISABELLA BANK CORPORATION FINANCIAL REVIEW
(Dollars in thousands except per share amounts)
This section reviews our financial condition and results of our operations for the three month periods ended March 31, 2014 and 2013. This analysis should be read in conjunction with our 2013 Annual Report on Form 10-K and with the unaudited interim condensed consolidated financial statements and notes, beginning on page 4 of this report.
Executive Summary
Net income for the first quarter of 2014 was $3,309 an increase of $222 when compared to the same period in 2013. As of March 31, 2014, our total assets were $1,513,371, and assets under management - which included loans sold and serviced, and assets managed by our Investment and Trust Services Department of $651,193 - were $2,164,564.
The primary driver for the increase in net income was an improvement of various credit quality indicators. These improvements resulted in declines in the level of the ALLL in both amount and as a percentage of gross loans; and a reversal of provision for loan losses of $242. During the first quarter of 2014, net loans charged-off declined to $158 which represented our lowest quarterly charge-offs since the first quarter of 2007. Additionally, we continue to see reductions in loans classified as less than satisfactory. While we experienced improvements in net loans charged-off and reductions in the level of loans classified as less than satisfactory, nonperforming loans increased during the quarter. This increase was primarily the result of three loans, all of which are well collateralized and closely monitored by management.
While competition for high quality commercial loans continues to be intense, we were able to grow our portfolio during the quarter by $7,598 without relaxing our underwriting standards. This growth was partially offset by declines in both residential real estate loans of $5,345 and consumer loans of $1,349, resulting in an increase in total loans of $374. The lack of demand for residential real estate loans has also led to noticeable declines in loan fees and a corresponding decline in the net yield on interest earning assets. Despite the relatively small net increase in loans during the quarter, we generated additional interest income through the purchases of AFS investment securities which were funded by increases in deposit accounts.
We anticipate that competition for commercial loans will continue to be significant, residential mortgage loan activity will remain soft, and growing our deposit base will be challenging throughout the foreseeable future. Despite these challenges, our unwavering commitment to core community banking principles and long term sustainable growth has, and will continue to, enable us to meet the needs of the communities we serve and increase shareholder value.


34

Table of Contents

Results of Operations

The following table outlines our quarterly results of operations and provides certain performance measures as of, and for the three month periods ended March 31, 2014, December 31, 2013, September 30, 2013, June 30, 2013, and March 31, 2013:
 
March 31
2014
 
December 31
2013
 
September 30
2013
 
June 30
2013
 
March 31
2013
INCOME STATEMENT DATA
 
 
 
 
 
 
 
 
 
Interest income
$
13,364

 
$
13,603

 
$
13,505

 
$
13,440

 
$
13,528

Interest expense
2,500

 
2,683

 
2,736

 
2,781

 
2,821

Net interest income
10,864

 
10,920

 
10,769

 
10,659

 
10,707

Provision for loan losses
(242
)
 
245

 
351

 
215

 
300

Noninterest income
2,249

 
2,130

 
2,862

 
2,736

 
2,447

Noninterest expenses
9,486

 
9,578

 
9,320

 
9,324

 
9,191

Federal income tax expense
560

 
303

 
674

 
643

 
576

Net Income
$
3,309

 
$
2,924

 
$
3,286

 
$
3,213

 
$
3,087

PER SHARE
 
 
 
 
 
 
 
 
 
Basic earnings
0.43

 
0.38

 
0.43

 
0.42

 
0.40

Diluted earnings
0.42

 
0.37

 
0.42

 
0.41

 
0.39

Dividends
0.22

 
0.21

 
0.21

 
0.21

 
0.21

Tangible book value*
15.82

 
15.62

 
15.43

 
15.19

 
14.95

Market value
 
 
 
 
 
 
 
 
 
High
23.94

 
24.84

 
25.50

 
26.00

 
25.10

Low
22.25

 
21.12

 
23.40

 
21.12

 
21.55

Close*
23.00

 
23.85

 
24.85

 
24.75

 
25.00

Common shares outstanding*
7,727,547

 
7,723,023

 
7,709,781

 
7,703,589

 
7,688,928

PERFORMANCE RATIOS
 
 
 
 
 
 
 
 
 
Return on average total assets (annualized)
0.88
%
 
0.80
%
 
0.91
%
 
0.89
%
 
0.86
%
Return on average shareholders' equity (annualized)
8.04
%
 
7.18
%
 
8.27
%
 
7.76
%
 
7.51
%
Return on average tangible shareholders' equity (annualized)
10.92
%
 
9.78
%
 
11.16
%
 
11.10
%
 
10.86
%
Net interest margin yield (FTE annualized)
3.42
%
 
3.50
%
 
3.48
%
 
3.50
%
 
3.54
%
BALANCE SHEET DATA*
 
 
 
 
 
 
 
 
 
Gross loans
$
808,411

 
$
808,037

 
$
807,849

 
$
803,452

 
$
767,522

AFS securities
555,144

 
512,062

 
501,057

 
499,424

 
520,931

Total assets
1,513,371

 
1,493,137

 
1,459,341

 
1,451,415

 
1,434,705

Deposits
1,065,935

 
1,043,766

 
1,023,931

 
1,021,424

 
1,029,760

Borrowed funds
272,536

 
279,326

 
266,001

 
262,460

 
232,410

Shareholders' equity
165,971

 
160,609

 
161,305

 
159,288

 
165,308

Gross loans to deposits
75.84
%
 
77.42
%
 
78.90
%
 
78.66
%
 
74.53
%
ASSETS UNDER MANAGEMENT*
 
 
 
 
 
 
 
 
 
Loans sold with servicing retained
$
292,382

 
$
293,665

 
$
294,999

 
$
295,047

 
$
301,476

Assets managed by our Investment and Trust Services Department
358,811

 
351,420

 
351,505

 
336,132

 
336,632

Total assets under management
2,164,564

 
2,138,222

 
2,105,845

 
2,082,594

 
2,072,813

ASSET QUALITY*
 
 
 
 
 
 
 
 
 
Nonperforming loans to gross loans
0.65
%
 
0.42
%
 
0.53
%
 
0.52
%
 
0.90
%
Nonperforming assets to total assets
0.42
%
 
0.32
%
 
0.37
%
 
0.36
%
 
0.56
%
ALLL to gross loans
1.37
%
 
1.42
%
 
1.44
%
 
1.46
%
 
1.55
%
CAPITAL RATIOS
 
 
 
 
 
 
 
 
 
Shareholders' equity to assets*
10.97
%
 
10.76
%
 
11.05
%
 
10.97
%
 
11.52
%
Tier 1 capital to average assets*
8.38
%
 
8.46
%
 
8.45
%
 
8.38
%
 
8.28
%
Tier 1 risk-based capital*
13.88
%
 
13.67
%
 
13.75
%
 
13.59
%
 
13.61
%
Total risk-based capital*
15.13
%
 
14.92
%
 
15.00
%
 
14.84
%
 
14.86
%
* At end of period

35

Table of Contents

Average Balances, Interest Rate, and Net Interest Income
The following schedules present the daily average amount outstanding for each major category of interest earning assets, nonearning assets, interest bearing liabilities, and noninterest bearing liabilities. These schedules also present an analysis of interest income and interest expense for the periods indicated. All interest income is reported on a FTE basis using a 34% federal income tax rate. Nonaccruing loans, for the purpose of the following computations, are included in the average loan amounts outstanding. FRB and FHLB restricted equity holdings are included in accrued income and other assets.
The following table displays the results for the three month periods ended:
 
March 31
2014
 
December 31
2013
 
March 31
2013

Average
Balance
 
Tax
Equivalent
Interest
 
Average
Yield /
Rate
 
Average
Balance
 
Tax
Equivalent
Interest
 
Average
Yield /
Rate
 
Average
Balance
 
Tax
Equivalent
Interest
 
Average
Yield /
Rate
INTEREST EARNING ASSETS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans
$
805,812

