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MACATAWA BANK CORP - Quarter Report: 2022 June (Form 10-Q)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2022

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: 000-25927

MACATAWA BANK CORPORATION
(Exact name of registrant as specified in its charter)

Michigan

38-3391345
(State or other jurisdiction of  incorporation or organization)

(I.R.S. Employer Identification No.)

10753 Macatawa Drive, Holland, Michigan 49424
(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (616) 820-1444

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


Title of each class

Trading Symbol

Name of each exchange on which registered

Common stock

MCBC

NASDAQ

Indicate by checkmark 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.
Yes No

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes No

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

Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company ☒
Emerging Growth Company ☐

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

The number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 34,253,147 shares of the Company’s Common Stock (no par value) were outstanding as of July 28, 2022.


Forward-Looking Statements

This report contains forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and Macatawa Bank Corporation. Forward-looking statements are identifiable by words or phrases such as “outlook”, “plan” or “strategy” that an event or trend “could”, “may”, “should”, “will”, “is likely”, or is “possible” or “probable” to occur or “continue”, has “begun” or “is scheduled” or “on track” or that the Company or its management “anticipates”, “believes”, “estimates”, “plans”, “forecasts”, “intends”, “predicts”, “projects”, or “expects” a particular result, or is “committed”, “confident”, “optimistic” or has an “opinion” that an event will occur, or other words or phrases such as “ongoing”, “future”, “signs”, “efforts”, “tend”, “exploring”, “appearing”, “until”, “near term”, “concern”, “going forward”, “focus”, “starting”, “initiative,” “trend” and variations of such words and similar expressions. Such statements are based upon current beliefs and expectations and involve substantial risks and uncertainties which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These statements include, among others, those related to the risks and uncertainties related to, and the impact of, the  COVID-19 pandemic on the business, financial conditions and results of operations of our company and our customers, future levels of earning assets, future composition of our loan portfolio, trends in credit quality metrics, future capital levels and capital needs, real estate valuation, future levels of repossessed and foreclosed properties and nonperforming assets, future levels of losses and costs associated with the administration and disposition of repossessed and foreclosed properties and nonperforming assets, future levels of loan charge-offs, future levels of other real estate owned, future levels of provisions for loan losses and reserve recoveries, the rate of asset dispositions, future dividends, future growth and funding sources, future cost of funds, future liquidity levels, future profitability levels, future interest rate levels, future net interest margin levels, the effects on earnings of changes in interest rates, future economic conditions, future effects of new or changed accounting standards, future loss recoveries, loan demand and loan growth, future amounts of unrecognized tax benefits and the future level of other revenue sources. Management’s determination of the provision and allowance for loan losses, the appropriate carrying value of intangible assets (including deferred tax assets) and other real estate owned, and the fair value of investment securities (including whether any impairment on any investment security is temporary or other-than-temporary and the amount of any impairment) involves judgments that are inherently forward-looking. All statements with references to future time periods are forward-looking. All of the information concerning interest rate sensitivity is forward-looking. Our ability to sell other real estate owned at its carrying value or at all, successfully implement new programs and initiatives, increase efficiencies, maintain our current levels of deposits and other sources of funding, maintain liquidity, respond to declines in collateral values and credit quality, increase loan volume, originate high quality loans, maintain or improve mortgage banking income, realize the benefit of our deferred tax assets, continue payment of dividends and improve profitability, is not entirely within our control and is not assured. The future effect of changes in the real estate, financial and credit markets and the national and regional economy on the banking industry, generally, and Macatawa Bank Corporation, specifically, are also inherently uncertain. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“risk factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. Macatawa Bank Corporation does not undertake to update forward-looking statements to reflect the impact of circumstances or events that may arise after the date of the forward-looking statements.

Risk factors include, but are not limited to, the risk factors described in “Item 1A - Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2021. These and other factors are representative of the risk factors that may emerge and could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.


INDEX



Page
Number



Part I.
Financial Information:
 
     

Item 1.


4




10




Item 2.


38




Item 3.


53




Item 4.


54



Part II.
Other Information:





Item 2.


55




Item 6.


55




56

Part I
Financial Information
Item 1.
MACATAWA BANK CORPORATION
CONSOLIDATED BALANCE SHEETS
As of June 30, 2022 (unaudited) and December 31, 2021
(Dollars in thousands, except per share data)


   
June 30,
2022
   
December 31,
2021
 
ASSETS
           
Cash and due from banks
 
$
38,376
   
$
23,669
 
Federal funds sold and other short-term investments
   
721,826
     
1,128,119
 
Cash and cash equivalents
   
760,202
     
1,151,788
 
Debt securities available for sale, at fair value
   
435,628
     
416,063
 
Debt securities held to maturity (fair value 2022 - $341,274 and 2021 - $139,272)
   
352,721
     
137,003
 
Federal Home Loan Bank (FHLB) stock
   
10,211
     
11,558
 
Loans held for sale, at fair value
   
1,163
     
1,407
 
Total loans
   
1,111,915
     
1,108,993
 
Allowance for loan losses
   
(14,631
)
   
(15,889
)
Net loans
   
1,097,284
     
1,093,104
 
Premises and equipment – net
   
41,088
     
41,773
 
Accrued interest receivable
   
5,108
     
4,088
 
Bank-owned life insurance
   
52,963
     
52,468
 
Other real estate owned - net
   
2,343
     
2,343
 
Net deferred tax asset
   
6,516
     
2,163
 
Other assets
   
15,981
     
14,993
 
Total assets
 
$
2,781,208
   
$
2,928,751
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Deposits
               
Noninterest-bearing
 
$
903,334
   
$
886,115
 
Interest-bearing
   
1,591,249
     
1,691,843
 
Total deposits
   
2,494,583
     
2,577,958
 
Other borrowed funds
   
30,000
     
85,000
 
Accrued expenses and other liabilities
   
13,516
     
11,788
 
Total liabilities
   
2,538,099
     
2,674,746
 
Commitments and contingent liabilities
   
     
 
Shareholders’ equity
               
Common stock, no par value, 200,000,000 shares authorized; 34,253,147 and 34,259,945 shares issued and outstanding at June 30, 2022 and December 31, 2021
   
219,456
     
219,082
 
Retained earnings
   
42,332
     
35,220
 
Accumulated other comprehensive loss
   
(18,679
)
   
(297
)
Total shareholders’ equity
   
243,109
     
254,005
 
Total liabilities and shareholders’ equity
 
$
2,781,208
   
$
2,928,751
 

See accompanying notes to consolidated financial statements.

-4-

MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
Three and six month periods ended June 30, 2022 and 2021
(unaudited)
(Dollars in thousands, except per share data)

   
Three Months
Ended
June 30,
2022
   
Three Months
Ended
June 30,
2021
   
Six Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2021
 
Interest income
                       
Loans, including fees
 
$
10,344
   
$
13,303
   
$
20,741
   
$
26,770
 
Securities
                               
Taxable
   
2,618
     
792
     
4,052
     
1,579
 
Tax-exempt
   
702
     
760
     
1,434
     
1,518
 
FHLB Stock
   
51
     
56
     
102
     
117
 
Federal funds sold and other short-term investments
   
1,720
     
273
     
2,249
     
474
 
Total interest income
   
15,435
     
15,184
     
28,578
     
30,458
 
Interest expense
                               
Deposits
   
245
     
244
     
403
     
523
 
Other borrowings
   
347
     
328
     
667
     
681
 
Long-term debt
   
     
155
     
     
307
 
Total interest expense
   
592
     
727
     
1,070
     
1,511
 
Net interest income
   
14,843
     
14,457
     
27,508
     
28,947
 
Provision for loan losses
   
     
(750
)
   
(1,500
)
   
(750
)
Net interest income after provision for loan losses
   
14,843
     
15,207
     
29,008
     
29,697
 
Noninterest income
                               
Service charges and fees
   
1,218
     
1,065
     
2,430
     
2,057
 
Net gains on mortgage loans
   
199
     
1,311
     
508
     
3,326
 
Trust fees
   
1,096
     
1,133
     
2,184
     
2,138
 
ATM and debit card fees
   
1,762
     
1,683
     
3,360
     
3,168
 
Bank owned life insurance (“BOLI”) income
   
230
     
250
     
470
     
526
 
Other
   
626
     
727
     
1,144
     
1,492
 
Total noninterest income
   
5,131
     
6,169
     
10,096
     
12,707
 
Noninterest expense
                               
Salaries and benefits
   
6,402
     
6,502
     
12,691
     
12,914
 
Occupancy of premises
   
1,071
     
994
     
2,243
     
2,031
 
Furniture and equipment
   
988
     
978
     
2,004
     
1,915
 
Legal and professional
   
271
     
274
     
465
     
496
 
Marketing and promotion
   
195
     
175
     
390
     
350
 
Data processing
   
924
     
855
     
1,808
     
1,762
 
FDIC assessment
   
197
     
159
     
377
     
329
 
Interchange and other card expense
   
406
     
388
     
779
     
746
 
Bond and D&O Insurance
   
129
     
111
     
259
     
222
 
Other
   
1,330
     
1,282
     
2,636
     
2,438
 
Total noninterest expenses
   
11,913
     
11,718
     
23,652
     
23,203
 
Income before income tax
   
8,061
     
9,658
     
15,452
     
19,201
 
Income tax expense
   
1,493
     
1,840
     
2,884
     
3,605
 
Net income
 
$
6,568
   
$
7,818
   
$
12,568
   
$
15,596
 
Basic earnings per common share
 
$
0.19
   
$
0.23
   
$
0.37
   
$
0.46
 
Diluted earnings per common share
 
$
0.19
   
$
0.23
   
$
0.37
   
$
0.46
 
Cash dividends per common share
 
$
0.08
   
$
0.08
   
$
0.16
   
$
0.16
 

See accompanying notes to consolidated financial statements.

-5-


MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
Three and six month periods ended June 30, 2022 and 2021
(unaudited)
(Dollars in thousands)

   
Three Months
Ended
June 30,
2022
   
Three Months
Ended
June 30,
2021
   
Six Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2021
 
Net income
 
$
6,568
   
$
7,818
   
$
12,568
   
$
15,596
 
Other comprehensive income (loss):
                               
Unrealized gains (losses):
                               
Net change in unrealized gains (losses) on debt securities available for sale
   
(8,251
)
   
739
     
(23,371
)
   
(2,651
)
Net unrealized gain at time of transfer on securities transferred to held-to-maturity
                113        
Amortization of net unrealized gains on securities transferred to held-to-maturity
    (6 )           (10 )      
Tax effect
   
1,734
     
(155
)
   
4,886
     
557
 
Net change in unrealized gains (losses) on debt securities available for sale, net of tax
   
(6,523
)
   
584
     
(18,382
)
   
(2,094
)
Less: reclassification adjustments:
                               
Reclassification for gains included in net income
   
     
     
     
 
Tax effect
   
     
     
     
 
Reclassification for gains included in net income, net of tax
   
     
     
     
 
Other comprehensive income (loss), net of tax
   
(6,523
)
   
584
     
(18,382
)
   
(2,094
)
Comprehensive income (loss)
 
$
45
   
$
8,402
   
$
(5,814
)
 
$
13,502
 

See accompanying notes to consolidated financial statements.

-6-

MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Three and six month periods ended June 30, 2022 and 2021
(unaudited)
(Dollars in thousands, except per share data)

   
Common
Stock
   
Retained Earnings
   
Accumulated
Other
Comprehensive
Income (Loss)
   
Total
Shareholders’
Equity
 
Balance, April 1, 2021
 
$
218,687
   
$
22,156
   
$
1,536
   
$
242,379
 
Net income for the three months ended June 30, 2021
   
     
7,818
     
     
7,818
 
Cash dividends at $0.08 per share
   
     
(2,723
)
   
     
(2,723
)
Repurchase of 815 shares for taxes withheld on vested restricted stock
    (7 )                 (7 )
Other comprehensive income, net of tax
   
     
     
584
     
584
 
Stock compensation expense
   
166
     
     
     
166
 
Balance, June 30, 2021
 
$
218,846
   
$
27,251
   
$
2,120
   
$
248,217
 
                                 
                                 
Balance, April 1, 2022
 
$
219,266
   
$
38,492
   
$
(12,156
)
 
$
245,602
 
Net income for the three months ended June 30, 2022
   
     
6,568
     
     
6,568
 
Cash dividends at $0.08 per share
   
     
(2,728
)
   
     
(2,728
)
Repurchase of 815 shares for taxes withheld on vested restricted stock
   
(7
)
   
     
     
(7
)
Other comprehensive income, net of tax
   
     
     
(6,523
)
   
(6,523
)
Stock compensation expense
   
197
     
     
     
197
 
Balance, June 30, 2022
 
$
219,456
   
$
42,332
   
$
(18,679
)
 
$
243,109
 

   
Common
Stock
   
Retained Earnings
   
Accumulated
Other
Comprehensive
Income (Loss)
   
Total
Shareholders’
Equity
 
Balance, January 1, 2021
 
$
218,528
   
$
17,101
   
$
4,214
   
$
239,843
 
Net income for the six months ended June 30, 2021
   
     
15,596
     
     
15,596
 
Cash dividends at $0.16 per share
   
     
(5,446
)
   
     
(5,446
)
Repurchase of 1,341 shares for taxes withheld on vested restricted stock
   
(12
)
   
     
     
(12
)
Other comprehensive income, net of tax
   
     
     
(2,094
)
   
(2,094
)
Stock compensation expense
   
330
     
     
     
330
 
Balance, June 30, 2021
 
$
218,846
   
$
27,251
   
$
2,120
   
$
248,217
 
                                 
                                 
Balance, January 1, 2022
 
$
219,082
   
$
35,220
   
$
(297
)
 
$
254,005
 
Net income for the six months ended June 30, 2022
   
     
12,568
     
     
12,568
 
Cash dividends at $0.16 per share
   
     
(5,456
)
   
     
(5,456
)
Repurchase of 2,153 shares for taxes withheld on vested restricted stock
   
(20
)
   
     
     
(20
)
Other comprehensive income, net of tax
   
     
     
(18,382
)
   
(18,382
)
Stock compensation expense
   
394
     
     
     
394
 
Balance, June 30, 2022
 
$
219,456
   
$
42,332
   
$
(18,679
)
 
$
243,109
 

See accompanying notes to consolidated financial statements.

-7-

MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six month periods ended June 30, 2022 and 2021
(unaudited)
(Dollars in thousands)


   
Six Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2021
 
Cash flows from operating activities
           
Net income
 
$
12,568
   
$
15,596
 
Adjustments to reconcile net income to net cash from operating activities:
               
Depreciation and amortization
   
1,204
     
1,143
 
Stock compensation expense
   
394
     
330
 
Provision for loan losses
   
(1,500
)
   
(750
)
Origination of loans for sale
   
(18,548
)
   
(86,498
)
Proceeds from sales of loans originated for sale
   
19,300
     
90,494
 
Net gains on mortgage loans
   
(508
)
   
(3,326
)
Write-down of other real estate
   
     
4
 
Net loss on sales of other real estate
   
     
20
 
Deferred income tax expense (benefit)
   
533
     
(144
)
Earnings in bank-owned life insurance
   
(470
)
   
(526
)
Change in accrued interest receivable and other assets
   
(2,008
)
   
1,384
 
Change in accrued expenses and other liabilities
   
66
     
(803
)
Net cash from operating activities
   
11,031
     
16,924
 
Cash flows from investing activities
               
Loan originations and payments, net
   
(2,680
)
   
191,152
 
Purchases of securities available for sale
   
(186,326
)
   
(50,605
)
Purchases of securities held to maturity
   
(137,355
)
   
(51,232
)
Purchase of bank-owned life insurance
          (10,000 )
Proceeds from:
               
Maturities and calls of securities
   
22,746
     
31,013
 
Principal paydowns on securities
   
43,968
     
23,429
 
Sales of other real estate
   
     
170
 
Proceeds from redemption of FHLB stock
    1,347        
Proceeds from payout of bank-owned insurance claim
   
     
560
 
Additions to premises and equipment
   
(466
)
   
(861
)
Net cash from investing activities
   
(258,766
)
   
133,626
 
Cash flows from financing activities
               
Change in deposits
   
(83,375
)
   
301,489
 
Repayments and maturities of other borrowed funds
    (80,000 )     (10,000 )
Proceeds from other borrowed funds
   
25,000
     
 
Repurchase of shares for taxes withheld on vested restricted stock
   
(20
)
   
(12
)
Cash dividends paid
   
(5,456
)
   
(5,446
)
Net cash from financing activities
   
(143,851
)
   
286,031
 
Net change in cash and cash equivalents
   
(391,586
)
   
436,581
 
Cash and cash equivalents at beginning of period
   
1,151,788
     
783,736
 
Cash and cash equivalents at end of period
 
$
760,202
   
$
1,220,317
 

See accompanying notes to consolidated financial statements.

-8-

MACATAWA BANK CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Six month periods ended June 30, 2022 and 2021
(unaudited)
(Dollars in thousands)


   
Six Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2021
 
Supplemental cash flow information
           
Interest paid
 
$
1,106
   
$
1,535
 
Income taxes paid
   
3,000
     
4,000
 
Supplemental noncash disclosures:
               
Security settlement
   
1,662
     
736
 
Transfer of securities from available for sale to held to maturity
    123,469        

See accompanying notes to consolidated financial statements.


-9-

MACATAWA BANK CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation: The accompanying consolidated financial statements include the accounts of Macatawa Bank Corporation (“the Company”, “our”, “we”) and its wholly-owned subsidiary, Macatawa Bank (“the Bank”). All significant intercompany accounts and transactions have been eliminated in consolidation.

Macatawa Bank is a Michigan chartered bank with depository accounts insured by the Federal Deposit Insurance Corporation. The Bank operates 26 full service branch offices providing a full range of commercial and consumer banking and trust services in Kent County, Ottawa County, and northern Allegan County, Michigan.

Recent Events:   In response to the COVID-19 pandemic, federal state and local governments have taken and continue to take actions designed to mitigate the effect on public health and to address the economic impact from the virus.  The effects of COVID-19 and its related variants could, among other risks, result in a material increase in requests from the Company’s customers for loan deferrals, modifications to the terms of loans, or other borrower accommodations; have a material adverse impact on the financial condition of the Company’s customers, potentially impacting their ability to make payments to the Company as scheduled driving an increase in delinquencies and loan losses; result in additional material provision for loan losses; result in a decreased demand for the Company’s loans; or negatively impact the Company’s ability to access capital on attractive terms or at all.  Those effects could have a material adverse impact on the Company’s and its customers’ business, financial condition, and results of operations.