 
$
9,751

 
4.84
%
 
$
806,749

 
$
10,293

 
5.10
%
 
$
766,741

 
$
10,330

 
5.39
%
Taxable investment securities
353,013

 
1,998

 
2.26
%
 
326,717

 
1,809

 
2.21
%
 
343,518

 
1,834

 
2.14
%
Nontaxable investment securities
189,000

 
2,332

 
4.94
%
 
178,678

 
2,214

 
4.96
%
 
155,668

 
2,009

 
5.16
%
Trading account securities
524

 
8

 
6.11
%
 
741

 
9

 
4.86
%
 
1,570

 
21

 
5.35
%
Other
26,604

 
153

 
2.30
%
 
31,341

 
116

 
1.48
%
 
30,376

 
116

 
1.53
%
Total earning assets
1,374,953

 
14,242

 
4.14
%
 
1,344,226

 
14,441

 
4.30
%
 
1,297,873

 
14,310

 
4.41
%
NONEARNING ASSETS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
ALLL
(11,634
)
 
 
 
 
 
(11,668
)
 
 
 
 
 
(12,085
)
 
 
 
 
Cash and demand deposits due from banks
17,690

 
 
 
 
 
18,406

 
 
 
 
 
18,661

 
 
 
 
Premises and equipment
26,018

 
 
 
 
 
25,956

 
 
 
 
 
25,937

 
 
 
 
Accrued income and other assets
94,704

 
 
 
 
 
92,958

 
 
 
 
 
101,816

 
 
 
 
Total assets
$
1,501,731

 
 
 
 
 
$
1,469,878

 
 
 
 
 
$
1,432,202

 
 
 
 
INTEREST BEARING LIABILITIES
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest bearing demand deposits
$
197,776

 
41

 
0.08
%
 
$
183,022

 
40

 
0.09
%
 
$
186,798

 
41

 
0.09
%
Savings deposits
252,979

 
94

 
0.15
%
 
242,141

 
91

 
0.15
%
 
241,401

 
91

 
0.15
%
Time deposits
451,350

 
1,481

 
1.31
%
 
450,792

 
1,571

 
1.39
%
 
461,537

 
1,742

 
1.51
%
Borrowed funds
270,010

 
884

 
1.31
%
 
270,327

 
981

 
1.45
%
 
230,573

 
947

 
1.64
%
Total interest bearing liabilities
1,172,115

 
2,500

 
0.85
%
 
1,146,282

 
2,683

 
0.94
%
 
1,120,309

 
2,821

 
1.01
%
NONINTEREST BEARING LIABILITIES
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Demand deposits
155,176

 
 
 
 
 
151,526

 
 
 
 
 
137,959

 
 
 
 
Other
9,861

 
 
 
 
 
9,114

 
 
 
 
 
9,420

 
 
 
 
Shareholders’ equity
164,579

 
 
 
 
 
162,956

 
 
 
 
 
164,514

 
 
 
 
Total liabilities and shareholders’ equity
$
1,501,731

 
 
 
 
 
$
1,469,878

 
 
 
 
 
$
1,432,202

 
 
 
 
Net interest income (FTE)
 
 
$
11,742

 
 
 
 
 
$
11,758

 
 
 
 
 
$
11,489

 
 
Net yield on interest earning assets (FTE)
 
 
 
 
3.42
%
 
 
 
 
 
3.50
%
 
 
 
 
 
3.54
%
Net Interest Income
Net interest income is the amount by which interest income on earning assets exceeds the interest expenses on interest bearing liabilities. Net interest income is influenced by changes in the balance and mix of assets and liabilities and market interest rates. We exert some control over these factors; however, FRB monetary policy and competition have a significant impact. Interest

36

Table of Contents

income includes loan fees of $476, $761, and $821 for the three month periods ended March 31, 2014, December 31, 2013, and March 31, 2013, respectively. For analytical purposes, net interest income is adjusted to an FTE basis by adding the income tax savings from interest on tax exempt loans, AFS securities, and trading securities, thus making year to year comparisons more meaningful.
Volume and Rate Variance Analysis
The following table sets forth the effect of volume and rate changes on interest income and expense for the periods indicated. For the purpose of this table, changes in interest due to volume and rate were determined as follows:
Volume—change in volume multiplied by the previous period's rate.
Rate—change in the FTE rate multiplied by the previous period's volume.
The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.
 
Three Months Ended 
 March 31, 2014 Compared to December 31, 2013 
 Increase (Decrease) Due to
 
Three Months Ended 
 March 31, 2014 Compared to March 31, 2013 
 Increase (Decrease) Due to

Volume
 
Rate
 
Net
 
Volume
 
Rate
 
Net
Changes in interest income
 
 
 
 
 
 
 
 
 
 
 
Loans
$
(12
)
 
$
(530
)
 
$
(542
)
 
$
509

 
$
(1,088
)
 
$
(579
)
Taxable AFS securities
148

 
41

 
189

 
52

 
112

 
164

Nontaxable AFS securities
127

 
(9
)
 
118

 
414

 
(91
)
 
323

Trading securities
(3
)
 
2

 
(1
)
 
(16
)
 
3

 
(13
)
Other
(20
)
 
57

 
37

 
(16
)
 
53

 
37

Total changes in interest income
240

 
(439
)
 
(199
)
 
943

 
(1,011
)
 
(68
)
Changes in interest expense
 
 
 
 
 
 
 
 
 
 
 
Interest bearing demand deposits
3

 
(2
)
 
1

 
2

 
(2
)
 

Savings deposits
4

 
(1
)
 
3

 
4

 
(1
)
 
3

Time deposits
2

 
(92
)
 
(90
)
 
(38
)
 
(223
)
 
(261
)
Borrowed funds
(1
)
 
(96
)
 
(97
)
 
142

 
(205
)
 
(63
)
Total changes in interest expense
8

 
(191
)
 
(183
)
 
110

 
(431
)
 
(321
)
Net change in interest margin (FTE)
$
232

 
$
(248
)
 
$
(16
)
 
$
833

 
$
(580
)
 
$
253

As shown in the following table, we experienced significant downward pressure on our net yield on interest earning assets over the past 12 months. This pressure is a direct result of FRB monetary policy which has reduced yields on interest earning assets more than rates on interest bearing liabilities. The persistent low interest rate environment coupled with an increase in the concentration of AFS securities as a percentage of earnings assets has also placed downward pressure on net interest margin yield and net interest income.
 
Average Yield / Rate for the Three Month Periods Ended:

March 31
2014

December 31
2013

September 30
2013

June 30
2013

March 31
2013
Total earning assets
4.14
%
 
4.30
%
 
4.31
%
 
4.35
%
 
4.41
%
Total interest bearing liabilities
0.85
%
 
0.94
%
 
0.96
%
 
0.99
%
 
1.01
%
Net yield on interest earning assets (FTE)
3.42
%

3.50
%
 
3.48
%
 
3.50
%
 
3.54
%
 
Quarter to Date Net Interest Income (FTE)

March 31
2014
 
December 31
2013
 
September 30
2013
 
June 30
2013
 
March 31
2013
Total interest income (FTE)
$
14,242

 
$
14,441

 
$
14,290

 
$
14,225

 
$
14,310

Total interest expense
2,500

 
2,683

 
2,736

 
2,781

 
2,821

Net interest income (FTE)
$
11,742

 
$
11,758

 
$
11,554

 
$
11,444

 
$
11,489


37

Table of Contents

One of the the primary contributors to the decline in the net yield on interest earning assets and net interest income has been a drastic decline in loan fees in the first quarter of 2014. Loan fees have declined as the demand for residential mortgage loans has diminished and the competition for commercial loans remains intense. As shown in the following table, the net yield on interest earning assets and net interest income excluding the impact of loan fees (FTE) has consistently improved since the second quarter of 2013.
 
March 31
2014
 
December 31
2013
 
September 30
2013
 
June 30
2013
 
March 31
2013
Net interest income (FTE)
$
11,742

 
$
11,758

 
$
11,554

 
$
11,444

 
$
11,489

Less loan fees
476

 
761

 
738

 
862

 
821

Net interest income excluding loan fees (FTE)
$
11,266

 
$
10,997

 
$
10,816

 
$
10,582

 
$
10,668

Net yield on interest earning assets excluding loan fees (FTE)
3.28
%
 
3.27
%
 
3.26
%
 
3.23
%
 
3.29
%
Despite the challenging current interest rate and competitive loan environments, we anticipate that net interest income and the net yield on interest earning assets (FTE) will modestly increase in future periods as most interest earning assets have already repriced at lower rates while some interest bearing liabilities will likely reprice at lower interest rates in coming periods and loan fees are expected to stabilize.
Allowance for Loan and Lease Losses
The viability of any financial institution is ultimately determined by its management of credit risk. Loans represent our single largest concentration of risk. The ALLL is our estimation of losses within the existing loan portfolio. We allocate the ALLL throughout the loan portfolio based on our assessment of the underlying risks associated with each loan segment. Our assessments include allocations based on specific impairment valuation allowances, historical charge-offs, internally assigned credit ratings, and past due and nonaccrual balances. A portion of the ALLL is not allocated to any one loan segment, but is instead a reflection of other qualitative risks within the loan portfolio.
The following table summarizes our charge-off and recovery activity for the three month periods ended March 31:

2014
 
2013
 
Variance
ALLL at beginning of period
$
11,500

 
$
11,936

 
$
(436
)
Loans charged-off
 
 
 
 
 
Commercial and agricultural
223

 
211

 
12

Residential real estate
113

 
190

 
(77
)
Consumer
114

 
121

 
(7
)
Total loans charged-off
450

 
522

 
(72
)
Recoveries
 
 
 
 
 
Commercial and agricultural
214

 
57

 
157

Residential real estate
36

 
53

 
(17
)
Consumer
42

 
85

 
(43
)
Total recoveries
292

 
195

 
97

Net loans charged-off
158

 
327

 
(169
)
Provision for loan losses
(242
)
 
300

 
(542
)
ALLL at end of period
$
11,100

 
$
11,909

 
$
(809
)


38

Table of Contents

The following table summarizes our charge-offs, recoveries, provisions for loan losses, and ALLL balances as of, and for the three month periods ended:

March 31
2014
 
December 31
2013
 
September 30
2013
 
June 30
2013
 
March 31
2013
Total loans charged-off
$
450

 
$
497

 
$
602

 
$
719

 
$
522

Total recoveries
292

 
152

 
151

 
295

 
195

Net loans charged-off
158

 
345

 
451

 
424

 
327

Net loans charged-off to average loans outstanding
0.02
 %
 
0.04
%
 
0.06
%
 
0.05
%
 
0.04
%
Provision for loan losses
$
(242
)
 
$
245

 
$
351

 
$
215

 
$
300

Provision for loan losses to average loans outstanding
(0.03
)%
 
0.03
%
 
0.04
%
 
0.03
%
 
0.04
%
ALLL as a% of loans at end of period
1.37
 %
 
1.42
%
 
1.44
%
 
1.46
%
 
1.55
%
As the level of net loans charged-off continues to decline and credit quality indicators return to pre-recessionary levels, we have reduced the ALLL in both amount and as a percentage of loans. While overall net loans charged-off is likely to approximate current levels, charge-offs on residential real estate loans are anticipated to increase slightly as a percentage of net loans charged-off due to anticipated increased foreclosures as a result of the impact of the CFPB ability to repay rules. For further discussion of the allocation of the ALLL, see “Note 5 – Loans and ALLL” of our interim condensed consolidated financial statements.
Loans Past Due and Loans in Nonaccrual Status
Increases in past due and nonaccrual loans can have a significant impact on the ALLL. To determine the potential impact, and corresponding estimated losses, we analyze our historical loss trends on loans past due greater than 30 days and nonaccrual loans. We monitor all loans that are past due and in nonaccrual status for indicators of additional deterioration.
 
Total Past Due and Nonaccrual

March 31
2014
 
December 31
2013
 
September 30
2013
 
June 30
2013
 
March 31
2013
Commercial and agricultural
$
4,986

 
$
3,621

 
$
5,371

 
$
4,962

 
$
8,713

Residential real estate
7,067

 
7,008

 
6,339

 
5,080

 
4,077

Consumer
113

 
259

 
152

 
104

 
212

Total
$
12,166

 
$
10,888

 
$
11,862

 
$
10,146

 
$
13,002

Total past due and nonaccrual loans to gross loans
1.50
%
 
1.35
%
 
1.47
%
 
1.26
%
 
1.69
%
A summary of loans past due and in nonaccrual status, including the composition of the ending balance of nonaccrual loans by type, is included in “Note 5 – Loans and ALLL” of our interim condensed consolidated financial statements.
Troubled Debt Restructurings
We have taken a proactive approach to avoid foreclosures on borrowers who are willing to work with us in modifying their loans, thus making them more affordable. While this approach has allowed certain borrowers to develop a payment structure that will allow them to continue making payments in lieu of foreclosure, it has contributed to a significant increase in the level of loans classified as TDRs. The modifications have been successful for us and our customers as very few of the modified loans have resulted in foreclosures. At the time of the TDR, the loan is reviewed to determine whether or not to classify the loan as accrual or nonaccrual. The majority of new modifications result in terms that satisfy our criteria for continued interest accrual. TDRs that have been placed in nonaccrual status may be placed back on accrual status after six months of continued performance.
We restructure debt with borrowers who due to temporary financial difficulties are unable to service their debt under the original terms. We may extend the amortization period, reduce interest rates, forgive principal, or a combination of these modifications. Typically, the modifications are for a period of five years or less. There were no TDRs that were Government sponsored as of March 31, 2014 or December 31, 2013.
Losses associated with TDRs, if any, are included in the estimation of the ALLL in the quarter in which a loan is identified as a TDR, and we review the ALLL estimation each reporting period to ensure its continued appropriateness.

39

Table of Contents

The following tables provide a roll-forward of TDRs for the:

Three Months Ended March 31, 2014
 
Accruing Interest
 
Nonaccrual
 
Total
 
Number
of
Loans
 
Balance
 
Number
of
Loans
 
Balance
 
Number
of
Loans
 
Balance
January 1, 2014
165

 
$
24,423

 
15

 
$
1,442

 
180

 
$
25,865

New modifications
12

 
770

 
2

 
77

 
14

 
847

Principal payments

 
(273
)
 

 
(30
)
 

 
(303
)
Loans paid-off
(10
)
 
(718
)
 

 

 
(10
)
 
(718
)
Partial charge-off

 

 

 
(18
)
 

 
(18
)
Balances charged-off
(1
)
 
(6
)
 

 

 
(1
)
 
(6
)
Transfers to OREO

 

 
(2
)
 
(34
)
 
(2
)
 
(34
)
Transfers to accrual status
2

 
57

 
(2
)
 
(57
)
 

 

Transfers to nonaccrual status
(3
)
 
(1,299
)
 
3

 
1,299

 

 

March 31, 2014
165

 
$
22,954

 
16

 
$
2,679

 
181

 
$
25,633


Three Months Ended March 31, 2013
 
Accruing Interest
 
Nonaccrual
 
Total
 
Number
of
Loans
 
Balance
 
Number
of
Loans
 
Balance
 
Number
of
Loans
 
Balance
January 1, 2013
115

 
$
16,531

 
19

 
$
2,824

 
134

 
$
19,355

New modifications
8

 
819

 
1

 
98

 
9

 
917

Principal payments

 
(265
)
 

 
(37
)
 

 
(302
)
Loans paid-off
(3
)
 
(130
)
 
(1
)
 
(200
)
 
(4
)
 
(330
)
Partial charge-off

 
(15
)
 

 
(211
)
 

 
(226
)
Balances charged-off

 

 

 

 

 

Transfers to OREO

 

 
(1
)
 
(12
)
 
(1
)
 
(12
)
Transfers to accrual status

 

 

 

 

 

Transfers to nonaccrual status
(1
)
 
(40
)
 
1

 
40

 

 

March 31, 2013
119

 
$
16,900

 
19

 
$
2,502

 
138

 
$
19,402

The following table summarizes our TDRs as of:
 
March 31, 2014
 
December 31, 2013
 
 

Accruing
Interest
 
Nonaccrual
 
Total
 
Accruing
Interest
 
Nonaccrual
 
Total
 
Total
Change
Current
$
20,459

 
$
2,076

 
$
22,535

 
$
21,690

 
$
1,189

 
$
22,879

 
$
(344
)
Past due 30-59 days
1,674

 
8

 
1,682

 
2,158

 
37

 
2,195

 
(513
)
Past due 60-89 days
486

 

 
486

 
575

 

 
575

 
(89
)
Past due 90 days or more
335

 
595

 
930

 

 
216

 
216

 
714

Total
$
22,954

 
$
2,679

 
$
25,633

 
$
24,423

 
$
1,442

 
$
25,865

 
$
(232
)
Additional disclosures about TDRs are included in “Note 5 – Loans and ALLL” of our interim condensed consolidated financial statements.