The Bank was a participating lender in the Small Business Administration’s (“SBA”) Paycheck Protection Program (“PPP”). PPP loans are forgivable, in whole or in part, if the proceeds are used for payroll and other permitted purposes in accordance with the requirements of the PPP. These loans carry a fixed rate of 1.00% and a term of two years (loans made before June 5, 2020) or five years (loans made on or after June 5, 2020), if not forgiven, in whole or in part. Payments are deferred until either the date on which the SBA remits the amount of forgiveness proceeds to the lender or the date that is 10 months after the last day of the covered period if the borrower does not apply for forgiveness within that 10 month period. Fees generated based on the origination of PPP loans are deferred and amortized into interest income over the contractual period of 24 months or 60 months, as applicable. Upon SBA forgiveness, unamortized fees are then recognized into interest income.

In 2020:
 
The Bank originated 1,738 PPP loans totaling $346.7 million in principal.
 
Fees generated totaled $10.0 million.
 
765 PPP loans totaling $113.5 million were forgiven.
 
Total net fees of $5.4 million were recognized.
 
In 2021: 
 
The Bank originated 1,000 PPP loans totaling $128.1 million in principal.
 
Fees generated totaled $5.6 million.
 
1,722 PPP loans totaling $318.4 million were forgiven.
 
Total net fees of $8.3 million were recognized.

In the six months ended June 30, 2022:
 
217 PPP loans totaling $40.3 million were forgiven.
 
Total net fees of $1.2 million were recognized.

As of June 30, 2022, 21 PPP loans totaling $2.8 million in principal remained outstanding and total net fees of $94,000 remained unrecognized.

-10-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Basis of Presentation: The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America 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 accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) believed necessary for a fair presentation have been included.

Operating results for the three and six month periods ended June 30, 2022 are not necessarily indicative of the results that may be expected for the year ending December 31, 2022. For further information, refer to the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021.

Use of Estimates:  To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and future results could differ.  The allowance for loan losses, valuation of deferred tax assets, loss contingencies, fair value of other real estate owned and fair values of financial instruments are particularly subject to change.

Allowance for Loan Losses: The allowance for loan losses (allowance) is a valuation allowance for probable incurred credit losses inherent in our loan portfolio, increased by the provision for loan losses and recoveries, and decreased by charge-offs of loans. Management believes the allowance for loan losses balance to be adequate based on known and inherent risks in the portfolio, past loan loss experience, information about specific borrower situations and estimated collateral values, economic conditions and other relevant factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Management continues its collection efforts on previously charged-off balances and applies recoveries as additions to the allowance for loan losses.

The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-classified loans and is based on historical loss experience adjusted for current qualitative factors. The Company maintains a loss migration analysis that tracks loan losses and recoveries based on loan class and the loan risk grade assignment for commercial loans. At June 30, 2022, an 18 month annualized historical loss experience was used for commercial loans and a 12 month historical loss experience period was applied to residential mortgage loans and consumer loans. These historical loss percentages are adjusted (both upwards and downwards) for certain qualitative factors, including economic trends, credit quality trends, valuation trends, concentration risk, quality of loan review, changes in personnel, external factors and other considerations.

A loan is impaired when, based on current information and events, it is believed to be probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified and a concession has been made, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired.

Commercial and commercial real estate loans with relationship balances exceeding $500,000 and an internal risk grading of 6 or worse are evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated and the loan is reported at the present value of estimated future cash flows using the loan’s existing interest rate or at the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans, are collectively evaluated for impairment and they are not separately identified for impairment disclosures.

Troubled debt restructurings are also considered impaired with impairment generally measured at the present value of estimated future cash flows using the loan’s effective rate at inception or using the fair value of collateral, less estimated costs to sell, if repayment is expected solely from the collateral.

Foreclosed Assets: Assets acquired through or instead of loan foreclosure, primarily other real estate owned, are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis. If fair value declines, a valuation allowance is recorded through expense. Costs after acquisition are expensed unless they add value to the property.

-11-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Income Taxes: Income tax expense is the sum of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

The Company recognizes a tax position as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded. The Company recognizes interest and penalties related to income tax matters in income tax expense.

Revenue From Contracts With Customers: The Company records revenue from contracts with customers in accordance with Accounting Standards Codification Topic 606, “Revenue from Contracts with Customers” (“Topic 606”).  Under Topic 606, the Company must identify the contract with a customer, identify the performance obligations in the contract, determine the transaction price, allocate the transaction price to the performance obligations in the contract, and recognize revenue when (or as) it satisfies a performance obligation. No revenue has been recognized in the current reporting period that results from performance obligations satisfied in previous periods.

The Company’s primary sources of revenue are derived from interest and dividends earned on loans, securities and other financial instruments that are not within the scope of Topic 606.  The Company has evaluated the nature of its contracts with customers and determined that further disaggregation of revenue from contracts with customers into more granular categories beyond what is presented in the Consolidated Statements of Income is not necessary.

The Company generally satisfies its performance obligations on contracts with customers as services are rendered, and the transaction prices are typically fixed and charged either on a periodic basis (generally monthly) or based on activity. Because performance obligations are satisfied as services are rendered and the transaction prices are fixed, there is little judgment involved in applying Topic 606 that significantly affects the determination of the amount and timing of revenue from contracts with customers.

Interest Income: The Company’s largest source of revenue is interest income which is primarily recognized on an accrual basis based on contractual terms written into loans and investment contracts.

Noninterest Revenue:  The Company derives the majority of its noninterest revenue from: (1) service charges for deposit related services, (2) gains related to mortgage loan sales, (3) trust fees and (4) debit and credit card interchange income.  Most of these services are transaction based and revenue is recognized as the related service is provided.

Derivatives:  Certain of the Bank’s commercial loan customers have entered into interest rate swap agreements directly with the Bank.  At the same time the Bank enters into a swap agreement with its customer, the Bank enters into a corresponding interest rate swap agreement with a correspondent bank at terms mirroring the Bank’s interest rate swap with its commercial loan customer.   This is known as a back-to-back swap agreement.  Under this arrangement the Bank has two freestanding interest rate swaps, each of which is carried at fair value.  As the terms mirror each other, there is no income statement impact to the Bank.  At June 30, 2022 and December 31, 2021, the total notional amount of such agreements was $129.8 million and $140.7 million, respectively, and resulted in a derivative asset with a fair value of $4.6 million and $3.3 million, respectively, which were included in other assets and a derivative liability of $4.6 million and $3.3 million, respectively, which were included in other liabilities.

Mortgage Banking Derivatives: Commitments to fund mortgage loans (interest rate locks) to be sold into the secondary market and forward commitments for the future delivery of these mortgage loans are accounted for as derivatives not qualifying for hedge accounting.  Fair values of these mortgage derivatives are estimated based on changes in mortgage interest rates from the date the interest rate on the loan is locked.  The Bank enters into commitments to sell mortgage backed securities, which it later buys back in order to hedge its exposure to interest rate risk in its mortgage pipeline.  At times, the Bank also enters into forward commitments for the future delivery of mortgage loans when loans are closed but not yet sold, in order to hedge the change in interest rates resulting from its commitments to sell the loans.
    
-12-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Changes in the fair values of these interest rate lock and mortgage backed security and forward commitment derivatives are included in net gains on mortgage loans.  The fair value of interest rate lock commitments was $(5,000) at June 30, 2022 and $25,000 at December 31, 2021.  The net fair value of mortgage backed security derivatives was $300 at June 30, 2022 and $(13,000) at December 31, 2021.

Loans Held for Sale:  Mortgage loans originated and intended for sale in the secondary market are carried at fair value, as determined by outstanding commitments from investors. As of June 30, 2022 and December 31, 2021, these loans had net unrealized gains of $16,000 and $51,000, respectively, which are reflected in their carrying value.  Changes in fair value of loans held for sale are included in net gains on mortgage loans.  Loans are sold with servicing released; therefore no mortgage servicing right assets are established.
 
Newly Issued Not Yet Effective StandardsFASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.  This ASU provides financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date by replacing the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates.  The new guidance eliminates the probable initial recognition threshold and, instead, reflects an entity’s current estimate of all expected credit losses. The new guidance broadens the information that an entity must consider in developing its expected credit loss estimate for assets measured either collectively or individually to include forecasted information, as well as past events and current conditions. There is no specified method for measuring expected credit losses, and an entity is allowed to apply methods that reasonably reflect its expectations of the credit loss estimate. Although an entity may still use its current systems and methods for recording the allowance for credit losses, under the new rules, the inputs used to record the allowance for credit losses generally will need to change to appropriately reflect an estimate of all expected credit losses and the use of reasonable and supportable forecasts. Additionally, credit losses on available-for-sale debt securities will now have to be presented as an allowance rather than as a write-down.

ASU No. 2019-10 Financial Instruments – Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842) – Effective Dates updated the effective date of this ASU for smaller reporting companies, such as the Company, to fiscal years beginning after December 15, 2022.  The Company selected a software vendor for applying this new ASU for Current Expected Credit Losses (“CECL”), began implementation of the software in the second quarter of 2018, completed integration during the third quarter of 2018 and ran parallel computations with both systems using the current GAAP incurred loss model in the fourth quarter of 2018.  The Company went live with this software beginning in January 2019 for its monthly incurred loss computations and began modeling the new current expected credit loss model assumptions to the allowance for loan losses computation.  In the periods since, the Company modeled the various methods prescribed in the ASU against the Company’s identified loan segments.  The Company anticipates continuing to run parallel computations as it continues to evaluate the impact of adoption of the new standard.

ASU 2020-04, Reference Rate Reform (Topic 848), Facilitation of the Effects of Reference Rate Reform on Financial Reporting provides temporary optional expedients and exceptions to GAAP guidance on contract modifications and hedge accounting to ease the financial reporting burdens of the expected market transition from LIBOR and other interbank offered rates to alternative reference rates. Entities can elect not to apply certain modification accounting requirements to contracts affected by reference rate reform, if certain criteria are met. Entities that make such elections would not have to remeasure contracts at the modification date or reassess a previous accounting determination.  Entities can elect various optional expedients that would allow them to continue applying hedge accounting for hedging relationships affected by reference rate reform, if certain criteria are met. We are utilizing the timeline guidance published by the Alternative Reference Rates Committee to develop and achieve internal milestones during this transitional period.  We have discontinued the use of new LIBOR-based loans and interest rate derivatives, according to regulatory guidelines.  The amended guidance under Topic 848 and our ability to elect its temporary optional expedients and exceptions are effective for us through December 31, 2022.  We expect to adopt the LIBOR transition relief allowed under this standard.

-13-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

ASU No. 2022-01 Derivatives and Hedging (Topic 815): Fair Value Hedging - Portfolio Layer Method.  This ASU expands the current last-of-layer method of hedge accounting that permits only one hedged layer to allow multiple hedged layers of a single closed portfolio.  To reflect this expansion, the last-of-layer method is renamed the portfolio layer method.  This ASU expands the scope of the portfolio layer method to include nonprepayable assets, specifies eligible hedging instruments in a single-layer hedge, provides additional guidance on the accounting for and disclosure of hedge basis adjustments and specifies how hedge basis adjustments should be considered when determining credit losses for the assets included in the closed portfolio.  This ASU is effective for public business entities for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years.  As the Company does not engage in this type of hedging activity, the Company does not believe adoption of this ASU will have any impact on its financial results or disclosures.

ASU No. 2022-02 Financial Instruments - Credit Losses (Topic 326): Troubled Debt Restructurings and Vintage Disclosures.  This ASU eliminates the accounting guidance for troubled debt restructurings (TDRs) by creditors in Subtopic 310-40, Receivables - Troubled Debt Restructurings by Creditors, while adding disclosures for certain loan restructurings by creditors when a borrower is experiencing financial difficulty.  This guidance requires an entity to determine whether the modification results in a new loan or a continuation of an existing loan.  Additionally, the ASU requires disclosure of current period gross writeoffs by year of origination for financing receivables.  This ASU is effective for the Company for fiscal years beginning after December 15, 2022.  The Company does not believe adoption of this ASU will have a material impact on its financial results and will add the required disclosures for gross chargeoffs in its financial statements upon adoption of the new standard.

-14-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 2 – SECURITIES

The amortized cost and fair value of securities at period-end were as follows (dollars in thousands):

   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
June 30, 2022
                       
Available for Sale
                       
U.S. Treasury and federal agency securities
 
$
209,323
   
$
29
   
$
(9,396
)
 
$
199,956
 
U.S. Agency MBS and CMOs
   
102,755
     
73
     
(8,699
)
   
94,129
 
Tax-exempt state and municipal bonds
   
39,567
     
97
     
(267
)
   
39,397
 
Taxable state and municipal bonds
   
99,040
     
13
     
(5,389
)
   
93,664
 
Corporate bonds and other debt securities
   
8,690
     
9
     
(217
)
   
8,482
 
   
$
459,375
   
$
221
   
$
(23,968
)
 
$
435,628
 
                                 
Held to Maturity
                               
U.S. Treasury
  $ 231,935     $ 71     $ (8,291 )   $ 223,715  
Tax-exempt state and municipal bonds
    120,786
      139
      (3,366 )     117,559
 

 
$
352,721
   
$
210
   
$
(11,657
)
 
$
341,274
 

   
Amortized
Cost
   
Gross
Unrealized
Gains
   
Gross
Unrealized
Losses
   
Fair
Value
 
December 31, 2021
                       
Available for Sale
                       
U.S. Treasury and federal agency securities
 
$
208,153
   
$
215
   
$
(1,523
)
 
$
206,845
 
U.S. Agency MBS and CMOs
   
87,343
     
416
     
(962
)
   
86,797
 
Tax-exempt state and municipal bonds
   
36,298
     
1,258
     
     
37,556
 
Taxable state and municipal bonds
   
79,394
     
812
     
(645
)
   
79,561
 
Corporate bonds and other debt securities
   
5,251
     
63
     
(10
)
   
5,304
 
   
$
416,439
   
$
2,764
   
$
(3,140
)
 
$
416,063
 
Held to Maturity
                               
Tax-exempt state and municipal bonds
 
$
137,003
   
$
2,484
    $ (215 )  
$
139,272
 

There were no sales of securities in the three and six month periods ended June 30, 2022 and 2021.

On January 1, 2022, the Company reclassified ten U.S. Treasury securities with an amortized cost of $123.5 million from available for sale to held to maturity, as it has the intent and ability to hold these securities to maturity.  These securities had net unrealized gains of $113,000 at the date of transfer, which will continue to be reported in accumulated other comprehensive income, and will be amortized over the remaining life of the securities as an adjustment of yield. The effect on interest income of the amortization of net unrealized gains is offset by the amortization of the premium on the securities transferred.

Contractual maturities of debt securities at June 30, 2022 were as follows (dollars in thousands):

   
Held–to-Maturity Securities
   
Available-for-Sale Securities
 
   
Amortized
Cost
   
Fair
Value
   
Amortized
Cost
   
Fair
Value
 
Due in one year or less
 
$
20,307
   
$
20,126
   
$
15,795
   
$
15,795
 
Due from one to five years
   
310,172
     
299,759
     
267,490
     
258,879
 
Due from five to ten years
   
22,242
     
21,389
     
74,995
     
68,458
 
Due after ten years
   
     
     
101,095
     
92,496
 
   
$
352,721
   
$
341,274
   
$
459,375
   
$
435,628
 

-15-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 2 – SECURITIES (Continued)

Securities with unrealized losses at June 30, 2022 and December 31, 2021, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (dollars in thousands):

   
Less than 12 Months
   
12 Months or More
   
Total
 
June 30, 2022
 
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
 
Available for Sale
                                   
U.S. Treasury and federal agency securities
 
$
156,760
   
$
(5,059
)
 
$
34,712
   
$
(4,337
)
 
$
191,472
   
$
(9,396
)
U.S. Agency MBS and CMOs
   
71,643
     
(6,522
)
   
12,257
     
(2,177
)
   
83,900
     
(8,699
)
Tax-exempt state and municipal bonds
   
14,305
     
(267
)
   
     
     
14,305
     
(267
)
Taxable state and municipal bonds
   
79,673
     
(4,298
)
   
8,070
     
(1,091
)
   
87,743
     
(5,389
)
Corporate bonds and other debt securities
   
6,748
     
(217
)
   
     
     
6,748
     
(217
)
Total
 
$
329,129
   
$
(16,363
)
 
$
55,039
   
$
(7,605
)
 
$
384,168
   
$
(23,968
)
                                                 
Held to Maturity
                                               
U.S. Treasury   $ 213,866     $ (8,291 )   $     $     $ 213,866     $ (8,291 )
Tax-exempt state and municipal bonds     94,354       (3,366 )               94,354       (3,366 )
 
$
308,220
   
$
(11,657
)
 
$
   
$
 
$
308,220
   
$
(11,657
)

   
Less than 12 Months
   
12 Months or More
   
Total
 
December 31, 2021
 
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
   
Fair
Value
   
Unrealized
Loss
 
Available for Sale
                                   
U.S. Treasury and federal agency securities
 
$
77,066
   
$
(955
)
 
$
18,432
   
$
(568
)
 
$
95,498
   
$
(1,523
)
U.S. Agency MBS and CMOs
   
52,254
     
(830
)
   
4,190
     
(132
)
   
56,444
     
(962
)
Tax-exempt state and municipal bonds
   
     
     
     
     
     
 
Taxable state and municipal bonds
   
37,648
     
(638
)
   
498
     
(7
)
   
38,146
     
(645
)
Corporate bonds and other debt securities
   
1,352
     
(10
)
   
     
     
1,352
     
(10
)
Total
 
$
168,320
   
$
(2,433
)
 
$
23,120
   
$
(707
)
 
$
191,440
   
$
(3,140
)
                                                 
Held to Maturity
                                               
Tax-exempt state and municipal bonds
 
$
61,166
   
$
(215
)
 
$
   
$
   
$
61,166
   
$
(215
)

Other-Than-Temporary-Impairment

Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. At June 30, 2022, 355 securities available for sale with fair values totaling $384.2 million had unrealized losses totaling $24.0 million. At June 30, 2022, 57 securities held to maturity with fair values totaling $308.2 million had unrealized losses totaling $11.7 million. Management has the intent and ability to hold the securities classified as held to maturity until they mature, at which time the Company will receive full value for the securities. In addition, management believes it is more likely than not that the Company will not be required to sell any of its investment securities before a recovery of cost.  Management determined that the unrealized losses for each period and each investment were attributable to changes in interest rates and not due to credit quality.  As such, no OTTI charges were necessary during each period.