40

Table of Contents

Impaired Loans
The following is a summary of information pertaining to impaired loans as of:
 
March 31, 2014
 
December 31, 2013

Outstanding
Balance
 
Unpaid
Principal
Balance
 
Valuation
Allowance
 
Outstanding
Balance
 
Unpaid
Principal
Balance
 
Valuation
Allowance
TDRs
 
 
 
 
 
 
 
 
 
 
 
Commercial real estate
$
10,870

 
$
11,399

 
$
1,580

 
$
10,663

 
$
11,193

 
$
1,585

Commercial other
1,305

 
1,335

 
47

 
1,310

 
1,340

 
62

Agricultural real estate
1,455

 
1,455

 
29

 
1,459

 
1,459

 
30

Agricultural other
18

 
138

 

 
79

 
199

 

Residential real estate senior liens
11,904

 
12,455

 
2,157

 
12,266

 
12,841

 
2,010

Residential real estate junior liens
20

 
20

 
4

 
20

 
20

 
4

Consumer secured
61

 
68

 
1

 
68

 
69

 

Total TDRs
25,633

 
26,870

 
3,818

 
25,865

 
27,121

 
3,691

Other impaired loans
 
 
 
 
 
 
 
 
 
 
 
Commercial real estate
1,835

 
2,268

 
284

 
1,707

 
2,193

 
330

Commercial other
24

 
105

 

 
136

 
217

 
58

Agricultural real estate
82

 
82

 

 

 

 

Agricultural other
225

 
250

 

 

 

 

Residential real estate senior liens
1,212

 
1,784

 
179

 
1,795

 
2,473

 
268

Residential real estate junior liens
24

 
43

 
6

 
28

 
45

 
5

Home equity lines of credit
169

 
469

 
7

 
193

 
493

 

Consumer secured

 

 

 
51

 
79

 

Total other impaired loans
3,571

 
5,001

 
476

 
3,910

 
5,500

 
661

Total impaired loans
$
29,204

 
$
31,871

 
$
4,294

 
$
29,775

 
$
32,621

 
$
4,352

Additional disclosure related to impaired loans is included in “Note 5 – Loans and ALLL” of our interim condensed consolidated financial statements.
Nonperforming Assets
The following table summarizes our nonperforming assets as of:

March 31
2014
 
December 31
2013
Nonaccrual loans
$
4,345

 
$
3,244

Accruing loans past due 90 days or more
893

 
142

Total nonperforming loans
5,238

 
3,386

Foreclosed assets
1,126

 
1,412

Total nonperforming assets
$
6,364

 
$
4,798

Nonperforming loans as a % of total loans
0.65
%
 
0.42
%
Nonperforming assets as a % of total assets
0.42
%
 
0.32
%
After a loan is 90 days past due, it is generally placed in nonaccrual status unless it is well secured and in the process of collection. Upon transferring the loans to nonaccrual status, we perform an evaluation to determine the net realizable value of the underlying collateral. This evaluation is used to help determine if any charge-offs are necessary. Loans may be placed back on accrual status after six months of continued performance.
During the first quarter of 2014, total nonperforming loans increased primarily as a result of three loans (two were accruing loans past due 90 days or more and one was in nonaccrual status), all of which were fully collateralized and closely monitored by management. Included in the increase in accruing loans past due 90 days or more are two loans totaling $625 as of March 31, 2014. We anticipate full payoffs on these loans in the near future.

41

Table of Contents

Included in the nonaccrual loan balances above were loans currently classified as TDRs as of:

March 31
2014
 
December 31
2013
Commercial and agricultural
$
2,024

 
$
833

Residential real estate
654

 
609

Consumer
1

 

Total
$
2,679

 
$
1,442

The following table lists individually significant commercial and agricultural loan relationships in nonaccrual status as of March 31, 2014 and December 31, 2013. To be classified as individually significant, the recorded investment in nonaccrual loans to each borrower must have exceeded $1,000 as of the end of either period.
 
March 31, 2014
 
December 31, 2013

Outstanding
Balance
 
Specific
Allocation
 
Outstanding
Balance
 
Specific
Allocation
Borrower 1
$
1,119

 
$

1 
 
$

 
$

Others not individually significant
3,226

 
 
 
 
3,244

 
 
Total
$
4,345

 
 
 
 
$
3,244

 
 
1 No specific allocation as the net realizable value of the loan's underlying collateral value exceeded the loan's carrying balance.
Additional disclosures about nonaccrual loans are included in “Note 5 – Loans and ALLL” of our interim condensed consolidated financial statements.
We continue to devote considerable attention to identifying impaired loans and adjusting the net carrying value of these loans to their current net realizable values through the establishment of a specific reserve or the recording of a charge-off. We believe that all loans deemed to be impaired have been identified.
We believe that the level of the ALLL is appropriate as of March 31, 2014 and we will continue to closely monitor overall credit quality and our policies and procedures related to the analysis of the ALLL to ensure that the ALLL remains appropriate.

42

Table of Contents

Noninterest Income and Noninterest Expenses
Noninterest income consists of service charges and fees, gains on sale of mortgage loans, earnings on corporate owned life insurance policies, gains and losses on sales of AFS securities, and other income. Significant account balances are highlighted in the following table with additional descriptions of significant fluctuations:

Three Months Ended March 31
 
 
 
 
 
Change
 
2014
 
2013
 
$
 
%
Service charges and fees
 
 
 
 
 
 
 
NSF and overdraft fees
$
513

 
$
516

 
$
(3
)
 
(0.58
)%
ATM and debit card fees
487

 
455

 
32

 
7.03
 %
Freddie Mac servicing fee
183

 
184

 
(1
)
 
(0.54
)%
Service charges on deposit accounts
86

 
90

 
(4
)
 
(4.44
)%
Net OMSRs income (loss)
91

 
8

 
83

 
N/M

All other
34

 
28

 
6

 
21.43
 %
Total service charges and fees
1,394

 
1,281

 
113

 
8.82
 %
Gain on sale of mortgage loans
115

 
358

 
(243
)
 
(67.88
)%
Earnings on corporate owned life insurance policies
184

 
169

 
15

 
8.88
 %
Gains (losses) on sale of AFS securities

 
99

 
(99
)
 
(100.00
)%
Other
 
 
 
 
 
 
 
Trust and brokerage advisory fees
507

 
410

 
97

 
23.66
 %
Other
49

 
130

 
(81
)
 
(62.31
)%
Total other
556

 
540

 
16

 
2.96
 %
Total noninterest income
$
2,249

 
$
2,447

 
$
(198
)
 
(8.09
)%
Significant changes in noninterest income are detailed below:
As customers continue to increase their dependence on ATM and debit cards, we have seen a corresponding increase in fees. We do not anticipate significant changes to our ATM and debit fee structure; however, we do expect that these fees will continue to increase as the usage of ATM and debit cards increase.
Offering rates on residential mortgage loans is the most significant driver behind fluctuations in the gain on sale of mortgage loans and net OMSRs income (loss). As offering rates increase, we typically experience reductions in the gain on sale of mortgage loans. Offsetting these declines are increases in the value of our mortgage servicing portfolio leading to the increase in net OMSRs income. As mortgage rates are expected to approximate current levels in the foreseeable future and purchase money mortgage activity will likely remain soft, we do not anticipate any significant changes in origination volumes or the gain on sale of mortgage loans.
We are continually analyzing our AFS securities for potential sale opportunities. These analyses identified several mortgage-backed securities pools in 2013 that made economic sense to sell. Currently we are not planning any significant investment sales during 2014.
In recent periods, we have invested considerable efforts to increase our market share in trust and brokerage advisory services. These efforts have translated into increases in trust fees and brokerage and advisory fees. We expect this trend to continue.
The fluctuations in all other income is spread throughout various categories, none of which are individually significant. We do not anticipate any significant fluctuations from current levels in 2014.