Securities with a carrying value of approximately $3.7 million and $4.9 million were pledged as security for public deposits, letters of credit and for other purposes required or permitted by law at June 30, 2022 and December 31, 2021, respectively.


-16-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 3 – LOANS



Portfolio loans were as follows (dollars in thousands):


   
June 30,
2022
   
December 31,
2021
 
Commercial and industrial:
           
Commercial and industrial, excluding PPP
 
$
407,788
   
$
378,318
 
PPP
   
2,791
     
41,939
 
Total commercial and industrial
   
410,579
     
420,257
 
Commercial real estate:
               
Residential developed
   
4,094
     
4,862
 
Unsecured to residential developers
   
     
5,000
 
Vacant and unimproved
   
35,912
     
36,240
 
Commercial development
   
112
     
171
 
Residential improved
   
102,885
     
100,077
 
Commercial improved
   
258,676
     
259,039
 
Manufacturing and industrial
   
117,424
     
110,712
 
Total commercial real estate
   
519,103
     
516,101
 
Consumer:
               
Residential mortgage
   
125,771
     
117,800
 
Unsecured
   
168
     
210
 
Home equity
   
52,671
     
51,269
 
Other secured
   
3,623
     
3,356
 
Total consumer
   
182,233
     
172,635
 
Total loans
   
1,111,915
     
1,108,993
 
Allowance for loan losses
   
(14,631
)
   
(15,889
)
   
$
1,097,284
   
$
1,093,104
 


The totals above are shown net of deferred fees and costs.  Deferred fees on loans totaled $1.4 million and $2.6 million at June 30, 2022 and December 31, 2021, respectively.  Deferred costs on loans totaled $1.4 million and $1.3 million at June 30, 2022 and December 31, 2021, respectively.

-17-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 – LOANS (Continued)

Activity in the allowance for loan losses by portfolio segment was as follows (dollars in thousands):


Three months ended June 30, 2022
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
 
$
5,329
   
$
7,071
   
$
2,153
   
$
63
   
$
14,616
 
Charge-offs
   
(38
)
   
     
(22
)
   
     
(60
)
Recoveries
   
5
     
38
     
32
     
     
75
 
Provision for loan losses
   
(40
)
   
(87
)
   
153
     
(26
)
   
 
Ending Balance
 
$
5,256
   
$
7,022
   
$
2,316
   
$
37
   
$
14,631
 


Three months ended June 30, 2021
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
 
$
5,801
   
$
8,898
   
$
2,718
   
$
35
   
$
17,452
 
Charge-offs
   
     
     
(30
)
   
     
(30
)
Recoveries
   
35
     
72
     
27
     
     
134
 
Provision for loan losses
   
(630
)
   
(230
)
   
141
     
(31
)
   
(750
)
Ending Balance
 
$
5,206
   
$
8,740
   
$
2,856
   
$
4
   
$
16,806
 


Six months ended June 30, 2022
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
 
$
5,176
   
$
8,051
   
$
2,633
   
$
29
   
$
15,889
 
Charge-offs
   
(38
)
   
     
(57
)
   
     
(95
)
Recoveries
   
10
     
271
     
56
     
     
337
 
Provision for loan losses
   
108
     
(1,300
)
   
(316
)
   
8
     
(1,500
)
Ending Balance
 
$
5,256
   
$
7,022
   
$
2,316
   
$
37
   
$
14,631
 


Six months ended June 30, 2021
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Beginning balance
 
$
6,632
   
$
7,999
   
$
2,758
   
$
19
   
$
17,408
 
Charge-offs
   
     
     
(80
)
   
     
(80
)
Recoveries
   
55
     
111
     
62
     
     
228
 
Provision for loan losses
   
(1,481
)
   
630
     
116
     
(15
)
   
(750
)
Ending Balance
 
$
5,206
   
$
8,740
   
$
2,856
   
$
4
   
$
16,806
 


-18-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 – LOANS (Continued)

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method (dollars in thousands):


June 30, 2022
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
                             
Ending allowance attributable to loans:
                             
Individually reviewed for impairment
 
$
59
   
$
21
   
$
216
   
$
   
$
296
 
Collectively evaluated for impairment
   
5,197
     
7,001
     
2,100
     
37
     
14,335
 
Total ending allowance balance
 
$
5,256
   
$
7,022
   
$
2,316
   
$
37
   
$
14,631
 
Loans:
                                       
Individually reviewed for impairment
 
$
829
   
$
584
   
$
2,840
   
$
   
$
4,253
 
Collectively evaluated for impairment
   
409,750
     
518,519
     
179,393
     
     
1,107,662
 
Total ending loans balance
 
$
410,579
   
$
519,103
   
$
182,233
   
$
   
$
1,111,915
 


December 31, 2021
 
Commercial
and
Industrial
   
Commercial
Real Estate
   
Consumer
   
Unallocated
   
Total
 
Allowance for loan losses:
                             
Ending allowance attributable to loans:
                             
Individually reviewed for impairment
 
$
303
   
$
24
   
$
238
   
$
   
$
565
 
Collectively evaluated for impairment
   
4,873
     
8,027
     
2,395
     
29
     
15,324
 
Total ending allowance balance
 
$
5,176
   
$
8,051
   
$
2,633
   
$
29
   
$
15,889
 
Loans:
                                       
Individually reviewed for impairment
 
$
3,375
   
$
1,127
   
$
3,024
   
$
   
$
7,526
 
Collectively evaluated for impairment
   
416,882
     
514,974
     
169,611
     
     
1,101,467
 
Total ending loans balance
 
$
420,257
   
$
516,101
   
$
172,635
   
$
   
$
1,108,993
 


-19-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 – LOANS (Continued)

The following table presents loans individually evaluated for impairment by class of loans as of June 30, 2022 (dollars in thousands):


June 30, 2022
 
Unpaid
Principal
Balance
   
Recorded
Investment
   
Allowance
Allocated
 
With no related allowance recorded:
                 
Commercial and industrial
 
$
460
   
$
460
   
$
 
Commercial real estate:
                       
Residential improved
   
38
     
38
     
 
Commercial improved
   
46
     
46
     
 
     
84
     
84
     
 
Consumer
   
     
     
 
Total with no related allowance recorded
 
$
544
   
$
544
   
$
 
                         
With an allowance recorded:
                       
Commercial and industrial
 
$
369
   
$
369
   
$
59
 
Commercial real estate:
                       
Commercial improved
   
314
     
314
     
10
 
Manufacturing and industrial
   
186
     
186
     
11
 
     
500
     
500
     
21
 
Consumer:
                       
Residential mortgage
   
2,519
     
2,519
     
192
 
Unsecured
   
32
     
32
     
2
 
Home equity
   
289
     
289
     
22
 
     
2,840
     
2,840
     
216
 
Total with an allowance recorded
 
$
3,709
   
$
3,709
   
$
296
 
Total
 
$
4,253
   
$
4,253
   
$
296
 


-20-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 – LOANS (Continued)


The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2021 (dollars in thousands):


December 31, 2021
 
Unpaid
Principal
Balance
   
Recorded
Investment
   
Allowance
Allocated
 
With no related allowance recorded:
                 
Commercial and industrial
 
$
669
   
$
669
   
$
 
Commercial real estate:
                       
Residential improved
   
41
     
41
     
 
Commercial improved
   
577
     
577
     
 
     
618
     
618
     
 
Consumer
   
     
     
 
Total with no related allowance recorded
 
$
1,287
   
$
1,287
   
$
 
                         
With an allowance recorded:
                       
Commercial and industrial
 
$
2,706
   
$
2,706
   
$
303
 
Commercial real estate:
                       
Commercial improved
   
318
     
318
     
14
 
Manufacturing and industrial
   
191
     
191
     
10
 
     
509
     
509
     
24
 
Consumer:
                       
Residential mortgage
   
2,726
     
2,726
     
214
 
Unsecured
   
64
     
64
     
5
 
Home equity
   
234
     
234
     
19
 
     
3,024
     
3,024
     
238
 
Total with an allowance recorded
 
$
6,239
   
$
6,239
   
$
565
 
Total
 
$
7,526
   
$
7,526
   
$
565
 


-21-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 – LOANS (Continued)

The following table presents information regarding average balances of impaired loans and interest recognized on impaired loans for the three and six month periods ended June 30, 2022 and 2021 (dollars in thousands):


   
Three
Months
Ended
June 30,
2022
   
Three
Months
Ended
June 30,
2021
   
Six
Months
Ended
June 30,
2022
   
Six
Months
Ended
June 30,
2021
 
Average of impaired loans during the period:
                       
Commercial and industrial
 
$
2,284
   
$
1,916
   
$
3,232
   
$
3,251
 
Commercial real estate:
                               
Residential developed
   
     
     
     
22
 
Residential improved
   
39
     
33
     
39
     
60
 
Commercial improved
   
362
     
2,170
     
453
     
2,190
 
Manufacturing and industrial
   
187
     
197
     
188
     
198
 
Consumer
   
2,793
     
3,619
     
2,824
     
3,780
 
Interest income recognized during impairment:
                               
Commercial and industrial
   
26
     
9
     
165
     
143
 
Commercial real estate
   
18
     
35
     
28
     
66
 
Consumer
   
55
     
31
     
81
     
69
 
Cash-basis interest income recognized
                               
Commercial and industrial
   
27
     
8
     
158
     
134
 
Commercial real estate
   
21
     
35
     
34
     
66
 
Consumer
   
56
     
32
     
82
     
68
 


-22-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 – LOANS (Continued)

Nonaccrual loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.  The following tables present the recorded investment in nonaccrual and loans past due over 90 days still on accrual by class of loans as of June 30, 2022 and December 31, 2021:


June 30, 2022
 
Nonaccrual
   
Over 90
days
Accruing
 
Commercial and industrial
 
$
   
$
 
Commercial real estate:
               
Residential improved
   
5
     
 
     
5
     
 
Consumer:
               
Residential mortgage
   
85
     
 
     
85
     
 
Total
 
$
90
   
$
 


December 31, 2021
 
Nonaccrual
   
Over 90 days
Accruing
 
Commercial and industrial
 
$
   
$
 
Commercial real estate:
               
Residential improved
   
5
     
 
     
5
     
 
Consumer:
               
Residential mortgage
   
86
     
 
     
86
     
 
Total
 
$
91
   
$
 


-23-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 – LOANS (Continued)

The following table presents the aging of the recorded investment in past due loans as of June 30, 2022 and December 31, 2021 by class of loans (dollars in thousands):


June 30, 2022
 
30-90
Days
   
Greater Than
90 Days
   
Total
Past Due
   
Loans Not
Past Due
   
Total
 
Commercial and industrial
 
$
   
$
   
$
   
$
410,579
   
$
410,579
 
Commercial real estate:
                                       
Residential developed
   
     
     
     
4,094
     
4,094
 
Unsecured to residential developers
   
     
     
     
     
 
Vacant and unimproved
   
     
     
     
35,912
     
35,912
 
Commercial development
   
     
     
     
112
     
112
 
Residential improved
   
     
5
     
5
     
102,880
     
102,885
 
Commercial improved
   
     
     
     
258,676
     
258,676
 
Manufacturing and industrial
   
     
     
     
117,424
     
117,424
 
     
     
5
     
5
     
519,098
     
519,103
 
Consumer:
                                       
Residential mortgage
   
75
     
84
     
159
     
125,612
     
125,771
 
Unsecured
   
     
     
     
168
     
168
 
Home equity
   
33
     
     
33
     
52,638
     
52,671
 
Other secured
   
     
     
     
3,623
     
3,623
 
     
108
     
84
     
192
     
182,041
     
182,233
 
Total
 
$
108
   
$
89
   
$
197
   
$
1,111,718
   
$
1,111,915
 


December 31, 2021
 
30-90
Days
   
Greater Than
90 Days
   
Total
Past Due
   
Loans Not
Past Due
   
Total
 
Commercial and industrial
 
$
39
   
$
1
   
$
40
   
$
420,217
   
$
420,257
 
Commercial real estate:
                                       
Residential developed
   
     
     
     
4,862
     
4,862
 
Unsecured to residential developers
                      5,000       5,000  
Vacant and unimproved
   
     
     
     
36,240
     
36,240
 
Commercial development
   
     
     
     
171
     
171
 
Residential improved
   
     
5
     
5
     
100,072
     
100,077
 
Commercial improved
   
     
     
     
259,039
     
259,039
 
Manufacturing and industrial
   
     
     
     
110,712
     
110,712
 
     
     
5
     
5
     
516,096
     
516,101
 
Consumer:
                                       
Residential mortgage
   
     
84
     
84
     
117,716
     
117,800
 
Unsecured
   
     
     
     
210
     
210
 
Home equity
   
     
     
     
51,269
     
51,269
 
Other secured
   
     
     
     
3,356
     
3,356
 
     
     
84
     
84
     
172,551
     
172,635
 
Total
 
$
39
   
$
90
   
$
129
   
$
1,108,864
   
$
1,108,993
 


-24-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 – LOANS (Continued)


The Company had allocated $296,000 and $565,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings (“TDRs”) as of June 30, 2022 and December 31, 2021, respectively. These loans may have involved the restructuring of terms to allow customers to mitigate the risk of foreclosure by meeting a lower loan payment requirement based upon their current cash flow.  These may also include loans that renewed at existing contractual rates, but below market rates for comparable credit.  The Company has been active at utilizing these programs and working with its customers to reduce the risk of foreclosure.  For commercial loans, these modifications typically include an interest only period and, in some cases, a lowering of the interest rate on the loan.  In some cases, the modification will include separating the note into two notes with the first note structured to be supported by current cash flows and collateral, and the second note made for the remaining unsecured debt. The second note is charged off immediately and collected only after the first note is paid in full. This modification type is commonly referred to as an A-B note structure.  For consumer mortgage loans, the restructuring typically includes a lowering of the interest rate to provide payment and cash flow relief.  For each restructuring, a comprehensive credit underwriting analysis of the borrower’s financial condition and prospects of repayment under the revised terms is performed to assess whether the structure can be successful and that cash flows will be sufficient to support the restructured debt. An analysis is also performed to determine whether the restructured loan should be on accrual status.  Generally, if the loan is on accrual at the time of restructure, it will remain on accrual after the restructuring. In some cases, a nonaccrual loan may be placed on accrual at restructuring if the loan’s actual payment history demonstrates it would have cash flowed under the restructured terms. After six consecutive payments under the restructured terms, a nonaccrual restructured loan is reviewed for possible upgrade to accruing status.



In situations where there is a subsequent modification or renewal and the loan is brought to market terms, including a contractual interest rate not less than a market interest rate for new debt with similar credit risk characteristics, the TDR and impaired loan designations may be removed. In addition, the TDR designation may also be removed from loans modified under an A-B note structure.  If the remaining “A” note is at a market rate at the time of restructuring (taking into account the borrower’s credit risk and prevailing market conditions), the loan can be removed from TDR designation in a subsequent calendar year after six months of performance in accordance with the new terms. The market rate relative to the borrower’s credit risk is determined through analysis of market pricing information gathered from peers and use of a loan pricing model.  The general objective of the model is to achieve a consistent return on equity from one credit to the next, taking into consideration differences in credit risk.  In the model, credits with higher risk receive a higher potential loss allocation, and therefore require a higher interest rate to achieve the target return on equity.



As with other impaired loans, an allowance for loan loss is estimated for each TDR based on the most likely source of repayment for each loan. For impaired commercial real estate loans that are collateral dependent, the allowance is computed based on the fair value of the underlying collateral, less estimated costs to sell. For impaired commercial loans where repayment is expected from cash flows from business operations, the allowance is computed based on a discounted cash flow computation. Certain groups of TDRs, such as residential mortgages, have common characteristics and for them the allowance is computed based on a discounted cash flow computation on the change in weighted rate for the pool.  The allowance allocations for commercial TDRs where we have reduced the contractual interest rate are computed by measuring cash flows using the new payment terms discounted at the original contractual rate.



The following table presents information regarding troubled debt restructurings as of June 30, 2022 and December 31, 2021 (dollars in thousands):


   
June 30, 2022
   
December 31, 2021
 
   
Number of
Loans
   
Outstanding
Recorded
Balance
   
Number of
Loans
   
Outstanding
Recorded
Balance
 
Commercial and industrial
   
3
   
$
830
     
4
   
$
3,375
 
Commercial real estate
   
5
     
584
     
6
     
1,127
 
Consumer
   
37
     
2,840
     
44
     
3,024
 
     
45
   
$
4,254
     
54
   
$
7,526
 


-25-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 – LOANS (Continued)


The following table presents information related to accruing TDRs as of June 30, 2022 and December 31, 2021. The table presents the amount of accruing troubled debt restructurings that were on nonaccrual status prior to the restructuring, accruing at the time of restructuring and those that were upgraded to accruing status after receiving six consecutive monthly payments in accordance with the restructured terms as of each period reported (dollars in thousands):


   
June 30,
2022
   
December 31,
2021
 
Accruing TDR - nonaccrual at restructuring
 
$
   
$
 
Accruing TDR - accruing at restructuring
   
3,789
     
4,552
 
Accruing TDR - upgraded to accruing after six consecutive payments
   
460
     
2,968
 
   
$
4,249
   
$
7,520
 



There was one consumer loan TDR executed during the three month period ended June 30, 2022. The pre-TDR balance of the loan was $99,000 and there was no writedown upon TDR. There were no TDRs executed during the three month period ended March 31, 2022 or during the three and six month periods ended June 30, 2021.



According to the accounting standards, not all loan modifications are TDRs.  TDRs are modifications or renewals where the Company has granted a concession to a borrower in financial distress. The Company reviews all modifications and renewals for determination of TDR status.  In some situations a borrower may be experiencing financial distress, but the Company does not provide a concession. These modifications are not considered TDRs. In other cases, the Company might provide a concession, such as a reduction in interest rate, but the borrower is not experiencing financial distress. This could be the case if the Company is matching a competitor’s interest rate.  These modifications would also not be considered TDRs.  Finally, any renewals at existing terms for borrowers not experiencing financial distress would not be considered TDRs.  As with other loans not considered TDR or impaired, allowance allocations are based on the historical based allocation for the applicable loan grade and loan class.