43

Table of Contents

Noninterest expenses include compensation and benefits, furniture and equipment, occupancy, and other expenses. Significant account balances are highlighted in the following table with additional descriptions of significant fluctuations:

Three Months Ended March 31
 
 
 
 
 
Change
 
2014
 
2013
 
$
 
%
Compensation and benefits
 
 
 
 
 
 
 
Employee salaries
$
4,042

 
$
3,876

 
$
166

 
4.28
 %
Employee benefits
1,444

 
1,569

 
(125
)
 
(7.97
)%
Total compensation and benefits
5,486

 
5,445

 
41

 
0.75
 %
Furniture and equipment
 
 
 
 
 
 
 
Service contracts
620

 
536

 
84

 
15.67
 %
Depreciation
445

 
464

 
(19
)
 
(4.09
)%
ATM and debit card fees
188

 
168

 
20

 
11.90
 %
All other
15

 
21

 
(6
)
 
(28.57
)%
Total furniture and equipment
1,268

 
1,189

 
79

 
6.64
 %
Occupancy
 
 
 
 
 
 
 
Outside services
207

 
170

 
37

 
21.76
 %
Depreciation
174

 
161

 
13

 
8.07
 %
Utilities
156

 
136

 
20

 
14.71
 %
Property taxes
134

 
135

 
(1
)
 
(0.74
)%
All other
71

 
63

 
8

 
12.70
 %
Total occupancy
742

 
665

 
77

 
11.58
 %
Other
 
 
 
 
 
 
 
Marketing and community relations
243

 
242

 
1

 
0.41
 %
FDIC insurance premiums
202

 
272

 
(70
)
 
(25.74
)%
Directors fees
195

 
199

 
(4
)
 
(2.01
)%
Audit and related fees
138

 
139

 
(1
)
 
(0.72
)%
Education and travel
121

 
122

 
(1
)
 
(0.82
)%
Postage and freight
108

 
99

 
9

 
9.09
 %
Printing and supplies
102

 
86

 
16

 
18.60
 %
Loan underwriting fees
95

 
116

 
(21
)
 
(18.10
)%
Consulting fees
91

 
72

 
19

 
26.39
 %
All other
695

 
545

 
150

 
27.52
 %
Total other
1,990

 
1,892

 
98

 
5.18
 %
Total noninterest expenses
$
9,486

 
$
9,191

 
$
295

 
3.21
 %
Significant changes in noninterest expenses are detailed below:
Employee salaries have increased as a result of normal merit increases and additional staffing required by our continued growth. The decline in employee benefits is related to health care costs as a result of lower than anticipated claims. Employee benefits are expected to increase in future periods as a result of anticipated increases in health care costs.
Service contracts have increased during 2014 due to costs related to data lines as well as increases in various other contracts as we continue to expand our on-line services offered to customers. Service contracts are anticipated to approximate current levels for the remainder of 2014.
FDIC insurance premiums increased in 2013 as a result of us receiving less of a refund for prepaid FDIC insurance premiums than we had anticipated. FDIC insurance premiums have returned to normalized levels and are anticipated to approximate current levels for the remainder of 2014.
The fluctuations in all other expenses are spread throughout various categories, none of which are individually significant.

44

Table of Contents

Analysis of Changes in Financial Condition

March 31
2014
 
December 31
2013
 
$ Change
 
% Change
(unannualized)
ASSETS
 
 
 
 
 
 
 
Cash and cash equivalents
$
18,667

 
$
41,558

 
$
(22,891
)
 
(55.08
)%
Certificates of deposit held in other financial institutions
580

 
580

 

 

Trading securities
521

 
525

 
(4
)
 
(0.76
)%
AFS securities
 
 
 
 
 
 
 
Amortized cost of AFS securities
555,176

 
517,614

 
37,562

 
7.26
 %
Unrealized Gains (losses) on AFS securities
(32
)
 
(5,552
)
 
5,520

 
N/M

AFS securities
555,144

 
512,062

 
43,082

 
8.41
 %
Mortgage loans AFS
489

 
1,104

 
(615
)
 
(55.71
)%
Loans
 
 
 
 


 
 
Gross loans
808,411

 
808,037

 
374

 
0.05
 %
Less allowance for loan and lease losses
11,100

 
11,500

 
(400
)
 
(3.48
)%
Net loans
797,311

 
796,537

 
774

 
0.10
 %
Premises and equipment
26,009

 
25,719

 
290

 
1.13
 %
Corporate owned life insurance policies
24,585

 
24,401

 
184

 
0.75
 %
Accrued interest receivable
6,725

 
5,442

 
1,283

 
23.58
 %
Equity securities without readily determinable fair values
18,965

 
18,293

 
672

 
3.67
 %
Goodwill and other intangible assets
46,263

 
46,311

 
(48
)
 
(0.10
)%
Other assets
18,112

 
20,605

 
(2,493
)
 
(12.10
)%
TOTAL ASSETS
$
1,513,371

 
$
1,493,137

 
$
20,234

 
1.36
 %
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
Deposits
$
1,065,935

 
$
1,043,766

 
$
22,169

 
2.12
 %
Borrowed funds
272,536

 
279,326

 
(6,790
)
 
(2.43
)%
Accrued interest payable and other liabilities
8,929

 
9,436

 
(507
)
 
(5.37
)%
Total liabilities
1,347,400

 
1,332,528

 
14,872

 
1.12
 %
Shareholders’ equity
165,971

 
160,609

 
5,362

 
3.34
 %
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
1,513,371

 
$
1,493,137

 
$
20,234

 
1.36
 %
The following table outlines the changes in loans:

March 31
2014
 
December 31
2013
 
$ Change
 
% Change
(unannualized)
Commercial
$
399,702

 
$
392,104

 
$
7,598

 
1.94
 %
Agricultural
92,059

 
92,589

 
(530
)
 
(0.57
)%
Residential real estate
284,586

 
289,931

 
(5,345
)
 
(1.84
)%
Consumer
32,064

 
33,413

 
(1,349
)
 
(4.04
)%
Total
$
808,411

 
$
808,037

 
$
374

 
0.05
 %

45

Table of Contents

The following table displays loan balances as of:

March 31
2014
 
December 31
2013
 
September 30
2013
 
June 30
2013
 
March 31
2013
Commercial
$
399,702

 
$
392,104

 
$
388,973

 
$
389,044

 
$
364,350

Agricultural
92,059

 
92,589

 
92,927

 
87,516

 
81,196

Residential real estate
284,586

 
289,931

 
291,825

 
293,158

 
288,962

Consumer
32,064

 
33,413

 
34,124

 
33,734

 
33,014

Total
$
808,411

 
$
808,037

 
$
807,849

 
$
803,452

 
$
767,522

While loan balances have increased by almost $41,000 since March 31, 2013, our portfolio has remained essentially unchanged since June 30, 2013. We continue to see declines in residential real estate loans which have been offset by increases in commercial and agricultural loans. This trend is likely to continue as the demand for residential real estate loans is anticipated to remain soft due to continuing uncertainty in the residential real estate markets, increases in interest rates, and the implementation of CFPB underwriting guidelines.
The following table outlines the changes in deposits:

March 31
2014
 
December 31
2013
 
$ Change
 
% Change
(unannualized)
Noninterest bearing demand deposits
$
158,241

 
$
158,428

 
$
(187
)
 