Payment defaults on TDRs have been minimal and during the three and six month periods ended June 30, 2022 and 2021 and the balance of loans that became delinquent by more than 90 days past due or that were transferred to nonaccrual within 12 months of restructuring were not material.


In March 2020, guidance issued by the federal banking agencies in consultation with FASB and the Coronavirus Aid, Relief and Economic Security (“CARES”) Act collectively specified that COVID-19 related modifications on loans that were not more than 30 days past due as of December 31, 2019 are not TDRs. Through June 30, 2022, the Bank had applied this guidance and modified 726 individual loans with aggregate principal balances totaling $337.2 million.  As of June 30, 2022, all of these modifications had expired and the loans had returned to their contractual payment terms.

-26-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 – LOANS (Continued)


Credit Quality Indicators:   The Company categorizes loans into risk categories based on relevant information about the ability of the borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors.  The Company analyzes commercial loans individually and classifies these relationships by credit risk grading. The Company uses an eight point grading system, with grades 5 through 8 being considered classified, or watch, credits.  All commercial loans are assigned a grade at origination, at each renewal or any amendment.  When a credit is first downgraded to a watch credit (either through renewal, amendment, loan officer identification or the loan review process), an Administrative Loan Review (“ALR”) is generated by the credit department and the loan officer. All watch credits have an ALR completed quarterly which analyzes the collateral position and cash flow of the borrower and its guarantors.  Management meets quarterly with loan officers to discuss each of these credits in detail and to help formulate solutions where progress has stalled. When necessary, the loan officer proposes changes to the assigned loan grade as part of the ALR.  Additionally, Loan Review reviews all loan grades upon origination, renewal or amendment and again as loans are selected though the loan review process.  The credit will stay on the ALR until either its grade has improved to a 4 or the credit relationship is at a zero balance. The Company uses the following definitions for the risk grades:



1. Excellent - Loans supported by extremely strong financial condition or secured by the Bank’s own deposits. Minimal risk to the Bank and the probability of serious rapid financial deterioration is extremely small.



2. Above Average - Loans supported by sound financial statements that indicate the ability to repay or borrowings secured (and margined properly) with marketable securities. Nominal risk to the Bank and probability of serious financial deterioration is highly unlikely. The overall quality of these credits is very high.



3. Good Quality - Loans supported by satisfactory asset quality and liquidity, good debt capacity coverage, and good management in all critical positions. Loans are secured by acceptable collateral with adequate margins. There is a slight risk of deterioration if adverse market conditions prevail.



4. Acceptable Risk - Loans carrying an acceptable risk to the Bank, which may be slightly below average quality. The borrower has limited financial strength with considerable leverage. There is some probability of deterioration if adverse market conditions prevail. These credits should be monitored closely by the Relationship Manager.



5. Marginally Acceptable - Loans are of marginal quality with above normal risk to the Bank. The borrower shows acceptable asset quality but very little liquidity with high leverage. There is inconsistent earning performance without the ability to sustain adverse market conditions. The primary source of repayment is questionable, but the secondary source of repayment still remains an option. Very close attention by the Relationship Manager and management is needed.



6. Substandard - Loans are inadequately protected by the net worth and paying capacity of the borrower or the collateral pledged. The primary and secondary sources of repayment are questionable. Heavy debt condition may be evident and volume and earnings deterioration may be underway. It is possible that the Bank will sustain some loss if the deficiencies are not immediately addressed and corrected.



7. Doubtful - Loans supported by weak or no financial statements, as well as the ability to repay the entire loan, are questionable. Loans in this category are normally characterized less than adequate collateral, insolvent, or extremely weak financial condition. A loan classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses makes collection or liquidation in full highly questionable. The possibility of loss is extremely high, however, activity may be underway to minimize the loss or maximize the recovery.



8. Loss - Loans are considered uncollectible and of little or no value as a bank asset.

-27-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 – LOANS (Continued)

As of June 30, 2022 and December 31, 2021, the risk grade category of commercial loans by class of loans were as follows (dollars in thousands):


June 30, 2022
    1
      2
      3
      4
      5
      6
      7
      8
   
Total
 
Commercial and industrial
 
$
17,825
   
$
11,677
   
$
145,802
   
$
230,669
   
$
4,412
   
$
194
   
$
   
$
   
$
410,579
 
                                                                         
Commercial real estate:
                                                                       
Residential developed
   
     
     
     
4,094
     
     
     
     
     
4,094
 
Unsecured to residential developers
   
     
     
     
     
     
     
     
     
 
Vacant and unimproved
   
     
1,708
     
15,804
     
18,400
     
     
     
     
     
35,912
 
Commercial development
   
     
     
112
     
     
     
     
     
     
112
 
Residential improved
   
     
     
22,706
     
80,141
     
33
     
     
5
     
     
102,885
 
Commercial improved
   
     
18,166
     
68,671
     
164,785
     
6,740
     
314
     
     
     
258,676
 
Manufacturing & industrial
   
     
3,361
     
36,259
     
74,523
     
3,281
     
     
     
     
117,424
 
   
$
17,825
   
$
34,912
   
$
289,354
   
$
572,612
   
$
14,466
   
$
508
   
$
5
   
$
   
$
929,682
 


December 31, 2021
    1
      2
      3       4
      5
      6
      7
      8
   
Total
 
Commercial and industrial
 
$
56,979
   
$
19,300
   
$
110,877
   
$
227,087
   
$
2,700
   
$
3,314
   
$
   
$
   
$
420,257
 
                                                                         
Commercial real estate:
                                                                       
Residential developed
   
     
     
     
4,862
     
     
     
     
     
4,862
 
Unsecured to residential developers                       5,000                               5,000  
Vacant and unimproved
   
     
1,763
     
13,492
     
20,985
     
     
     
     
     
36,240
 
Commercial development
   
     
     
171
     
     
     
     
     
     
171
 
Residential improved
   
     
     
24,450
     
75,503
     
119
     
     
5
     
     
100,077
 
Commercial improved
   
     
15,115
     
71,211
     
165,268
     
7,127
     
318
     
     
     
259,039
 
Manufacturing & industrial
   
     
     
41,757
     
65,601
     
3,354
     
     
     
     
110,712
 
   
$
56,979
   
$
36,178
   
$
261,958
   
$
564,306
   
$
13,300
   
$
3,632
   
$
5
   
$
   
$
936,358
 



Commercial loans rated a 6 or worse per the Company’s internal risk rating system are considered substandard, doubtful or loss. Commercial loans classified as substandard or worse were as follows at period-end (dollars in thousands):


   
June 30,
2022
   
December 31,
2021
 
Not classified as impaired
 
$
108
   
$
233
 
Classified as impaired
   
405
     
3,404
 
Total commercial loans classified substandard or worse
 
$
513
   
$
3,637
 



The Company considers the performance of the loan portfolio and its impact on the allowance for loan losses. For consumer loan classes, the Company also evaluates credit quality based on the aging status of the loan, which was previously presented, and by payment activity. The following table presents the recorded investment in consumer loans based on payment activity (dollars in thousands):


June 30, 2022
 
Residential
Mortgage
   
Consumer
Unsecured
   
Home
Equity
   
Consumer
Other
 
Performing
 
$
125,686
   
$
168
   
$
52,671
   
$
3,623
 
Nonperforming
   
85
     
     
     
 
Total
 
$
125,771
   
$
168
   
$
52,671
   
$
3,623
 

-28-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 3 –  LOANS (Continued)

December 31, 2021
 
Residential
Mortgage
   
Consumer
Unsecured
   
Home
Equity
   
Consumer
Other
 
Performing
 
$
117,716
   
$
210
   
$
51,269
   
$
3,356
 
Nonperforming
   
84
     
     
     
 
Total
 
$
117,800
   
$
210
   
$
51,269
   
$
3,356
 

NOTE 4 – FAIR VALUE

ASC Topic 820, Fair Value Measurements and Disclosures, establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three levels of inputs that may be used to measure fair value include:


Level 1:
Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.


Level 2:
Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.


Level 3:
Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

Investment Securities: The fair values of investment securities are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). The fair values of certain securities held to maturity are determined by computing discounted cash flows using observable and unobservable market inputs (Level 3 inputs).

Loans Held for Sale: The fair value of loans held for sale is based upon binding quotes from third party investors (Level 2 inputs).

Impaired Loans: Loans identified as impaired are measured using one of three methods: the loan’s observable market price, the fair value of collateral or the present value of expected future cash flows.  For each period presented, no impaired loans were measured using the loan’s observable market price. If an impaired loan has had a charge-off or if the fair value of the collateral is less than the recorded investment in the loan, we establish a specific reserve and report the loan as nonrecurring Level 3. The fair value of collateral of impaired loans is generally based on recent real estate appraisals, less costs to sell. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Other Real Estate Owned: Other real estate owned (OREO) properties are initially recorded at fair value, less estimated costs to sell when acquired, establishing a new cost basis.  Adjustments to OREO are measured at fair value, less costs to sell. Fair values are generally based on third party appraisals or realtor evaluations of the property. These appraisals and evaluations may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach.  Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less estimated costs to sell, an impairment loss is recognized through a valuation allowance, and the property is reported as nonrecurring Level 3.

Interest Rate Swaps: For interest rate swap agreements, we measure fair value utilizing pricing provided by a third-party pricing source that that uses market observable inputs, such as forecasted yield curves, and other unobservable inputs and accordingly, interest rate swap agreements are classified as Level 3.

-29-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 4 – FAIR VALUE (Continued)

Assets and liabilities measured at fair value on a recurring basis are summarized below (in thousands):

    
Fair
Value
   
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
   
Significant Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
June 30, 2022
                       
Available for sale securities                        
U.S. Treasury and federal agency securities
 
$
199,956
   
$
   
$
199,956
   
$
 
U.S. Agency MBS and CMOs
   
94,129
     
     
94,129
     
 
Tax-exempt state and municipal bonds
   
39,397
     
     
39,397
     
 
Taxable state and municipal bonds
   
93,664
     
     
93,664
     
 
Corporate bonds and other debt securities
   
8,482
     
     
8,482
     
 
Other equity securities
   
1,354
     
     
1,354
     
 
Loans held for sale
   
1,163
     
     
1,163
     
 
Interest rate swaps
   
4,556
     
     
     
4,556
 
Interest rate swaps
   
(4,556
)
   
     
     
(4,556
)
                                 
December 31, 2021
                               
Available for sale securities
                               
U.S. Treasury and federal agency securities
 
$
206,845
   
$
   
$
206,845
   
$
 
U.S. Agency MBS and CMOs
   
86,797
     
     
86,797
     
 
Tax-exempt state and municipal bonds
   
37,556
     
     
37,556
     
 
Taxable state and municipal bonds
   
79,561
     
     
79,561
     
 
Corporate bonds and other debt securities
   
5,304
     
     
5,304
     
 
Other equity securities
   
1,470
     
     
1,470
     
 
Loans held for sale
   
1,407
     
     
1,407
     
 
Interest rate swaps
   
3,277
     
     
     
3,277
 
Interest rate swaps
   
(3,277
)
   
     
     
(3,277
)

Assets measured at fair value on a non-recurring basis are summarized below (in thousands):

 
 
Fair
Value
   
Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)
   
Significant Other
Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
June 30, 2022
                       
Impaired loans
 
$
337
   
$
   
$
   
$
337
 
                                 
December 31, 2021
                               
Impaired loans
 
$
2,903
   
$
   
$
   
$
2,903
 

-30-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 4 – FAIR VALUE (Continued)

Quantitative information about Level 3 fair value measurements measured on a non-recurring basis was as follows at period end (dollars in thousands):


 
Asset Fair
Value
 
Valuation
Technique
 
Unobservable
Inputs
 
Range (%)
June 30, 2022                  
Impaired Loans
 
$
337
 
Sales comparison approach
 
Adjustment for differences
between comparable sales
 
1.5 to 20.0
          Income approach  
Capitalization rate
  9.5 to 11.0


 
Asset Fair
Value
 
Valuation
Technique
 
Unobservable
Inputs
 
Range (%)
December 31, 2021                  
Impaired Loans
 
$
2,903
 
Sales comparison approach
 
Adjustment for differences
between comparable sales
 
1.5 to 20.0
         
Income approach
 
Capitalization rate
 
9.5 to 11.0


The carrying amounts and estimated fair values of financial instruments, not previously presented, were as follows at June 30, 2022 and December 31, 2021 (dollars in thousands):



  June 30, 2022     December 31, 2021  
 
Level in
Fair Value
Hierarchy
 
Carrying
Amount
   
Fair
Value
   
Carrying
Amount
   
Fair
Value
 
Financial assets
                         
Cash and due from banks
Level 1
 
$
38,376
   
$
38,376
   
$
23,669
   
$
23,669
 
Federal funds sold and other short-term investments
Level 1
   
721,826
     
721,826
     
1,128,119
     
1,128,119
 
Securities held to maturity
Level 3
   
352,721
     
341,274
     
137,003
     
139,272
 
FHLB stock
 Level 3
   
10,211
     
10,211
     
11,558
     
11,558
 
Loans, net
 Level 2
   
1,096,946
     
1,082,028
     
1,090,201
     
1,106,324
 
Bank owned life insurance
 Level 3
   
52,963
     
52,963
     
52,468
     
52,468
 
Accrued interest receivable
 Level 2
   
5,108
     
5,108
     
4,088
     
4,088
 
Financial liabilities
                                 
Deposits
 Level 2
   
(2,494,583
)
   
(2,494,501
)
   
(2,577,958
)
   
(2,577,885
)
Other borrowed funds
 Level 2
   
(30,000
)
   
(29,117
)
   
(85,000
)
   
(86,322
)
Accrued interest payable
 Level 2    
(35
)
   
(35
)
   
(72
)
   
(72
)
Off-balance sheet credit-related items
                                 
Loan commitments
     
     
     
     
 

The methods and assumptions used to estimate fair value are described as follows.
 
Carrying amount is the estimated fair value for cash and cash equivalents, bank owned life insurance, accrued interest receivable and payable, demand deposits, short-term borrowings and variable rate loans or deposits that reprice frequently and fully. Security fair values are determined by matrix pricing, which is a mathematical technique widely used in the industry to value debt securities as discussed above. For fixed rate loans, interest-bearing time deposits in other financial institutions, or deposits and for variable rate loans or deposits with infrequent repricing or repricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life and credit risk (including consideration of widening credit spreads). Fair value of debt is based on current rates for similar financing. It was not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability, so fair value approximates its cost. The fair value of off-balance sheet credit-related items is not significant.

The estimated fair values of financial instruments disclosed above as follow the guidance in ASU 2016-01 which prescribes an “exit price” approach in estimating and disclosing fair value of financial instruments incorporating discounts for credit, liquidity and marketability factors.

-31-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 5 - DERIVATIVES

Derivatives not designated as hedges are not speculative and result from a service provided to certain commercial loan borrowers. The Company executes interest rate swaps with commercial banking customers desiring longer-term fixed rate loans, while simultaneously entering into interest rate swaps with a correspondent bank to offset the impact of the interest rate swaps with the commercial banking customers. The net result is the desired floating rate loans and a minimization of the risk exposure of the interest rate swap transactions. As the interest rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the commercial banking customer interest rate swaps and the offsetting interest rate swaps with the correspondent bank are recognized directly to earnings. Since they offset perfectly, there is no net impact to earnings.

The notional and fair value of derivative instruments as of June 30, 2022 and December 31, 2021 are reflected in the following table (dollars in thousands):

   
Notional
Amount
 
Balance Sheet Location
 
Fair Value
 
June 30, 2022
             
Derivative assets
             
Interest rate swaps
 
$
64,898
 
Other Assets
 
$
4,556
 
                   
Derivative liabilities
                 
Interest rate swaps
   
64,898
 
Other Liabilities
   
4,556
 

   
Notional
Amount
 
Balance Sheet Location
 
Fair Value
 
December 31, 2021
                 
Derivative assets
                 
Interest rate swaps
 
$
70,356
 
Other Assets
 
$
3,277
 
                   
Derivative liabilities
                 
Interest rate swaps
   
70,356
 
Other Liabilities
   
3,277
 

The fair value of interest rate swaps in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk related to these agreements, was $4.6 million and $3.3 million as of June 30, 2022 and December 31, 2021, respectively. Securities pledged as collateral totaling $1.8 million and $3.0 million were provided to the counterparty correspondent bank as of June 30, 2022 and December 31, 2021, respectively.

Interest rate swaps entered into with commercial loan customers had notional amounts aggregating $64.9 million as of June 30, 2022 and $70.4 million at December 31, 2021. Associated credit exposure is generally mitigated by securing the interest rate swaps with the underlying collateral of the loan instrument that has been hedged.

-32-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 6 – DEPOSITS

Deposits are summarized as follows (dollars in thousands):

   
June 30,
2022
   
December 31,
2021
 
Noninterest-bearing demand
 
$
903,334
   
$
886,115
 
Interest bearing demand
   
640,277
     
736,573
 
Savings and money market accounts
   
868,222
     
865,528
 
Certificates of deposit
   
82,750
     
89,742
 
   
$
2,494,583
   
$
2,577,958
 

Time deposits that exceed the FDIC insurance limit of $250,000 were approximately $26.8 million at June 30, 2022 and $28.2 million at December 31, 2021.

NOTE 7 - OTHER BORROWED FUNDS

Other borrowed funds include advances from the Federal Home Loan Bank and borrowings from the Federal Reserve Bank.