(0.12
)%
Interest bearing demand deposits
194,407

 
192,089

 
2,318

 
1.21
 %
Savings deposits
261,444

 
243,237

 
18,207

 
7.49
 %
Certificates of deposit
356,847

 
362,473

 
(5,626
)
 
(1.55
)%
Brokered certificates of deposit
65,273

 
56,329

 
8,944

 
15.88
 %
Internet certificates of deposit
29,723

 
31,210

 
(1,487
)
 
(4.76
)%
Total
$
1,065,935

 
$
1,043,766

 
$
22,169

 
2.12
 %
The following table displays balances of deposits as of:

March 31
2014
 
December 31
2013
 
September 30
2013
 
June 30
2013
 
March 31
2013
Noninterest bearing demand deposits
$
158,241

 
$
158,428

 
$
143,013

 
$
139,942

 
$
137,322

Interest bearing demand deposits
194,407

 
192,089

 
186,630

 
173,184

 
183,055

Savings deposits
261,444

 
243,237

 
245,217

 
248,098

 
248,881

Certificates of deposit
356,847

 
362,473

 
366,349

 
368,713

 
374,280

Brokered certificates of deposit
65,273

 
56,329

 
51,410

 
57,701

 
53,329

Internet certificates of deposit
29,723

 
31,210

 
31,312

 
33,786

 
32,893

Total
$
1,065,935

 
$
1,043,766

 
$
1,023,931

 
$
1,021,424

 
$
1,029,760

While loan growth since June 30, 2013 has been sluggish, we have enjoyed consistent deposit growth over the same time period. As a result of the current interest rate environment, we continue to see declines in certificates of deposits. However, these declines have been offset by increases in noninterest bearing demand deposits, interest bearing demand deposits, and savings accounts. We expect this trend to continue for the foreseeable future.

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As deposit growth has outpaced loan demand, we continue to deploy deposits into purchases of AFS securities to provide additional interest income. While most of the growth in AFS securities over the past 12 months has been in states and political subdivisions, we anticipate that future increases in our AFS securities will be in the form of mortgage-backed securities and collateralized mortgage obligations. The following table displays fair values of AFS securities as of:

March 31
2014
 
December 31
2013
 
September 30
2013
 
June 30
2013
 
March 31
2013
Government sponsored enterprises
$
23,883

 
$
23,745

 
$
24,155

 
$
24,249

 
$
25,491

States and political subdivisions
219,644

 
201,988

 
193,786

 
187,302

 
192,564

Auction rate money market preferred
2,755

 
2,577

 
2,639

 
2,943

 
3,091

Preferred stocks
6,053

 
5,827

 
6,144

 
6,559

 
6,708

Mortgage-backed securities
157,856

 
144,115

 
146,393

 
149,407

 
163,533

Collateralized mortgage obligations
144,953

 
133,810

 
127,940

 
128,964

 
129,544

Total
$
555,144

 
$
512,062

 
$
501,057

 
$
499,424

 
$
520,931

The following table displays balances of borrowed funds as of:

March 31
2014
 
December 31
2013
 
September 30
2013
 
June 30
2013
 
March 31
2013
FHLB advances
$
162,000

 
$
162,000

 
$
162,000

 
$
162,000

 
$
152,000

Securities sold under agreements to repurchase without stated maturity dates
94,741

 
106,025

 
81,405

 
71,668

 
64,122

Securities sold under agreements to repurchase with stated maturity dates
1,195

 
11,301

 
16,296

 
16,292

 
16,288

Federal funds purchased
14,600

 

 
6,300

 
12,500

 

Total
$
272,536

 
$
279,326

 
$
266,001

 
$
262,460

 
$
232,410

Capital
Capital consists solely of common stock, retained earnings, and accumulated other comprehensive income (loss). We are currently authorized to raise capital through dividend reinvestment, employee and director stock purchases, and shareholder stock purchases. Pursuant to these authorizations, we issued 35,814 shares or $850 of common stock during the first three months of 2014, as compared to 37,591 shares or $902 of common stock during the same period in 2013. We also offer the Directors Plan in which participants either directly purchase stock or purchase stock units through deferred fees, in lieu of cash payments. Pursuant to this plan, we increased shareholders’ equity by $137 and $146 during the three month periods ended March 31, 2014 and 2013, respectively.
We have approved a publicly announced common stock repurchase plan. Pursuant to this plan, we repurchased 37,415 shares or $893 of common stock compared to 20,509 shares for $480 during the first three months of 2014 and 2013, respectively. As of March 31, 2014, we were authorized to repurchase up to an additional 99,981 shares of common stock.
There are no significant regulatory constraints placed on our capital. The FRB’s current recommended minimum primary capital to assets requirement is 6.00%. Our primary capital to adjusted average assets, which consists of shareholders' equity plus the ALLL acquisition intangibles, was 8.38% as of March 31, 2014.
The FRB has established a minimum risk based capital standard. Under this standard, a framework has been established that assigns risk weights to each category of on and off balance sheet items to arrive at risk adjusted total assets. Regulatory capital is divided by the risk adjusted assets with the resulting ratio compared to the minimum standard to determine whether a corporation has adequate capital. The minimum standard is 8.00%, of which at least 4.00% must consist of equity capital net of goodwill. The following table sets forth the percentages required under the Risk Based Capital guidelines and our values as of:

March 31
2014
 
December 31
2013
 
Required
Equity Capital
13.88
%
 
13.67
%
 
4.00
%
Secondary Capital
1.25
%
 
1.25
%
 
4.00
%
Total Capital
15.13
%
 
14.92
%
 
8.00
%
Secondary capital includes only the ALLL. The percentage for the secondary capital under the required column is the maximum amount allowed from all sources.

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Table of Contents

The FRB and FDIC also prescribe minimum capital requirements for Isabella Bank. At March 31, 2014, the Bank exceeded these minimum capital requirements. On July 2, 2013, the FRB published revised BASEL III Capital standards for banks. The rules redefine what is included or deducted from equity capital, changes risk weighting for certain on and off-balance sheet assets, increases the minimum required equity capital to be considered well capitalized, and introduces a capital cushion buffer. The rules, which will be gradually phased in between 2015 and 2019, are not expected to have a material impact on the Corporation.
Contractual Obligations and Loan Commitments
We are party to credit related financial instruments with off-balance-sheet risk. These financial instruments are entered into in the normal course of business to meet the financing needs of our customers. These financial instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contract or notional amounts of these instruments reflect the extent of involvement we have in a particular class of financial instrument.
The following table summarizes our credit related financial instruments with off-balance-sheet risk as of:
 
March 31
2014
 
December 31
2013
Unfunded commitments under lines of credit
$
121,480

 
$
121,959

Commercial and standby letters of credit
4,229

 
4,169

Commitments to grant loans
14,220

 
29,096

Total
$
139,929

 
$
155,224

Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. These commitments may expire without being drawn upon. Therefore, the total commitment amounts do not necessarily represent future cash requirements.
Commercial and standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements, including commercial paper, bond financing, and similar transactions. These commitments to extend credit and letters of credit generally mature within one year. The credit risk involved in these transactions is essentially the same as that involved in extending loans to customers. We evaluate each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary upon the extension of credit, is based on a credit evaluation of the borrower. While we consider standby letters of credit to be guarantees, the amount of the liability related to such guarantees on the commitment date is not significant and a liability related to such guarantees is not recorded on the consolidated balance sheets.
Commitments to grant loans 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. The amount of collateral obtained, if it is deemed necessary, is based on management’s credit evaluation of the customer. Commitments to grant loans include loans committed to be sold to the secondary market.
Our exposure to credit-related loss in the event of nonperformance by the counter parties to the financial instruments for commitments to extend credit and standby letters of credit could be up to the contractual notional amount of those instruments. We use the same credit policies as we do for extending loans to customers. No significant losses are anticipated as a result of these commitments.
Fair Value
We utilize fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Trading securities, AFS securities, and certain liabilities are recorded at fair value on a recurring basis. Additionally, from time-to-time, we may be required to record at fair value other assets on a nonrecurring basis, such as mortgage loans AFS, foreclosed assets, OMSRs, and certain other assets and liabilities. These nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting or write-downs of individual assets.
For further information regarding fair value measurements see “Note 11 – Fair Value” of our notes to the interim condensed consolidated financial statements.