Federal Home Loan Bank Advances

At period-end, advances from the Federal Home Loan Bank were as follows (dollars in thousands):

Principal Terms
 
Advance
Amount
 
Range of Maturities
 
Weighted
Average
Interest Rate
 
June 30, 2022              
Single maturity fixed rate advances
 
$
10,000
 
July 2024
   
2.63
%
Putable advances
   
20,000
 
November 2024
   
1.81
%
   
$
30,000
           

Principal Terms
 
Advance
Amount
 
Range of Maturities
 
Weighted
Average
Interest Rate
 
December 31, 2021              
Single maturity fixed rate advances
 
$
30,000
 
May 2023 to July 2024
   
2.87
%
Putable advances
   
55,000
 
November 2024 to July 2031
   
0.74
%
   
$
85,000
           

Each advance is subject to a prepayment fee if paid prior to its maturity date. Fixed rate advances are payable at maturity. Amortizable mortgage advances are fixed rate advances with scheduled repayments based upon amortization to maturity. These advances were collateralized by residential and commercial real estate loans totaling $393.6 million and $361.9 million under a blanket lien arrangement at June 30, 2022 and December 31, 2021, respectively.
-33-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 7 - OTHER BORROWED FUNDS (Continued)

Scheduled repayments of FHLB advances as of June 30, 2022  were as follows (in thousands):

2022  
$
 
2023    
 
2024
   
30,000
 
2025
   
 
2026
   
 
Thereafter
   
 
   
$
30,000
 

On January 21, 2022, the FHLB exercised its option to put an advance totaling $25.0 million to the Company. This advance carried an interest rate of 0.01% and had a maturity date of July 21, 2031.  The Company paid off this advance as required on January 21, 2022. On January 21, 2022, the Company executed a new $25.0 million advance with the FHLB with similar terms.  This advance carried an interest rate of 0.05% and a maturity date of January 21, 2032. The first put date for this advance was April 21, 2022.  The FHLB exercised its put option on this advance and it was paid off by the Company as required on April 21, 2022. On May 27, 2022, the FHLB exercised its put option on a $10.0 million advance that carried an interest rate of 0.45% and the Company paid the advance off as required on May 27, 2022.  On May 27, 2022, the Company prepaid three other advances, totaling $20.0 million, with rates ranging from 2.91% to 3.05%, resulting in a prepayment penalty of $87,000, which is included in interest expense in the three months ended June 30, 2022.

Federal Reserve Bank borrowings

The Company has a financing arrangement with the Federal Reserve Bank. There were no borrowings outstanding at June 30, 2022 and December 31, 2021, and the Company had approximately $6.7 million and $4.0 million in unused borrowing capacity based on commercial and mortgage loans pledged to the Federal Reserve Bank totaling $7.2 million and $4.4 million at June 30, 2022 and December 31, 2021, respectively.


NOTE 8 - EARNINGS PER COMMON SHARE



A reconciliation of the numerators and denominators of basic and diluted earnings per common share for the three and six month periods ended June 30, 2022 and 2021 are as follows (dollars in thousands, except per share data):


   
Three Months
Ended
June 30,
2022
   
Three Months
Ended
June 30,
2021
   
Six Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2021
 
Net income available to common shares
 
$
6,568
   
$
7,818
   
$
12,568
   
$
15,596
 
Weighted average shares outstanding, including participating stock awards - Basic
   
34,253,846
     
34,193,016
     
34,254,306
     
34,194,264
 
Dilutive potential common shares:
                               
Stock options
   
     
     
     
 
Weighted average shares outstanding - Diluted
   
34,253,846
     
34,193,016
     
34,254,306
     
34,194,264
 
Basic earnings per common share
 
$
0.19
   
$
0.23
   
$
0.37
   
$
0.46
 
Diluted earnings per common share
 
$
0.19
   
$
0.23
   
$
0.37
   
$
0.46
 



There were no antidilutive shares of common stock in the three and six month periods ended June 30, 2022 and 2021.

-34-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 9 - FEDERAL INCOME TAXES



Income tax expense was as follows (dollars in thousands):


   
Three Months
Ended
June 30,
2022
   
Three Months
Ended
June 30,
2021
   
Six Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2021
 
Current
 
$
1,416
   
$
1,456
   
$
2,351
   
$
3,749
 
Deferred
   
77
     
384
   
533
     
(144
)
   
$
1,493
   
$
1,840
   
$
2,884
   
$
3,605
 



The difference between the financial statement tax expense and amount computed by applying the statutory federal tax rate to pretax income was reconciled as follows (dollars in thousands):


   
Three Months
Ended
June 30,
2022
   
Three Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2021
 
Statutory rate
   
21
%
   
21
%
   
21
%
   
21
%
Statutory rate applied to income before taxes
 
$
1,693
   
$
2,028
   
$
3,245
   
$
4,032
 
Deduct
                               
Tax-exempt interest income
   
(143
)
   
(156
)
   
(297
)
   
(315
)
Bank-owned life insurance
   
(49
)
   
(53
)
   
(99
)
   
(111
)
Other, net
   
(8
)
   
21
     
35
     
(1
)
   
$
1,493
   
$
1,840
   
$
2,884
   
$
3,605
 



The realization of deferred tax assets is largely dependent upon future taxable income, future reversals of existing taxable temporary differences and the ability to carryback losses to available tax years. In assessing the need for a valuation allowance, we consider positive and negative evidence, including taxable income in carry-back years, scheduled reversals of deferred tax liabilities, expected future taxable income and tax planning strategies. Management believes it is more likely than not that all of the deferred tax assets  at June 30, 2022 will be realized against deferred tax liabilities and projected future taxable income.



The net deferred tax asset recorded included the following amounts of deferred tax assets and liabilities (dollars in thousands):


   
June 30,
2022
   
December 31,
2021
 
Deferred tax assets
           
Allowance for loan losses
 
$
3,072
   
$
3,337
 
Net deferred loan fees
   
10
   

275
 
Nonaccrual loan interest
   
30
     
57
 
Valuation allowance on other real estate owned
   
6
     
6
 
Unrealized loss on securities available for sale and transferred to held to maturity
    4,965       79  
Other
   
340
     
311
 
Gross deferred tax assets
   
8,423
     
4,065
 
Valuation allowance
   
     
 
Total net deferred tax assets
   
8,423
     
4,065
 
Deferred tax liabilities
               
Depreciation
   
(1,163
)
   
(1,199
)
Prepaid expenses
   
(288
)
   
(288
)
Other
   
(456
)
   
(415
)
Gross deferred tax liabilities
   
(1,907
)
   
(1,902
)
Net deferred tax asset
 
$
6,516
   
$
2,163
 



There were no unrecognized tax benefits at June 30, 2022 or December 31, 2021 and the Company does not expect the total amount of unrecognized tax benefits to significantly increase or decrease in the next twelve months. The Company is no longer subject to examination by the Internal Revenue Service for years before 2018.

-35-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 10 – COMMITMENTS AND OFF BALANCE-SHEET RISK

Some financial instruments are used to meet customer financing needs and to reduce exposure to interest rate changes. These financial instruments include commitments to extend credit and standby letters of credit. These involve, to varying degrees, credit and interest rate risk in excess of the amount reported in the financial statements.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment, and generally have fixed expiration dates. Collateral or other security is normally not obtained for these financial instruments prior to their use and many of the commitments are expected to expire without being used.  Standby letters of credit are conditional commitments to guarantee a customer’s performance to a third party. Exposure to credit loss if the other party does not perform is represented by the contractual amount for commitments to extend credit and standby letters of credit.

A summary of the contractual amounts of financial instruments with off‑balance‑sheet risk was as follows at period-end (dollars in thousands):

   
June 30,
2022
   
December 31,
2021
 
Commitments to make loans
 
$
101,807
   
$
128,648
 
Letters of credit
   
14,404
     
10,141
 
Unused lines of credit
   
769,114
     
677,902
 

The notional amount of commitments to fund mortgage loans to be sold into the secondary market was approximately $321,000 and $1.3 million at June 30, 2022 and December 31, 2021, respectively.

The Bank enters into commitments to sell mortgage backed securities, which it later buys back in order to hedge its exposure to interest rate risk in its mortgage pipeline. These commitments were approximately $3.8 million and $9.5 million at June 30, 2022 and December 31, 2021, respectively.

At June 30, 2022, approximately 68.4% of the Bank’s commitments to make loans were at fixed rates, offered at current market rates. The remainder of the commitments to make loans were at variable rates tied to prime or one month term SOFR and generally expire within 30 days. The majority of the unused lines of credit were at variable rates tied to prime.

NOTE 11 – CONTINGENCIES

The Company and its subsidiaries periodically become defendants in certain claims and legal actions arising in the ordinary course of business. As of June 30, 2022, there were no material pending legal proceedings to which the Company or any of its subsidiaries are a party or which any of its properties are the subject.

NOTE 12 – SHAREHOLDERS’ EQUITY

Regulatory Capital

The Company and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements.

The prompt corrective action regulations provide five categories, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If a bank is only adequately capitalized, regulatory approval is required to, among other things, accept, renew or roll-over brokered deposits. If a bank is undercapitalized, capital distributions and growth and expansion are limited, and plans for capital restoration are required.

-36-

MACATAWA BANK CORPORATION
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 12 – SHAREHOLDERS’ EQUITY (Continued)

The regulatory capital requirements include a common equity Tier 1 capital to risk-weighted assets ratio (CET1 ratio) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, which effectively results in a minimum CET1 ratio of 7.0%. The minimum ratio of Tier 1 capital to risk-weighted assets is 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5%), which effectively results in a minimum total capital to risk-weighted assets ratio of 10.5% (with the capital conservation buffer). The minimum leverage ratio is 4.0%.

At June 30, 2022  and December 31, 2021, actual capital levels and minimum required levels were (dollars in thousands):

               
Minimum
Capital
   
Minimum Capital
Adequacy With
   
To Be Well
Capitalized Under
Prompt Corrective
 
   
Actual
   
Adequacy
   
Capital Buffer
   
Action Regulations
 
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
June 30, 2022                                                
CET1 capital (to risk weighted assets)
                                               
Consolidated
 
$
261,788
     
16.5
%
 
$
71,209
     
4.5
%
 
$
110,769
     
7.0
%
   
N/A
     
N/A
 
Bank
   
253,830
     
16.0
     
71,196
     
4.5
     
110,750
     
7.0
   
$
102,839
     
6.5
%
Tier 1 capital (to risk weighted assets)
                                                               
Consolidated
   
261,788
     
16.5
     
94,945
     
6.0
     
134,505
     
8.5
     
N/A
     
N/A
 
Bank
   
253,830
     
16.0
     
94,928
     
6.0
     
134,482
     
8.5
     
126,571
     
8.0
 
Total capital (to risk weighted assets)
                                                               
Consolidated
   
276,419
     
17.5
     
126,593
     
8.0
     
166,154
     
10.5
     
N/A
     
N/A
 
Bank
   
268,461
     
17.0
     
126,571
     
8.0
     
166,124
     
10.5
     
158,214
     
10.0
 
Tier 1 capital (to average assets)
                                                               
Consolidated
   
261,788
     
9.1
     
114,682
     
4.0
     
N/A
     
N/A
     
N/A
     
N/A
 
Bank
   
253,830
     
8.9
     
114,675
     
4.0
     
N/A
     
N/A
     
143,344
     
5.0
 
                                                                 
December 31, 2021                                                                
CET1 capital (to risk weighted assets)
                                                               
Consolidated
 
$
254,302
     
17.2
%
 
$
66,381
     
4.5
%
 
$
103,259
     
7.0
%
   
N/A
     
N/A
 
Bank
   
246,239
     
16.7
     
66,370
     
4.5
     
103,242
     
7.0
   
$
95,867
     
6.5
%
Tier 1 capital (to risk weighted assets)
                                                               
Consolidated
   
254,302
     
17.2
     
88,508
     
6.0
     
125,386
     
8.5
     
N/A
     
N/A
 
Bank
   
246,239
     
16.7
     
88,493
     
6.0
     
125,365
     
8.5
     
117,991
     
8.0
 
Total capital (to risk weighted assets)
                                                               
Consolidated
   
270,191
     
18.3
     
118,011
     
8.0
     
154,889
     
10.5
     
N/A
     
N/A
 
Bank
   
262,128
     
17.8
     
117,991
     
8.0
     
154,863
     
10.5
     
147,488
     
10.0
 
Tier 1 capital (to average assets)
                                                               
Consolidated
   
254,302
     
8.7
     
116,664
     
4.0
     
N/A
     
N/A
     
N/A
     
N/A
 
Bank
   
246,239
     
8.4
     
116,654
     
4.0
     
N/A
     
N/A
     
145,818
     
5.0
 

The Bank was categorized as “well capitalized” at June 30, 2022 and December 31, 2021.

-37-

Item 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Macatawa Bank Corporation is a Michigan corporation and a registered bank holding company. It wholly-owns Macatawa Bank.  Macatawa Bank is a Michigan chartered bank with depository accounts insured by the FDIC. The Bank operates twenty-six branch offices and a lending and operational service facility, providing a full range of commercial and consumer banking and trust services in Kent County, Ottawa County, and northern Allegan County, Michigan. For further information regarding consolidation, see the Notes to Consolidated Financial Statements.
 
At June 30, 2022, we had total assets of $2.78 billion, total loans of $1.11 billion, total deposits of $2.49 billion and shareholders' equity of $243.1 million.  For the three months ended June 30, 2022, we recognized net income of $6.6 million compared to $7.8 million for the same period in 2021. For the six months ended June 30, 2022, we recognized net income of $12.6 million compared to $15.6 million for the same period in 2021.  The Bank was categorized as “well capitalized” under regulatory capital standards at June 30, 2022.
 
We paid a dividend of $0.08 per share in each quarter in 2021 and in each of the first two quarters of 2022.
 
RESULTS OF OPERATIONS
 
Summary: Net income for the three months ended June 30, 2022 was $6.6 million, compared to $7.8 million for the same period in 2021.  Net income per share on a diluted basis for the three months ended June 30, 2022 was $0.19 compared to $0.23 for the same period in 2021.  Net income for the six months ended June 30, 2022 was $12.6 million compared to $15.6 million for the same period in 2021.  Net income per share on a diluted basis for the six months ended June 30, 2022 was $0.37 compared to $0.46 for the same period in 2021.
 
The decrease in earnings in the three and six months ended June 30, 2022 compared to the same periods in 2021 was due primarily to lower levels of net interest income from lower PPP fee amortization and interest and lower mortgage banking income, partially offset by larger provision for loan loss benefits in the six month period.  Net interest income increased to $14.8 million in the three months ended June 30, 2022 compared to $14.5 million in the same period in 2021.   Net interest income decreased to $27.5 million in the six months ended June 30, 2022 compared to $28.9 million in the same period in 2021.   While down for the first six months of 2022, net interest income increased in the three months ended June 30, 2022 as a result of our asset sensitive position and the 25 basis point increase to the federal funds rate in March 2022, the 50 basis point increase in May 2022 and the 75 basis point increase in June 2022.  We anticipate further improvement in net interest income as a result of these and future expected federal funds rate increases.  Net interest income also benefitted in the 2022 periods from growth in our investment portfolio, which was up $235.3 million since December 31, 2021.  Net gains on sales of mortgage loans decreased to $199,000 in the three months ended June 30, 2022 compared to $1.3 million in the same period in 2021.  Net gains on sales of mortgage loans decreased to $508,000 in the six months ended June 30, 2022 compared to $3.3 million in the same period in 2021.
 
The provision for loan losses was $0 for the three months ended June 30, 2022, compared to a benefit of  $750,000 for the same period in 2021.  We were in a net loan recovery position for the three months ended June 30, 2022, with $15,000 in net loan recoveries, compared to $104,000 in net loan recoveries in the same period in 2021.  The provision was a benefit of $1.5 million for the six months ended June 30, 2022 compared to a benefit of $750,000 for the same period in 2021.  We were also in a net loan recovery position for the six months ended June 30, 2022, with $242,000 in net recoveries compared to $148,000 in net recoveries in the same period in 2021.  The provision for loan losses in 2021 was also impacted by higher levels of qualitative environmental factors to address uncertainty and increased risk of loss attributable to the COVID-19 pandemic.  Several of these factors were reduced in the first six months of 2022, reflecting improvement in economic conditions and mitigating effects of the COVID-19 pandemic.
 
Net Interest Income: Net interest income totaled $14.8 million for the three months ended June 30, 2022 compared to $14.5 million for the same period in 2021.   Net interest income decreased to $27.5 million in the six months ended June 30, 2022 compared to $28.9 million in the six months ended June 30, 2021.  Net interest income for the three and six month periods ended June 30, 2022 benefitted from increases in the federal funds rate and growth in our investment securities portfolio.  The federal funds rate increased 25 basis points in March 2022, 50 basis points in May 2022 and 75 basis points in June 2022.

-38-

Net interest income for the second quarter of 2022 increased $386,000 compared to the same period in 2021.  Of this increase, $1.1 million was from changes in rates earned or paid, partially offset by a decrease of $758,000 from changes in the volume of average interest earning assets and interest bearing liabilities.  The largest changes occurred in interest income on our investment portfolio as we deployed some of our excess investable funds.  The net change in interest income for taxable securities was an increase of $1.8 million, with $1.7 million due to an increase in average balances and an increase of $92,000 due to rate. The net change in our federal funds sold and other short-term investments was an increase of $1.4 million, of which $1.5 million was due to an increase in rate, partially offset by a reduction of $41,000 due to a decrease in volume.  The net change in interest income for commercial loans (excluding PPP loans) was an increase of $46,000, of which an increase of $238,000 was due to portfolio growth, partially offset by a decrease of $192,000 due to rate.  PPP loans caused a reduction of $2.8 million in net interest income in the second quarter of 2022 primarily due to lower PPP fee recognition and significant principal forgiveness between the second quarter of 2021 and the second quarter of 2022.  Additionally, residential mortgage loan interest income decreased by $176,000 in the second quarter of 2022 compared to the same period in 2021.  Of the $176,000 decrease in interest income on residential mortgage loans, $120,000 was due to a decrease in average balances and $56,000 was due to lower loan rates.  Interest expense changes in the second quarter of 2022 were primarily volume related as very little change was made to interest rates paid on our deposit balances in response to changes in federal funds rates.

Net interest income for the six months ended June 30, 2022 decreased $1.4 million compared to the same period in 2021.  Of this decrease, $2.6 million was from changes in the volume of average interest earning assets and interest bearing liabilities partially offset by an increase of $1.2 million from changes in rates earned or paid.  The largest changes occurred in interest income on PPP loans which fluctuated significantly in the first six months of 2022 compared to the same period in 2021, and in our investment portfolio as we deployed some of our excess investable funds.  The net change in interest income for PPP loans was a decrease of $4.3 million in the first six months of 2022 as compared to the same period in 2021. The net change in interest income for commercial loans (excluding PPP loans) was a $1.1 million decrease with $859,000 due to rate and $203,000 due to portfolio contraction. The net change in interest income for taxable securities was an increase of $2.5 million due to an increase in average balances. Interest income from federal funds sold and other short-term investments increased by $1.8 million in the first six months of 2022 compared to the same period in 2021 due to the 25 basis point increase in the federal funds rate in March 2022, the 50 basis point increase in May 2022 and the 75 basis point increase in June 2022.  This caused a $1.7 million increase in interest income, along with the positive impact of increases in average balances of federal funds sold and other short-term investments in the first six months of 2022, which  added $49,000 .  Of the $560,000 decrease in interest income on residential mortgage loans, $402,000 was due to a decrease in average balances resulting from a high volume of originations of refinanced loans which are sold versus retained in portfolio and $158,000 was due to lower loan rates.
 