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Table of Contents

Liquidity
Liquidity is monitored regularly by our Market Risk Committee, which consists of members of senior management. The committee reviews projected cash flows, key ratios, and liquidity available from both primary and secondary sources.
Our primary sources of liquidity are cash and cash equivalents, certificates of deposit held in other financial institutions, trading securities, and AFS securities. These categories totaled $574,912 or 37.99% of assets as of March 31, 2014 as compared to $554,725 or 37.15% as of December 31, 2013. Liquidity is important for financial institutions because of their need to meet loan funding commitments, depositor withdrawal requests, and various other commitments including expansion of operations, investment opportunities, and payment of cash dividends. Liquidity varies significantly daily, based on customer activity.
Our primary source of funds is deposit accounts. We also have the ability to borrow from the FHLB, the FRB, and through various correspondent banks in the form of federal funds purchased. These funding methods typically carry a higher interest rate than traditional market deposit accounts. Some borrowed funds, including FHLB advances, FRB Discount Window advances, and repurchase agreements, require us to pledge assets, typically in the form of certificates of deposits held in other financial institutions, trading securities, AFS securities, or loans as collateral. As of March 31, 2014, we had available lines of credit of $109,677.
The following table summarizes our sources and uses of cash for the three month periods ended March 31:
 
2014
 
2013
 
$ Variance
Net cash provided by (used in) operating activities
$
2,812

 
$
5,797

 
$
(2,985
)
Net cash provided by (used in) investing activities
(39,217
)
 
(13,262
)
 
(25,955
)
Net cash provided by (used in) financing activities
13,514

 
2,225

 
11,289

Increase (decrease) in cash and cash equivalents
(22,891
)
 
(5,240
)
 
(17,651
)
Cash and cash equivalents January 1
41,558

 
24,920

 
16,638

Cash and cash equivalents March 31
$
18,667

 
$
19,680

 
$
(1,013
)
Market Risk
Our primary market risks are interest rate risk and liquidity risk. We have no significant foreign exchange risk and do not utilize interest rate swaps or derivatives, except for interest rate locks and forward loan commitments, in the management of IRR. Any changes in foreign exchange rates or commodity prices would have an insignificant impact on our interest income and cash flows.
IRR is the exposure of our net interest income to changes in interest rates. IRR results from the difference in the maturity or repricing frequency of a financial institution's interest earning assets and its interest bearing liabilities. IRR is the fundamental method by which financial institutions earn income and create shareholder value. Excessive exposure to IRR could pose a significant risk to our earnings and capital.
The FRB has adopted a policy requiring us to effectively manage the various risks that can have a material impact on our safety and soundness. The risks include credit, interest rate, liquidity, operational, and reputational. We have policies, procedures, and internal controls for measuring and managing these risks. Specifically, our Funds Management policy and procedures include defining acceptable types and terms of investments and funding sources, liquidity requirements, limits on investments in long term assets, limiting the mismatch in repricing opportunity of assets and liabilities, and the frequency of measuring and reporting to our Board.
The primary technique to measure IRR is simulation analysis. Simulation analysis forecasts the effects on the balance sheet structure and net interest income under a variety of scenarios that incorporate changes in interest rates, the shape of yield curves, interest rate relationships, and loan prepayments. These forecasts are compared against net interest income projected in a stable interest rate environment. While many assets and liabilities reprice either at maturity or in accordance with their contractual terms, several balance sheet components demonstrate characteristics that require an evaluation to more accurately reflect their repricing behavior. Key assumptions in the simulation analysis include prepayments on loans, probable calls of investment securities, changes in market conditions, loan volumes and loan pricing, deposit sensitivity, and customer preferences. These assumptions are inherently uncertain as they are subject to fluctuation and revision in a dynamic environment. As a result, the simulation analysis cannot precisely forecast the impact of rising and falling interest rates on net interest income. Actual results will differ from simulated results due to many other factors, including changes in balance sheet components, interest rate changes, changes in market conditions, and management strategies.

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Table of Contents

Our interest rate sensitivity is estimated by first forecasting the next twelve months of net interest income under an assumed environment of a constant balance sheet and constant market interest rates (base case). We then compare the results of various simulation analyses to the base case. At March 31, 2014, we projected the change in net interest income during the next twelve months assuming market interest rates were to immediately decrease by 100 basis points and increase by 100, 200, 300, and 400 basis points in a parallel fashion over the entire yield curve during the same time period. We did not project scenarios showing decreases in interest rates beyond 100 basis points as this is considered extremely unlikely given current interest rate levels. These projections were based on our assets and liabilities remaining static over the next twelve months, while factoring in probable calls and prepayments of certain investment securities and real estate residential and consumer loans. While it is extremely unlikely that interest rates would immediately increase to these levels, we feel that these extreme scenarios help us identify potential gaps and mismatches in the repricing characteristics of assets and liabilities. We regularly monitor our forecasted net interest income sensitivity to ensure that it remains within established limits.
The following table summarizes our interest rate sensitivity as of:

March 31, 2014
Immediate basis point change assumption (short-term)
(100)
 
0
 
100
 
200
 
300
 
400
Percent change in net interest income vs. constant rates
(2.55
)%
 

 
(0.18
)%
 
(0.99
)%
 
(2.16
)%
 
(3.79
)%

December 31, 2013
Immediate basis point change assumption (short-term)
(100)
 
0
 
100
 
200
 
300
 
400
Percent change in net interest income vs. constant rates
(2.85
)%
 

 
0.25
%
 
(0.28
)%
 
(0.99
)%
 
(2.16
)%
The following tables provide information about assets and liabilities that are sensitive to changes in interest rates as of March 31, 2014 and December 31, 2013. The principal amounts of investments, loans, other interest earning assets assets, borrowings, and time deposits maturing were calculated based on the contractual maturity dates. Estimated cash flows for savings and NOW accounts are based on our estimated deposit decay rates.

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Table of Contents


March 31, 2014
 
2015
 
2016
 
2017
 
2018
 
2019
 
Thereafter
 
Total
 
Fair Value
Rate sensitive assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other interest bearing assets
$
922

 
$
480

 
$
100

 
$

 
$

 
$

 
$
1,502

 
$
1,502

Average interest rates
0.25
%
 
1.15
%
 
0.35
%
 

 

 

 
0.52
%
 
 
Trading securities
$
521

 
$

 
$

 
$

 
$

 
$

 
$
521

 
$
521

Average interest rates
3.32
%
 

 

 

 

 

 
3.32
%
 
 
AFS securities
$
125,595

 
$
75,207

 
$
65,406

 
$
55,800

 
$
40,650

 
$
192,486

 
$
555,144

 
$
555,144

Average interest rates
2.29
%
 
2.38
%
 
2.49
%
 
2.55
%
 
2.44
%
 
2.66
%
 
2.49
%
 
 
Fixed interest rate loans (1)
$
113,066

 
$
98,984

 
$
105,700

 
$
108,492

 
$
76,874

 
$
137,021

 
$
640,137

 
$
639,803

Average interest rates
5.26
%
 
5.09
%
 
4.78
%
 
4.49
%
 
4.39
%
 
4.29
%
 
4.71
%
 
 
Variable interest rate loans (1)
$
65,731

 
$
28,953

 
$
21,378

 
$
12,992

 
$
15,241

 
$
23,979

 
$
168,274

 
$
168,274

Average interest rates
4.41
%
 
4.08
%
 
3.77
%
 
3.41
%
 
3.34
%
 
3.86
%
 
4.02
%
 
 
Rate sensitive liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Borrowed funds
$
130,536