As we are in an asset-sensitive position, increases in market interest rates have a positive impact on margin as our interest earning assets reprice faster than our interest-bearing liabilities. Much of our asset-sensitivity is due to commercial and consumer loans that have variable interest rates.  For both loan types we established floor rates several years ago.  These floors provide protection to net interest income when short-term interest rates decline.  This asset sensitivity, however, will serve to enhance net interest income as the Federal Reserve has begun raising short-term interest rates.  The Federal Reserve's first rate increase since 2018 of 25 basis points in March 2022 was too late in the quarter to have a meaningful impact on our first quarter 2022 interest income but did positively affect our second quarter 2022 interest income, along with the Federal Reserve's 50 basis point increase in May 2022.  The 75 basis point increase in June 2022 along with the earlier increases will positively affect third quarter interest income.

-39-

The cost of funds decreased to 0.14% in the second quarter of 2022 compared to 0.17% in the second quarter of 2021.  For the first six months of 2022, the cost of funds decreased to 0.12% compared to 0.18% for the same period in 2021.  Decreases in the rates paid on our time deposits in response to the low rate environment over the past couple of years along with the impact of our redemption of the remaining trust preferred securities in the third quarter of 2021 and prepayment of certain Federal Home Loan Bank ("FHLB") advances caused the decrease in our cost of funds.

The following table shows an analysis of net interest margin for the three month periods ended June 30, 2022 and 2021 (dollars in thousands):

   
For the three months ended June 30,
 
   
2022
   
2021
 
   
Average
Balance
   
Interest
Earned
or Paid
   
Average
Yield
or Cost
   
Average
Balance
   
Interest
Earned
or Paid
   
Average
Yield
or Cost
 
Assets
                                   
Taxable securities
 
$
587,263
   
$
2,618
     
1.78
%
 
$
196,479
   
$
792
     
1.61
%
Tax-exempt securities (1)
   
164,148
     
702
     
2.20
     
139,771
     
760
     
2.80
 
Commercial loans (2)
   
922,796
     
8,587
     
3.72
     
890,750
     
8,541
     
3.79
 
PPP loans (3)
   
5,037
     
199
     
15.80
     
248,042
     
3,034
     
4.84
 
Residential mortgage loans
   
120,838
     
988
     
3.27
     
135,329
     
1,164
     
3.43
 
Consumer loans
   
55,876
     
570
     
4.09
     
55,449
     
564
     
4.08
 
Federal Home Loan Bank stock
   
10,211
     
51
     
1.97
     
11,558
     
56
     
1.93
 
Federal funds sold and other short-term investments
   
858,545
     
1,720
     
0.79
     
992,484
     
273
     
0.11
 
Total interest earning assets (1)
   
2,724,714
     
15,435
     
2.28
     
2,669,862
     
15,184
     
2.29
 
Noninterest earning assets:
                                               
Cash and due from banks
   
35,869
                     
34,276
                 
Other
   
86,798
                     
105,349
                 
Total assets
 
$
2,847,381
                   
$
2,809,487
                 
Liabilities
                                               
Deposits:
                                               
Interest bearing demand
 
$
679,168
   
$
54
     
0.03
%
 
$
658,842
   
$
39
     
0.02
%
Savings and money market accounts
   
871,875
     
146
     
0.07
     
819,030
     
62
     
0.03
 
Time deposits
   
88,341
     
45
     
0.20
     
102,967
     
143
     
0.56
 
Borrowings:
                                               
Other borrowed funds
   
54,305
     
347
     
2.53
     
62,198
     
328
     
2.09
 
Long-term debt
   
     
     
     
20,619
     
155
     
2.97
 
Total interest bearing liabilities
   
1,693,689
     
592
     
0.14
     
1,663,656
     
727
     
0.17
 
Noninterest bearing liabilities:
                                               
Noninterest bearing demand accounts
   
897,727
                     
887,559
                 
Other noninterest bearing liabilities
   
12,613
                     
13,756
                 
Shareholders' equity
   
243,352
                     
244,516
                 
Total liabilities and shareholders' equity
 
$
2,847,381
                   
$
2,809,487
                 
Net interest income
         
$
14,843
                   
$
14,457
         
Net interest spread (1)
                   
2.14
%
                   
2.12
%
Net interest margin (1)
                   
2.19
%
                   
2.19
%
Ratio of average interest earning assets to average interest bearing liabilities
   
160.87
%
                   
160.48
%
               

(1)
Yields are presented on a tax equivalent basis using an assumed tax rate of 21% at June 30, 2022 and 2021.
(2)
Includes loan fees of $158,000 and $356,000 for the three months ended June 30, 2022 and 2021, respectively.  Includes average nonaccrual loans of approximately $90,000 and $463,000 for the three months ended June 30, 2022 and 2021, respectively.  Excludes PPP loans.
(3)
Includes loan fees of $187,000 and $2.4 million for the three months ended June 30, 2022 and 2021, respectively.

-40-

The following table shows an analysis of net interest margin for the six month periods ended June 30, 2022 and 2021 (dollars in thousands):

   
For the six months ended June 30,
 
   
2022
   
2021
 
   
Average
Balance
   
Interest
Earned
or Paid
   
Average
Yield
or Cost
   
Average
Balance
   
Interest
Earned
or Paid
   
Average
Yield
or Cost
 
Assets
                                   
Taxable securities
 
$
495,627
   
$
4,053
     
1.64
%
 
$
193,267
   
$
1,579
     
1.63
%
Tax-exempt securities (1)
   
166,981
     
1,433
     
2.21
     
131,949
     
1,518
     
2.97
 
Commercial loans (2)
   
912,628
     
16,475
     
3.59
     
923,392
     
17,537
     
3.78
 
PPP loans (3)
   
12,658
     
1,251
     
19.66
     
244,314
     
5,586
     
4.55
 
Residential mortgage loans
   
118,682
     
1,926
     
3.24
     
142,972
     
2,486
     
3.48
 
Consumer loans
   
54,991
     
1,089
     
3.99
     
57,279
     
1,161
     
4.09
 
Federal Home Loan Bank stock
   
10,613
     
102
     
1.90
     
11,558
     
117
     
2.01
 
Federal funds sold and other short-term investments
   
984,183
     
2,249
     
0.45
     
899,217
     
474
     
0.11
 
Total interest earning assets (1)
   
2,756,363
     
28,578
     
2.10
     
2,603,948
     
30,458
     
2.37
 
Noninterest earning assets:
                                               
Cash and due from banks
   
34,196
                     
32,725
                 
Other
   
91,669
                     
101,866
                 
Total assets
 
$
2,882,228
                   
$
2,738,539
                 
Liabilities
                                               
Deposits:
                                               
Interest bearing demand
 
$
692,943
   
$
94
     
0.03
%
 
$
642,842
   
$
73
     
0.02
%
Savings and money market accounts
   
883,362
     
211
     
0.05
     
808,370
     
123
     
0.03
 
Time deposits
   
90,281
     
98
     
0.22
     
105,283
     
327
     
0.63
 
Borrowings:
                                               
Other borrowed funds
   
69,569
     
667
     
1.91
     
66,077
     
681
     
2.05
 
Long-term debt
   
     
     
     
20,619
     
307
     
2.96
 
Total interest bearing liabilities
   
1,736,155
     
1,070
     
0.12
     
1,643,191
     
1,511
     
0.18
 
Noninterest bearing liabilities:
                                               
Noninterest bearing demand accounts
   
886,537
                     
838,618
                 
Other noninterest bearing liabilities
   
12,083
                     
13,951
                 
Shareholders' equity
   
247,453
                     
242,779
                 
Total liabilities and shareholders' equity
 
$
2,882,228
                   
$
2,738,539
                 
Net interest income
         
$
27,508
                   
$
28,947
         
Net interest spread (1)
                   
1.98
%
                   
2.19
%
Net interest margin (1)
                   
2.02
%
                   
2.25
%
Ratio of average interest earning assets to average
interest bearing liabilities
   
158.76
%
                   
158.47
%
               

(1)
Yields are presented on a tax equivalent basis using an assumed tax rate of 21% at June 30, 2022 and 2021.
(2)
Includes loan fees of $257,000 and $525,000 for the six months ended June 30, 2022 and 2021, respectively.  Includes average nonaccrual loans of approximately $90,000 and $496,000 for the six months ended June 30, 2022 and 2021, respectively.  Excludes PPP loans.
(3)
Includes loan fees of $1.2 and $4.4 million for the six months ended June 30, 2022 and 2021, respectively.

-41-

The following table presents the dollar amount of changes in net interest income due to changes in volume and rate (dollars in thousands):

   
For the three months ended June 30,
2022 vs 2021
Increase (Decrease) Due to
   
For the six months ended June 30,
2022 vs 2021
Increase (Decrease) Due to
 
   
Volume
   
Rate
   
Total
   
Volume
   
Rate
   
Total
 
                                     
Interest income
                                   
Taxable securities
 
$
1,734
   
$
92
   
$
1,826
   
$
2,473
   
$
1
   
$
2,474
 
Tax-exempt securities
   
161
     
(219
)
   
(58
)
   
462
     
(547
)
   
(85
)
Commercial loans, excluding PPP loans
   
238
     
(192
)
   
46
     
(203
)
   
(859
)
   
(1,062
)
PPP loans
   
(2,940
)
   
105
     
(2,835
)
   
(5,267
)
   
932
     
(4,335
)
Residential mortgage loans
   
(120
)
   
(56
)
   
(176
)
   
(402
)
   
(158
)
   
(560
)
Consumer loans
   
4
     
2
     
6
     
(46
)
   
(26
)
   
(72
)
Federal Home Loan Bank stock
   
(6
)
   
1
     
(5
)
   
(9
)
   
(6
)
   
(15
)
Federal funds sold and other short-term investments
   
(41
)
   
1,488
     
1,447
     
49
     
1,726
     
1,775
 
Total interest income
   
(970
)
   
1,221
     
251
     
(2,943
)
   
1,063
     
(1,880
)
Interest expense
                                               
Interest bearing demand
 
$
1
   
$
14
   
$
15
   
$
6
   
$
15
     
21
 
Savings and money market accounts
   
4
     
80
     
84
     
12
     
76
     
88
 
Time deposits
   
(18
)
   
(80
)
   
(98
)
   
(41
)
   
(188
)
   
(229
)
Other borrowed funds
   
(44
)
   
63
     
19
     
35
     
(49
)
   
(14
)
Long-term debt
   
(155
)
   
     
(155
)
   
(307
)
   
     
(307
)
Total interest expense
   
(212
)
   
77
     
(135
)
   
(295
)
   
(146
)
   
(441
)
Net interest income
 
$
(758
)
 
$
1,144
   
$
386
   
$
(2,648
)
 
$
1,209
   
$
(1,439
)

Provision for Loan Losses: The provision for loan losses for the three months ended June 30, 2022 was $0 compared to a benefit of $750,000 for the same period in 2021.  The provision for loan losses for the first half of 2022 was a benefit of $1.5 million compared to a benefit of $750,000 for the same period in 2021.  Net loan recoveries were $15,000 in the three months ended June 30, 2022 compared to net loan recoveries of $104,000 in the same period in 2021.  Net loan recoveries were $242,000 in the six months ended June 30, 2022 compared to $148,000 in the same period in 2021.
 
Gross loan recoveries were $75,000 for the three months ended June 30, 2022 and $134,000 for the same period in 2021.  In the three months ended June 30, 2022, we had $60,000 in gross loan charge-offs, compared to $30,000 in the same period in 2021.  For the six months ended June 30, 2022, we experienced gross loan recoveries of $337,000 compared to $228,000 for the same period in 2021.  Gross loan charge-offs for the six months ended June 30, 2022 were $95,000 compared to $80,000 for the same period in 2021.
 
The amounts of loan loss provision in each period were the result of establishing our allowance for loan losses at levels believed necessary based upon our methodology for determining the adequacy of the allowance.  The provision for loan losses for the three and six month periods ended June 30, 2022 was impacted by net reductions to certain qualitative factors.  More information about our allowance for loan losses and our methodology for establishing its level may be found under the heading "Allowance for Loan Losses" below.
 
Noninterest Income: Noninterest income for the three and six month periods ended June 30, 2022 was $5.1 million and $10.1 million compared to $6.2 million and $12.7 million for the same periods in 2021, respectively.   The components of noninterest income are shown in the table below (in thousands):

   
Three Months
Ended
June 30,
2022
   
Three Months
Ended
June 30,
2021
   
Six Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2021
 
Service charges and fees on deposit accounts
 
$
1,218
   
$
1,065
   
$
2,430
   
$
2,057
 
Net gains on mortgage loans
   
199
     
1,311
     
508
     
3,326
 
Trust fees
   
1,096
     
1,133
     
2,184
     
2,138
 
ATM and debit card fees
   
1,762
     
1,683
     
3,360
     
3,168
 
Bank owned life insurance (“BOLI”) income
   
230
     
250
     
470
     
526
 
Investment services fees
   
345
     
339
     
658
     
816
 
Other income
   
281
     
388
     
486
     
676
 
Total noninterest income
 
$
5,131
   
$
6,169
   
$
10,096
   
$
12,707
 

-42-

Net gains on mortgage loans were down $1.1 million in the three months ended June 30, 2022  and were down $2.8 million in the six months ended June 30, 2022 compared to the same periods in 2021 as a result of changes in the volume of loans originated for sale.  In the previous two years volumes had been high due to a lower interest rate environment, spurring more refinancing of fixed rate loans which we sell into the secondary market.  Mortgage rates increased in the latter part of 2021 and the first half of 2022, causing a reduction in mortgage volume, and a shift to variable rate products, which we place in portfolio rather than sell.  Mortgage loans originated for sale in the three months ended June 30, 2022 were $8.4 million, compared to $39.2 million in the same period in 2021.  For the first six months of 2022, mortgage loans originated for sale were $18.5 million, compared to $86.5 million for the same period in 2021.
 
Trust fees were down $37,000 in the three months ended June 30, 2022 and were up $46,000 in the six months ended June 30, 2022 compared to the same periods in 2021. The changes for the three and six months ended June 30, 2022 were largely due to fluctuations in market valuations of trust assets resulting from overall stock market conditions.  ATM and debit card fees were up in the three and six months ended June 30, 2022 as compared to the same periods in 2021 due to higher volume of usage by our customers.  These volumes and resulting income have returned to more normal levels in the 2022 period following the COVID-19 related economic slowdown.  Service charges on deposit accounts increased in the three and six month periods ended June 30, 2022 as compared to the same periods in 2021 as customers returned to more normal behaviors in 2022 after having curtailed spending in 2021 due to uncertainty related to the COVID-19 pandemic.
 
Noninterest Expense: Noninterest expense increased by $195,000 to $11.9 million for the three month period ended June 30, 2022 as compared to $11.7 million in the same period in 2021.  Noninterest expense increased by $449,000 to $23.7 million for the six month period ended June 30, 2022 compared to $23.2 million for the same period in 2021.  The components of noninterest expense are shown in the table below (in thousands):

   
Three Months
Ended
June 30,
2022
   
Three Months
Ended
June 30,
2021
   
Six Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2021
 
Salaries and benefits
 
$
6,402
   
$
6,502
   
$
12,691
   
$
12,914
 
Occupancy of premises
   
1,071
     
994
     
2,243
     
2,031
 
Furniture and equipment
   
988
     
978
     
2,004
     
1,915
 
Legal and professional
   
271
     
274
     
465
     
496
 
Marketing and promotion
   
195
     
175
     
390
     
350
 
Data processing
   
924
     
855
     
1,808
     
1,762
 
FDIC assessment
   
197
     
159
     
377
     
329
 
Interchange and other card expense
   
406
     
388
     
779
     
746
 
Bond and D&O insurance
   
129
     
111
     
259
     
222
 
Outside services
   
520
     
491
     
1,014
     
925
 
Other noninterest expense
   
810
     
791
     
1,622
     
1,513
 
Total noninterest expense
 
$
11,913
   
$
11,718
   
$
23,652
   
$
23,203
 

Most categories of noninterest expense were relatively unchanged compared to the three and six months ended June 30, 2021 due to our ongoing efforts to manage expenses and scale our operations. Our largest component of noninterest expense, salaries and benefits, decreased by $100,000 in the three months ended June 30, 2022 from the same period in 2021. This decrease is primarily due to higher annual merit and inflationary increases and higher 401k matching contributions being more than offset by a decrease in variable-based compensation due to lower mortgage origination volume.  Salaries and benefits decreased by $223,000 for the six months ended June 30, 2022 compared to the same period in 2021 due to the same combination of factors.  The table below identifies the primary components of salaries and benefits (in thousands):
 
   
Three Months
Ended
June 30,
2022
   
Three Months
Ended
June 30,
2021
   
Six Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2021
 
Salaries and other compensation
 
$
5,772
     
5,683
   
$
11,398
     
11,467
 
Salary deferral from commercial loan originations
   
(219
)
   
(269
)
   
(433
)
   
(621
)
Bonus accrual
   
220
     
217
     
442
     
399
 
Mortgage production - variable comp
   
141
     
381
     
285
     
715
 
401k matching contributions
   
188
     
127
     
399
     
229
 
Medical insurance costs
   
300
     
363
     
600
     
725
 
Total salaries and benefits
 
$
6,402
   
$
6,502
   
$
12,691
   
$
12,914
 
 
-43-

Occupancy expenses were up $77,000 in the three months ended June 30, 2022 and were up $212,000 in the six month period ended June 30, 2022 compared to the same periods in 2021 due to fluctuations in maintenance costs incurred.  Furniture and equipment expenses were up $10,000 in the three months ended June 30, 2022 and were up $89,000 in the six months ended June 30, 2022 compared to the same periods in 2021 due to costs associated with equipment and service contracts primarily to improve information security.
 