 
$
22,000

 
$
30,000

 
$
40,000

 
$
30,000

 
$
20,000

 
$
272,536

 
$
276,357

Average interest rates
0.28
%
 
0.90
%
 
1.88
%
 
2.46
%
 
2.72
%
 
2.94
%
 
1.29
%
 
 
Savings and NOW accounts
$
40,265

 
$
36,318

 
$
32,642

 
$
29,371

 
$
26,456

 
$
290,799

 
$
455,851

 
$
455,851

Average interest rates
0.11
%
 
0.11
%
 
0.11
%
 
0.11
%
 
0.11
%
 
0.10
%
 
0.11
%
 
 
Fixed interest rate certificates of deposit
$
217,177

 
$
78,846

 
$
57,171

 
$
43,085

 
$
36,158

 
$
18,254

 
$
450,691

 
$
452,828

Average interest rates
0.87
%
 
1.94
%
 
1.81
%
 
1.53
%
 
1.33
%
 
1.64
%
 
1.31
%
 
 
Variable interest rate certificates of deposit
$
746

 
$
406

 
$

 
$

 
$

 
$

 
$
1,152

 
$
1,152

Average interest rates
0.04
%
 
0.40
%
 

 

 

 

 
0.17
%
 
 

December 31, 2013
 
2014
 
2015
 
2016
 
2017
 
2018
 
Thereafter
 
Total
 
Fair Value
Rate sensitive assets
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other interest bearing assets
$
19,903

 
$
480

 
$

 
$

 
$

 
$

 
$
20,383

 
$
20,385

Average interest rates
0.25
%
 
1.15
%
 

 

 

 

 
0.27
%
 
 
Trading securities
$
525

 
$

 
$

 
$

 
$

 
$

 
$
525

 
$
525

Average interest rates
2.77
%
 

 

 

 

 

 
2.77
%
 
 
AFS securities
$
131,892

 
$
73,723

 
$
63,190

 
$
52,078

 
$
37,972

 
$
153,207

 
$
512,062

 
$
512,062

Average interest rates
2.26
%
 
2.23
%
 
2.42
%
 
2.48
%
 
2.48
%
 
2.80
%
 
2.48
%
 
 
Fixed interest rate loans (1)
$
115,183

 
$
94,841

 
$
91,140

 
$
118,479

 
$
85,448

 
$
134,614

 
$
639,705

 
$
639,914

Average interest rates
5.31
%
 
5.17
%
 
4.93
%
 
4.53
%
 
4.33
%
 
4.33
%
 
4.75
%
 
 
Variable interest rate loans (1)
$
69,036

 
$
29,460

 
$
20,332

 
$
14,208

 
$
15,699

 
$
19,597

 
$
168,332

 
$
168,332

Average interest rates
4.76
%
 
3.90
%
 
4.06
%
 
3.36
%
 
3.35
%
 
3.99
%
 
4.19
%
 
 
Rate sensitive liabilities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Borrowed funds
$
126,950

 
$
32,376

 
$
10,000

 
$
30,000

 
$
40,000

 
$
40,000

 
$
279,326

 
$
283,060

Average interest rates
0.43
%
 
0.86
%
 
2.15
%
 
1.95
%
 
2.35
%
 
3.02
%
 
1.35
%
 
 
Savings and NOW accounts
$
47,000

 
$
33,569

 
$
30,200

 
$
27,198

 
$
24,522

 
$
272,837

 
$
435,326

 
$
435,326

Average interest rates
0.19
%
 
0.12
%
 
0.11
%
 
0.11
%
 
0.11
%
 
0.11
%
 
0.12
%
 
 
Fixed interest rate certificates of deposit
$
206,514

 
$
81,038

 
$
58,627

 
$
46,336

 
$
39,214

 
$
17,144

 
$
448,873

 
$
451,664

Average interest rates
0.89
%
 
1.93
%
 
1.95
%
 
1.63
%
 
1.34
%
 
1.66
%
 
1.36
%
 
 
Variable interest rate certificates of deposit
$
764

 
$
375

 
$

 
$

 
$

 
$

 
$
1,139

 
$
1,139

Average interest rates
0.04
%
 
0.40
%
 

 

 

 

 
0.16
%
 
 
 (1) The fair value reported is exclusive of the allocation of the ALLL.
We do not believe that there has been a material change in the nature or categories of our primary market risk exposure, or the particular markets that present the primary risk of loss. As of the date of this report, we do not know of or expect there to be any material change in the general nature of our primary market risk exposure in the near term. As of the date of this report, we do not expect to make material changes in those methods in the near term. We may change those methods in the future to adapt to changes in circumstances or to implement new techniques.

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Table of Contents

Item 3. Quantitative and Qualitative Disclosures about Market Risk
The information presented in the section captioned “Market Risk” in Management's Discussion and Analysis of Financial Condition and Results of Operations is incorporated herein by reference.
Item 4. Controls and Procedures
DISCLOSURE CONTROLS AND PROCEDURES
We carried out an evaluation, under the supervision and with the participation of the Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15(d)-15(e) under the Exchange Act) as of March 31, 2014, pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures as of March 31, 2014, were effective to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
During the most recent fiscal quarter, no change occurred in our internal control over financial reporting that materially affected, or is likely to materially effect, our internal control over financial reporting.


52

Table of Contents

PART II – OTHER INFORMATION
Item 1. Legal Proceedings
We are not involved in any material legal proceedings. We are involved in ordinary, routine litigation incidental to our business; however, no such routine proceedings are expected to result in any material adverse effect on operations, earnings, financial condition, or cash flows.
Item 1A. Risk Factors
There have been no material changes to the risk factors disclosed in Item 1A in our Annual Report on Form 10-K for the year ended December 31, 2013.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(A)
None
(B)
None
(C)
Repurchases of Common Stock
We have adopted and publicly announced a common stock repurchase plan. The plan was last amended on October 23, 2013, to allow for the repurchase of an additional 150,000 shares of common stock. These authorizations do not have expiration dates. As shares are repurchased under this plan, they are retired and revert back to the status of authorized, but unissued shares.
The following table provides information for the three month period ended March 31, 2014, with respect to this plan:
 
Shares Repurchased
 
Total Number of Shares Purchased as Part of Publicly Announced Plan or Program
 
Maximum Number of Shares That May Yet Be Purchased Under the Plans or Programs

Number
 
Average Price
Per Share
 
 
Balance, December 31
 
 
 
 
 
 
137,396

January 1 - 31
10,409

 
$
23.83

 
10,409

 
126,987

February 1 - 28
13,221

 
23.75

 
13,221

 
113,766

March 1 - 31
13,785

 
23.79

 
13,785

 
99,981

Balance, March 31
37,415

 
$
23.79

 
37,415

 
99,981


53

Table of Contents

Item 6. Exhibits
(a)
 
Exhibits
 
 
 
31(a)
 
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by the Principal Executive Officer
 
 
 
31(b)
 
Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 by the Principal Financial Officer
 
 
 
32
 
Section 1350 Certification of Principal Executive Officer and Principal Financial Officer
 
 
 
101.1*
 
101.INS (XBRL Instance Document)
 
 
 
 
 
101.SCH (XBRL Taxonomy Extension Schema Document)
 
 
 
 
 
101.CAL (XBRL Calculation Linkbase Document)
 
 
 
 
 
101.LAB (XBRL Taxonomy Label Linkbase Document)
 
 
 
 
 
101.DEF (XBRL Taxonomy Linkbase Document)
 
 
 
 
 
101.PRE (XBRL Taxonomy Presentation Linkbase Document)
In accordance with Rule 406T of Regulations S-T, the XBRL related information shall not be deemed to be “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to the liability of that section, and shall not be part of any registration statement or other document filed under the Securities Act or the Exchange Act, except as shall be expressly set forth by specific reference in such filing.


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Table of Contents

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.
 
 
Isabella Bank Corporation
 
 
 
 
Date:
May 8, 2014
 
 
/s/ Jae A. Evans
 
 
 
 
Jae A. Evans
 
 
 
 
Chief Executive Officer
 
 
 
 
(Principal Executive Officer)
 
 
 
 
Date:
May 8, 2014
 
 
/s/ Dennis P. Angner
 
 
 
 
Dennis P. Angner
 
 
 
 
President, Chief Financial Officer
 
 
 
 
(Principal Financial Officer, Principal Accounting Officer)

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