Data processing costs were up $69,000 and $46,000 in the three and six month periods ended June 30, 2022, respectively, compared to the same periods in 2021 due to higher usage of electronic banking services and debit cards by our customers.
 
Interchange and other card expenses were up $18,000 and $33,000 in the three and six month periods ended June 30, 2022, respectively, compared to the same periods in 2021 due to a higher number of debit cards issued and higher usage by our deposit customers.   The increase in expense correlates to the increase in our debit card interchange income in these periods.
 
Outside services were up $29,000 and $89,000 in the three and six month periods ended June 30, 2022, respectively, compared to the same periods in 2021 due to increased vendor costs and consultation related to efficiency in certain departments.
 
Federal Income Tax Expense: We recorded $1.5 million and $2.9 million in federal income tax expense for the three and six month periods ended June 30, 2022 compared to $1.8 million and $3.6 million for the same periods in 2021.  Our effective tax rates for the three and six months period ended June 30, 2022 were 18.52%  and 18.66% compared to 19.05%  and 18.78% for the same periods in 2021.
 
FINANCIAL CONDITION
 
Total assets were $2.78 billion at June 30, 2022, a decrease of $147.5 million from December 31, 2021. This change reflected increases of $19.6 million in debt securities available for sale, $215.7 million in debt securities held to maturity, $2.9 million in our loan portfolio, $988,000 in other assets and $495,000 in bank-owned life insurance, more than offset by a decrease of $391.6 million in cash and cash equivalents and $1.3 million in FHLB stock. Total deposits decreased by $83.4 million at June 30, 2022 compared to December 31, 2021 and FHLB borrowings decreased by $55.0 million from December 31, 2021 to June 30, 2022.
 
Cash and Cash Equivalents: Our cash and cash equivalents, which include federal funds sold and short-term investments, were $760.2 million at June 30, 2022 compared to $1.15 billion at December 31, 2021.  The decrease in these balances primarily related to an increase in our investment portfolio and decreases in deposit balances and other borrowings.
 
Securities: Debt securities available for sale were $435.6 million at June 30, 2022 compared to $416.1 million at December 31, 2021. The balance at June 30, 2022 primarily consisted of U.S. agency securities, agency mortgage backed securities and various municipal investments. Our held to maturity portfolio was $352.7 million at June 30, 2022 compared to $137.0 million at December 31, 2021.  Our held to maturity portfolio is comprised of U.S. Treasury securities and state, municipal and privately placed commercial bonds.

On January 1, 2022, we reclassified ten U.S. Treasury securities with an amortized cost of $123.5 million from available for sale to held to maturity, as we have the intent and ability to hold these securities to maturity.  All ten of these U.S. Treasury securities were purchased within the fourth quarter of 2021.  Subsequently and upon further analysis of these purchases, management decided to reclassify them to held to maturity given their short-term nature.  These securities had net unrealized gains of $113,000 at the date of transfer, which will continue to be reported in accumulated comprehensive income, and will be amortized over the remaining life of the securities as an adjustment of yield.  The effect on interest income of the amortization of net unrealized gains is offset by the amortization of the premium on the securities transferred. Total securities increased $235.3 million from $553.1 million at December 31, 2021 to $788.3 million at June 30, 2022 as we continued to deploy excess liquidity into higher yielding assets. We plan further growth of our investment portfolio in the third quarter of 2022.

We classify privately placed municipal and commercial bonds as held to maturity as they are typically non-transferable in the bond market.  In addition, going forward we will generally classify short-term U.S. Treasury securities as held to maturity.  Typically the final maturity on these short-term Treasury securities will be three years or less.  Longer-term Treasury securities and all other marketable debt securities are generally classified as available for sale.
 
Portfolio Loans and Asset Quality: Total portfolio loans increased by $2.9 million in the first six months of 2022 and were $1.11 billion at June 30, 2022 compared to $1.11 billion at December 31, 2021. During the first six months of 2022, our commercial portfolio decreased by $6.7 million.  We received forgiveness proceeds on 217 PPP loans totaling $40.3 million in the six months ended June 30, 2022.  Excluding the PPP loans, our commercial loans increased by $33.6 million in the first six months of 2022.  Our consumer portfolio increased by $1.6 million  and our residential mortgage portfolio increased by $8.0 million in the first six months of 2022.

-44-

Mortgage loans originated for portfolio are typically adjustable rate loans as well as fixed rate loans that conform to secondary market requirements and have a term of fifteen years or less.  Mortgage loans originated for portfolio in the first six months of 2022 increased $6.8 million compared to the same period in 2021, from $23.8 million in the first six months of 2021 to $30.7 million in the same period in 2022.
 
The volume of residential mortgage loans originated for sale in the first six months of 2022 decreased $68.0 million compared to the same period in 2021. Residential mortgage loans originated for sale were $18.5 million in the first six months of 2022 compared to $86.5 million in the first six months of 2021.
 
The following table shows our loan origination activity for loans to be held in portfolio during the first six months of 2022 and 2021, broken out by loan type and also shows average originated loan size (dollars in thousands):

   
Six months ended June 30, 2022
   
Six months ended June 30, 2021
 
   
Portfolio
Originations
   
Percent of
Total
Originations
   
Average
Loan Size
   
Portfolio
Originations
   
Percent of
Total
Originations
   
Average
Loan Size
 
Commercial real estate:
                                   
Residential developed
 
$
5,126
     
1.9
%
 
$
641
   
$
6,187
     
2.0
%
   
562
 
Unsecured to residential developers
   
     
     
     
     
     
 
Vacant and unimproved
   
9,262
     
3.5
     
1,323
     
6,301
     
2.0
     
788
 
Commercial development
   
     
     
     
     
     
 
Residential improved
   
39,227
     
14.7
     
665
     
51,854
     
16.6
     
535
 
Commercial improved
   
32,168
     
12.0
     
1,340
     
25,792
     
8.3
     
955
 
Manufacturing and
industrial
   
49,246
     
18.5
     
2,736
     
11,565
     
3.7
     
964
 
Total commercial real estate
   
135,029
     
50.6
     
1,164
     
101,699
     
32.5
     
656
 
Commercial and industrial, excluding PPP
   
68,250
     
25.6
     
644
     
30,203
     
9.7
     
408
 
PPP loans
   
     
     
     
128,420
     
41.1
     
128
 
Total commercial and commercial real estate
   
203,279
     
76.2
     
915
     
260,322
     
83.3
     
211
 
Consumer
                                               
Residential mortgage
   
30,690
     
11.5
     
320
     
23,844
     
7.6
     
346
 
Unsecured
   
     
     
     
     
     
 
Home equity
   
31,428
     
11.8
     
133
     
27,353
     
8.8
     
120
 
Other secured
   
1,306
     
0.5
     
57
     
1,024
     
0.3
     
26
 
Total consumer
   
63,424
     
23.8
     
178
     
52,221
     
16.7
     
155
 
Total loans
 
$
266,703
     
100.0
%
 
$
461
   
$
312,543
     
100.0
%
   
199
 

The following table shows a breakout of our commercial loan activity during the first six months of 2022 and 2021 (dollars in thousands):

   
Six Months
Ended
June 30,
2022
   
Six Months
Ended
June 30,
2021
 
Commercial loans originated
 
$
203,279
   
$
260,322
 
Repayments of commercial loans
   
(129,407
)
   
(345,088
)
Change in undistributed - available credit
   
(80,548
)
   
(73,418
)
Net increase (decrease) in total commercial loans
 
$
(6,676
)
 
$
(158,184
)

Overall, the commercial loan portfolio decreased $6.7 million in the first six months of 2022 reflecting forgiveness of PPP loans of $39.1 million in that time period.  Excluding PPP forgiveness, commercial loans grew by $32.5 million in the first six months of 2022.  Our commercial and industrial portfolio decreased by $9.7 million while our commercial real estate loans increased by $3.0 million.  Included in the commercial production for the first six months of 2021 is $128.4 million in PPP loans, while there were no such loans originated in the first six months of 2022.  Our overall production of commercial loans decreased by $57.0 million from $260.3 million in the first six months of 2021 to $203.3 million in the same period of 2022 mostly due to the significantly lower production of PPP loans (down $128.4 million).  Excluding PPP production, our commercial loan originations in the first six months of 2022 were $71.4 million higher than in the first six months of 2021.  This growth came largely from commercial and industrial originations which were up $38.0 million.  Commercial real estate originations were up $33.3 million in the first six months of 2022, primarily in the manufacturing and industrial category, which were up $37.7 million, and commercial improved, which were up $6.4 million, as these businesses expand following the pandemic slowdown.

-45-

Commercial and commercial real estate loans remained our largest loan segment and accounted for approximately 83.6% and 84.4% of the total loan portfolio at June 30, 2022 and December 31, 2021, respectively. Residential mortgage and consumer loans comprised approximately 16.3% and 15.6% of total loans at June 30, 2022 and December 31, 2021, respectively.
 
A further breakdown of the composition of the loan portfolio is shown in the table below (in thousands):

   
June 30, 2022
   
December 31, 2021
 
   
Balance
   
Percent of
Total Loans
   
Balance
   
Percent of
Total Loans
 
Commercial real estate: (1)
                       
Residential developed
 
$
4,094
     
0.4
%
 
$
4,862
     
0.4
%
Unsecured to residential developers
   
     
     
5,000
     
 
Vacant and unimproved
   
35,912
     
3.2
     
36,240
     
3.3
 
Commercial development
   
112
     
     
171
     
 
Residential improved
   
102,885
     
9.2
     
100,077
     
9.0
 
Commercial improved
   
258,676
     
23.3
     
259,039
     
23.4
 
Manufacturing and industrial
   
117,424
     
10.6
     
110,712
     
10.0
 
Total commercial real estate
   
519,103
     
46.7
     
516,101
     
46.5
 
Commercial and industrial, excluding PPP
   
407,788
     
36.7
     
378,318
     
34.1
 
PPP loans
   
2,791
     
0.2
     
41,939
     
3.8
 
Total commercial and commercial real estate
   
929,682
     
83.6
     
936,358
     
84.4
 
Consumer
                               
Residential mortgage
   
125,771
     
11.3
     
117,800
     
10.7
 
Unsecured
   
168
     
     
210
     
 
Home equity
   
52,671
     
4.7
     
51,269
     
4.6
 
Other secured
   
3,623
     
0.3
     
3,356
     
0.3
 
Total consumer
   
182,233
     
16.3
     
172,635
     
15.6
 
Total loans
 
$
1,111,915
     
100.0
%
 
$
1,108,993
     
100.0
%


(1)
Includes both owner occupied and non-owner occupied commercial real estate.
 
Commercial real estate loans accounted for 46.7% and 46.5% of the total loan portfolio at June 30, 2022 and December 31, 2021, respectively, and consisted primarily of loans to business owners and developers of owner and non-owner occupied commercial properties and loans to developers of single and multi-family residential properties. In the table above, we show our commercial real estate portfolio by loans secured by residential and commercial real estate, and by stage of development. Improved loans are generally secured by properties that are under construction or completed and placed in use. Development loans are secured by properties that are in the process of development or fully developed. Vacant and unimproved loans are secured by raw land for which development has not yet begun and agricultural land.

The Bank was a participating lender in the Small Business Administration's (“SBA”) Paycheck Protection Program (“PPP”). PPP loans are forgivable, in whole or in part, if the proceeds are used for payroll and other permitted purposes in accordance with the requirements of the PPP. These loans carry a fixed rate of 1.00% and a term of two years (loans made before June 5, 2020) or five years (loans made on or after June 5, 2020), if not forgiven, in whole or in part. Payments are deferred until either the date on which the SBA remits the amount of forgiveness proceeds to the lender or the date that is 10 months after the last day of the covered period if the borrower does not apply for forgiveness within that 10 month period. Fees generated based on the origination of PPP loans are deferred and amortized into interest income over the contractual period of 24 months or 60 months, as applicable. Upon SBA forgiveness, unamortized fees are then recognized into interest income.

In 2020:

The Bank originated 1,738 PPP loans totaling $346.7 million in principal.

Fees generated totaled $10.0 million.

765 PPP loans totaling $113.5 million were forgiven.

Total net fees of $5.4 million were recognized.

-46-

In 2021:

The Bank originated 1,000 PPP loans totaling $128.1 million in principal.

Fees generated totaled $5.6 million.

1,722 PPP loans totaling $318.4 million were forgiven.

Total net fees of $8.3 million were recognized.

In the six months ended June 30, 2022:

217 PPP loans totaling $40.3 million were forgiven.

Total net fees of $1.2 million were recognized.

As of June 30, 2022, 21 PPP loans totaling $2.8 million in principal remained outstanding and total net fees of $94,000 remained unrecognized.
 
Our consumer residential mortgage loan portfolio, which also includes residential construction loans made to individual homeowners, comprised 11.3% of portfolio loans at June 30, 2022 and 10.7% at December 31, 2021.  We expect to continue to retain in our loan portfolio certain types of residential mortgage loans (primarily high quality, low loan-to-value adjustable rate loans) in an effort to continue to diversify our credit risk and deploy our excess liquidity.
 
Our portfolio of other consumer loans includes loans secured by personal property and home equity fixed term and line of credit loans. This portfolio increased by $1.6 million to $56.5 million at June 30, 2022 from $54.8 million at December 31, 2021.  These other consumer loans comprised 5.0% of our portfolio loans at June 30, 2022 and 4.9% at December 31, 2021.
 
Our loan portfolio is reviewed regularly by our senior management, our loan officers, and an internal loan review team that is independent of our loan originators and credit administration. An administrative loan committee consisting of senior management and seasoned lending and collections personnel meets quarterly to manage our internal watch list and proactively manage high risk loans.
 
When reasonable doubt exists concerning collectability of interest or principal of one of our loans, the loan is placed in nonaccrual status. Any interest previously accrued but not collected is reversed and charged against current earnings.
 
Nonperforming assets are comprised of nonperforming loans, foreclosed assets and repossessed assets. At June 30, 2022, nonperforming assets totaled $2.4 million, unchanged from $2.4 million at December 31, 2021. There were no additions to other real estate owned in the first six months of 2022 or in the first six months of 2021.  At June 30, 2022, there were no loans in foreclosure, so we expect there to be few, if any, additions to other real estate owned in the remainder of 2022.  Proceeds from sales of foreclosed properties were $0 in the first six months of 2022, resulting in net realized loss on sales of $0.  Proceeds from sales of foreclosed properties were $170,000 in the first six months of 2021, resulting in net realized loss on sales of $20,000.
 
Nonperforming loans include loans on nonaccrual status and loans delinquent more than 90 days but still accruing.  Nonperforming loans at June 30, 2022 consisted of $5,000 of commercial real estate loans and $85,000 of consumer and residential mortgage loans.  As of June 30, 2022, nonperforming loans totaled $90,000, or 0.01% of total portfolio loans, compared to $92,000, or 0.01% of total portfolio loans, at December 31, 2021.
 
Foreclosed and repossessed assets include assets acquired in settlement of loans. Foreclosed assets totaled $2.3 million at June 30, 2022 and $2.3 million at December 31, 2021. The entire balance at June 30, 2022 was comprised of one commercial real estate property. All properties acquired through or in lieu of foreclosure are initially transferred at their fair value less estimated costs to sell and then evaluated monthly for impairment after transfer using a lower of cost or market approach. Updated property valuations are obtained at least annually on all foreclosed assets.

The following table shows the composition and amount of our nonperforming assets (dollars in thousands):

   
June 30,
2022
   
December 31,
2021
 
Nonaccrual loans
 
$
90
   
$
91
 
Loans 90 days or more delinquent and still accruing
   
     
1
 
Total nonperforming loans (NPLs)
   
90
     
92
 
Foreclosed assets
   
2,343
     
2,343
 
Repossessed assets
   
     
 
Total nonperforming assets (NPAs)
 
$
2,433
   
$
2,435
 
NPLs to total loans
   
0.01
%
   
0.01
%
NPAs to total assets
   
0.09
%
   
0.08
%

-47-

The following table shows the composition and amount of our troubled debt restructurings (TDRs) at June 30, 2022 and December 31, 2021 (dollars in thousands):

   
June 30, 2022
   
December 31, 2021
 
   
Commercial
   
Consumer
   
Total
   
Commercial
   
Consumer
   
Total
 
Performing TDRs
 
$
1,409
   
$
2,840
   
$
4,249
   
$
4,497
   
$
3,024
   
$
7,521
 
Nonperforming TDRs (1)
   
5
     
     
5
     
5
     
     
5
 
Total TDRs
 
$
1,414
   
$
2,840
   
$
4,254
   
$
4,502
   
$
3,024
   
$
7,526
 

(1)
Included in nonperforming asset table above
 
We had a total of $4.3 million and $7.5 million of loans whose terms have been modified in TDRs as of June 30, 2022 and December 31, 2021, respectively.  These loans may have involved the restructuring of terms to allow customers to mitigate the risk of foreclosure by meeting a lower loan payment requirement based upon their current cash flow.  These may also include loans that renewed at existing contractual rates, but below market rates for comparable credit.  For each restructuring, a comprehensive credit underwriting analysis of the borrower’s financial condition and prospects of repayment under the revised terms is performed to assess whether the structure can be successful and whether cash flows will be sufficient to support the restructured debt.  An analysis is also performed to determine whether the restructured loan should be on accrual status.  Generally, if the loan is on accrual at the time of restructure, it will remain on accrual after the restructuring.  In some cases, a nonaccrual loan may be placed on accrual at restructuring if the loan’s actual payment history demonstrates it would have cash flowed under the restructured terms.  After six consecutive payments under the restructured terms, a nonaccrual restructured loan is reviewed for possible upgrade to accruing status.  In situations where there is a subsequent modification or renewal and the loan is brought to market terms, including a contractual interest rate not less than a market interest rate for new debt with similar credit risk characteristics, the TDR and impaired designations may be removed.  Total TDRs decreased by $3.3 million from December 31, 2021 to June 30, 2022 due primarily to seasonal repayments on one commercial TDR operating line.  There were 45 loans identified as TDRs at June 30, 2022 compared to 54 loans at December 31, 2021.
 
As with other impaired loans, an allowance for loan loss is estimated for each TDR based on the most likely source of repayment for each loan.  For impaired commercial real estate loans that are collateral dependent, the allowance is computed based on the fair value of the underlying collateral, less estimated costs to sell.  For impaired commercial loans where repayment is expected from cash flows from business operations, the allowance is computed based on a discounted cash flow computation.  Certain groups of TDRs, such as residential mortgages, have common characteristics and for them the allowance is computed based on a discounted cash flow computation on the change in weighted rate for the pool.  The allowance allocations for commercial TDRs where we have reduced the contractual interest rate are computed by measuring cash flows using the new payment terms discounted at the original contractual rate.

In March 2020, guidance issued by the federal banking agencies in consultation with FASB and the Coronavirus Aid, Relief and Economic Security (“CARES”) Act collectively specified that COVID-19 related modifications on loans that were not more than 30 days past due as of December 31, 2019 are not TDRs. Through June 30, 2022, the Bank had applied this guidance and modified 726 individual loans with aggregate principal balances totaling $337.2 million.  As of June 30, 2022, all of these modifications had expired and the loans had returned to their contractual payment terms.

Allowance for loan losses: The allowance for loan losses at June 30, 2022 was $14.6 million, a decrease of $1.3 million from December 31, 2021.  The allowance for loan losses represented 1.32% of total portfolio loans at June 30, 2022 and 1.43% at December 31, 2021.  The ratios at June 30, 2022 and December 31, 2021 are impacted by $2.8 million and $41.9 million of remaining PPP loans, respectively, which are fully guaranteed and receive no allowance allocation.  The ratios excluding these loans were 1.32% and 1.49% at June 30, 2022 and December 31, 2021, respectively.  The allowance for loan losses to nonperforming loan coverage ratio decreased from 17270.7% at December 31, 2021 to 16256.7% at June 30, 2022.
 
The table below shows the changes in certain credit metrics over the past five quarters (dollars in thousands):

   
Quarter Ended
June 30,
2022
   
Quarter Ended
March 31,
2022
   
Quarter Ended
December 31,
2021
   
Quarter Ended
September 30,
2021
   
Quarter Ended
June 30,
2021
 
Nonperforming loans
 
$
90
   
$
90
   
$
92
   
$
420
   
$
433
 
Other real estate owned and repo assets
   
2,343
     
2,343
     
2,343
     
2,343
     
2,343
 
Total nonperforming assets
   
2,433
     
2,433
     
2,435
     
2,763
     
2,776
 
Net charge-offs (recoveries)
   
(15
)
   
(227
)
   
(107
)
   
(276
)
   
(104
)
Total delinquencies
   
197
     
171
     
129
     
437
     
126
 

At June 30, 2022, we had net loan recoveries in twenty-eight of the past thirty quarters.  Our total delinquencies were $197,000 at June 30, 2022 and $129,000 at December 31, 2021.  Our delinquency percentage at June 30, 2022 was 0.02%.

-48-

These factors all impact our necessary level of allowance for loan losses and our provision for loan losses. The allowance for loan losses decreased $1.3 million in the first six months of 2022.  We recorded a provision for loan loss benefit of $1.5 million for the six months ended June 30, 2022 compared to a benefit of  $750,000 for the same period of 2021.  Net loan recoveries were $242,000 for the six months ended June 30, 2022, compared to net loan recoveries of $148,000 for the same period in 2021. The ratio of net charge-offs (recoveries) to average loans was -0.06% on an annualized basis for the first six months of 2022 and -0.02% for the first six months of 2021.
 
While we have experienced low levels of gross charge-offs over recent quarters, we recognize that future charge-offs and resulting provisions for loan losses are expected to be impacted by the timing and extent of changes in the overall economy and the real estate markets.
 
Our allowance for loan losses is maintained at a level believed appropriate based upon our assessment of the probable estimated losses inherent in the loan portfolio. Our methodology for measuring the appropriate level of allowance and related provision for loan losses relies on several key elements, which include specific allowances for loans considered impaired, general allowance for commercial loans not considered impaired based upon applying our loan rating system, and general allocations based on historical trends for homogeneous loan groups with similar risk characteristics.
 
Overall, impaired loans decreased by $3.3 million to $4.3 million at June 30, 2022 compared to $7.5 million at December 31, 2021.  The specific allowance for impaired loans decreased by $269,000 to $296,000 at June 30, 2022, compared to $565,000 at December 31, 2021.  The specific allowance for impaired loans represented 7.0% of total impaired loans at June 30, 2022 and 7.5% at December 31, 2021.
 
The general allowance allocated to commercial loans that were not considered to be impaired was based upon the internal risk grade of such loans.  We use a loan rating method based upon an eight point system.  Loans are stratified between real estate secured and non-real estate secured.  The real estate secured portfolio is further stratified by the type of real estate.  Each stratified portfolio is assigned a loss allocation factor.  A higher numerical grade assigned to a loan category generally results in a greater allocation percentage.  Changes in risk grade of loans affect the amount of the allowance allocation.
 
The determination of our loss factors is based upon our actual loss history by loan grade and adjusted for significant factors that, in management's judgment, affect the collectability of the portfolio as of the analysis date.  We use a rolling 18 month actual net charge-off history as the base for our computation.  Over the past few years, the 18 month period computations have reflected sizeable decreases in net charge-off experience.  We addressed this volatility in the qualitative factor considerations applied in our allowance for loan losses computation. We also considered the extended period of strong asset quality in assessing the overall qualitative component.
 
We also have considered the effect of COVID-19 on our loan borrowers and our local economy.  With the widespread vaccination efforts, coupled with reduction in infection rates in the first and second quarters of 2022, we determined that adjustments to certain qualitative factors were appropriate in the first half of 2022.  We also considered the improving economic conditions, including sharp reductions in unemployment and actions taken by the Federal Reserve in response to employment and inflation.  As a result, we reduced the economic qualitative factor by 3 basis points in the first quarter of 2022.  No additional changes were made for this factor in the second quarter of 2022 as the continued high inflation and related concerns offset the positive impact of an improving labor market.  In the second quarter 2021, we added 20 basis points to our consumer loan portfolio qualitative factors to address the risk that economic impact payments may be masking consumer delinquency and default.  We removed this 20 basis point allocation in the first quarter of 2022 as we did not experience losses or increased delinquency in these portfolios.  We also reduced the qualitative factor for changes in lending personnel by 4 basis points in the first quarter of 2022.  Slightly offsetting this was the addition of 2 basis points for our qualitative factor related to the effect of rising interest rates in the first quarter of 2022 and another 3 basis points added in the second quarter of 2022.  One additional change to the allowance calculation in the first quarter of 2022 was the removal of a loan pool we had maintained for loans receiving three modifications during the pandemic.  These loans have all returned to contractual payment terms over an extended period of time and have returned to their normal loan pools.
 
Certain industry sectors have been more negatively impacted by the economic effects of COVID-19 than others such as hospitality, restaurants and sporting events.  We believe our commercial portfolio is adequately diversified, with our largest commercial concentrations in Real Estate, Rental and Leasing (31%), followed by Manufacturing (14%) and Retail Trade (10%).

-49-

The table below breaks down our commercial loan portfolio by industry type at June 30, 2022 and identifies the percentage of loans in each type that have a pass rating within our grading system (4 or better) and criticized rating (5 or worse) (dollars in thousands):

   
June 30, 2022
 
   
Excluding PPP
   
PPP Loans
   
Total
   
Percent of
Total Loans
   
Percent Grade 4 or Better
   
Percent Grade 5 or Worse
 
Industry:
                                   
Agricultural Products
 
$
32,505
     
   
$
32,505
     
3.50
%
   
98.58
%
   
1.42
%
Mining and Oil Extraction
   
1,302
     
     
1,302
     
0.14
%
   
95.31
%
   
4.69
%
Construction
   
81,385
     
49
     
81,434
     
8.76
%
   
97.44
%
   
2.56
%
Manufacturing
   
134,539
     
17
     
134,556
     
14.47
%
   
97.53
%
   
2.47
%
Wholesale Trade
   
77,861
     
     
77,861
     
8.38
%
   
100.00
%
   
0.00
%
Retail Trade
   
89,528
     
15
     
89,543
     
9.63
%
   
99.92
%
   
0.08
%
Transportation and Warehousing
   
48,533
     
15
     
48,548
     
5.22
%
   
98.31
%
   
1.69
%
Information
   
692
     
     
692
     
0.07
%
   
6.07
%
   
93.93
%
Finance and Insurance
   
39,166
     
     
39,166
     
4.21
%
   
100.00
%
   
0.00
%
Real Estate and Rental and Leasing
   
287,149
     
546
     
287,695
     
30.95
%
   
99.92
%
   
0.08
%
Professional, Scientific and Technical Services
   
3,918
     
258
     
4,176
     
0.45
%
   
94.95
%
   
5.05
%
Management of Companies and Enterprises
   
3,400
     
     
3,400
     
0.37
%
   
100.00
%
   
0.00
%
Administrative and Support Services
   
14,981
     
13
     
14,994
     
1.61
%
   
99.35
%
   
0.65
%
Education Services
   
3,849
     
     
3,849
     
0.41
%
   
97.92
%
   
2.08
%
Health Care and Social Assistance
   
32,696
     
39
     
32,735
     
3.52
%
   
100.00
%
   
0.00
%
Arts, Entertainment and Recreation
   
3,988
     
313
     
4,301
     
0.46
%
   
92.70
%
   
7.30
%
Accommodations and Food Services
   
39,078
     
1,114
     
40,192
     
4.32
%
   
83.61
%
   
16.39
%
Other Services
   
32,321
     
412
     
32,733
     
3.52
%
   
100.00
%
   
0.00
%
Total commercial loans
 
$
926,891
   
$
2,791
   
$
929,682
     
100.00
%
   
98.39
%
   
1.61
%
 
Considering the change in our qualitative factors and our commercial loan portfolio balances, the general allowance allocated to commercial loans was $12.1 million at June 30, 2022 and $12.9 million at December 31, 2021.  The qualitative component of our allowance allocated to commercial loans was $12.1 million at June 30, 2022, down $755,000 from $12.9 million at December 31, 2021.
 
Groups of homogeneous loans, such as residential real estate and open- and closed-end consumer loans, receive allowance allocations based on loan type.  A rolling 12 month (four quarter) historical loss experience period was applied to residential mortgage and consumer loan portfolios.  As with commercial loans that are not considered impaired, the determination of the allowance allocation percentage is based principally on our historical loss experience.  These allocations are adjusted for consideration of general economic and business conditions, credit quality and delinquency trends, collateral values, and recent loss experience for these similar pools of loans.  The homogeneous loan allowance was $2.1 million at June 30, 2022 and $2.4 million at December 31, 2021.
 
The allowance allocations are not intended to imply limitations on usage of the allowance for loan losses.  The entire allowance for loan losses is available for any loan losses without regard to loan type.
 
Bank-Owned Life Insurance:  Bank-owned life insurance increased $495,000 from December 31, 2021 to June 30, 2022 due to earnings on the underlying policies.
 
Premises and Equipment:   Premises and equipment totaled $41.1 million at June 30, 2022, down $685,000 from $41.8 million at December 31, 2021.
 
Deposits and Other Borrowings: Total deposits decreased $83.4 million to $2.49 billion at June 30, 2022, as compared to $2.58 billion at December 31, 2021.  Non-interest bearing checking account balances increased $17.2 million during the first six months of 2022.  Interest bearing demand account balances decreased $96.3 million and savings and money market account balances increased $2.7 million in the first six months of 2022.  The overall decrease in deposits so far in 2022 has related to our business and municipal customers beginning to release the higher balances they have retained during the COVID-19 pandemic.  Certificates of deposits decreased by $7.0 million in the first six months of 2022 reflecting the continued low market interest rates.  We believe our success in maintaining the balances of personal and business checking and savings accounts was primarily attributable to our focus on quality customer service, the desire of customers to deal with a local bank, the convenience of our branch network and the breadth and depth of our sophisticated product line.
 
Noninterest bearing demand accounts comprised 36% of total deposits at June 30, 2022 and 34% of total deposits at December 31, 2021.  These balances typically increase at year end for many of our commercial customers, then decline in the first half of the next year.  This didn’t happen in 2021 due to customers of all types holding higher balances due to the COVID-19 pandemic.  In addition, because of the generally low rates paid on interest bearing account alternatives, many of our business customers chose to keep their balances in these more liquid noninterest bearing demand account types.  Interest bearing demand accounts, including money market and savings accounts, comprised 60% of total deposits at June 30, 2022 and 62% at December 31, 2021. Time accounts as a percentage of total deposits were 3% at June 30, 2022 and 3% at December 31, 2021.

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Borrowed funds at June 30, 2022 consisted of $30.0 million of FHLB advances.  Borrowed funds at December 31, 2021 consisted of $85.0 million of FHLB advances.  On January 21, 2022, the FHLB exercised its option to put an advance totaling $25.0 million to the Company.  This advance carried an interest rate of 0.01% and had a maturity date of July 21, 2031.  The Company paid off this advance as required on January 21, 2022.  On January 21, 2022, we executed a new $25.0 million advance with the FHLB with similar terms.  This advance carried an interest rate of 0.05% and a maturity date of January 21, 2032.  The first put date for this advance was April 21, 2022.  The FHLB exercised its put option on this advance and it was paid off by the Company as required on April 21, 2022. The FHLB also exercised its put option on an advance totaling $10.0 million that carried an interest rate of 0.45% and a maturity date of February 27, 2030.  We paid off this advance as required on May 27, 2022.    Also on May 27, 2022, we prepaid three other advances totaling $20.0 million.  These advances had maturities ranging from May 24, 2023 to July 25, 2024 and interest rates ranging from 2.91% to 3.05%.   We incurred prepayment fees totaling $87,000, which are included in interest expense.  The reduction in future period interest expense from paying off these advances is such that the payback period is less than one quarter.
 
CAPITAL RESOURCES
 
Total shareholders' equity of $243.1 million at June 30, 2022 reflected a decrease of $10.9 million from $254.0 million at December 31, 2021. The decrease was primarily a result of a negative swing of $18.4 million in accumulated other comprehensive income ("AOCI") and a payment of $5.5 million in cash dividends to shareholders more than offsetting our net income of $12.6 million earned in the first six months of 2022.    The negative swing in AOCI was attributable to a sharp increase in market interest rates on bonds during the first half of 2022 causing a devaluation in market value on our investment securities available for sale.  The Bank was categorized as “well capitalized” at June 30, 2022.
 
Capital guidelines for U.S. banks include a common equity Tier 1 capital to risk-weighted assets ratio (CET1 ratio) of 4.5% and a capital conservation buffer of 2.5% of risk-weighted assets, effectively resulting in a minimum CET1 ratio of 7.0%. The minimum ratio of Tier 1 capital to risk-weighted assets is 6.0% (which, with the capital conservation buffer, effectively results in a minimum Tier 1 capital ratio of 8.5%), and the minimum total capital to risk-weighted assets ratio is 10.5% (with the capital conservation buffer). The minimum leverage ratio is 4.0%. The capital ratios for the Company and the Bank have continued to exceed the well capitalized minimum capital requirements.
 
The following table shows our regulatory capital ratios (on a consolidated basis) for the past several quarters:

Macatawa Bank Corporation
 
June 30,
2022
   
March 31,
2022
   
Dec 31,
2021
   
Sept 30,
2021
   
June 30,
2021
 
Total capital to risk weighted assets
   
17.5
%
   
17.9
%
   
18.3
%
   
18.6
%
   
19.7
%
Common Equity Tier 1 to risk weighted assets
   
16.5
     
16.9
     
17.2
     
17.4
     
17.1
 
Tier 1 capital to risk weighted assets
   
16.5
     
16.9
     
17.2
     
17.4
     
18.5
 
Tier 1 capital to average assets
   
9.1
     
8.8
     
8.7
     
8.5
     
9.5
 

On July 7, 2021, the Company redeemed all of the remaining outstanding trust preferred securities.
 
LIQUIDITY
 
Liquidity of Macatawa Bank: The liquidity of a financial institution reflects its ability to manage a variety of sources and uses of funds. Our Consolidated Statements of Cash Flows categorize these sources and uses into operating, investing and financing activities. We primarily focus on developing access to a variety of borrowing sources to supplement our deposit gathering activities and provide funds for our investment and loan portfolios. Our sources of liquidity include our borrowing capacity with the Federal Reserve Board's discount window, the Federal Home Loan Bank, federal funds purchased lines of credit and other secured borrowing sources with our correspondent banks, loan payments by our borrowers, maturity and sales of our securities available for sale, growth of our deposits, federal funds sold and other short-term investments, and the various capital resources discussed above.
 
Liquidity management involves the ability to meet the cash flow requirements of our customers. Our customers may be either borrowers with credit needs or depositors wanting to withdraw funds. Our liquidity management involves periodic monitoring of our assets considered to be liquid and illiquid, and our funding sources considered to be core and non-core and short-term (less than 12 months) and long-term. We have established parameters that monitor, among other items, our level of liquid assets to short-term liabilities, our level of non-core funding reliance and our level of available borrowing capacity. We maintain a diversified wholesale funding structure and actively manage our maturing wholesale sources to reduce the risk to liquidity shortages. We have also developed a contingency funding plan to stress test our liquidity requirements arising from certain events that may trigger liquidity shortages, such as rapid loan growth in excess of normal growth levels or the loss of deposits and other funding sources under extreme circumstances.

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We have actively pursued initiatives to maintain a strong liquidity position.  The Bank has reduced its reliance on non-core funding sources, including brokered deposits, and focused on achieving a non-core funding dependency ratio below its peer group average.  We have had no brokered deposits on our balance sheet since December 2011.  We continue to maintain significant on-balance sheet liquidity.  At June 30, 2022, the Bank held $721.8 million of federal funds sold and other short-term investments.  In addition, the Bank had available borrowing capacity from correspondent banks of approximately $277.3 million as of June 30, 2022.

In addition to normal loan funding, we also maintain liquidity to meet customer financing needs through unused lines of credit, unfunded loan commitments and standby letters of credit.  The level and fluctuation of these commitments is also considered in our overall liquidity management.  At June 30, 2022, we had a total of $769.1 million in unused lines of credit, $101.8 million in unfunded loan commitments and $14.4 million in standby letters of credit.
 
Liquidity of Holding Company: The primary sources of liquidity for the Company are dividends from the Bank, existing cash resources and the capital markets if the need to raise additional capital arises.  Banking regulations and the laws of the State of Michigan in which our Bank is chartered limit the amount of dividends the Bank may declare and pay to the Company in any calendar year.  Under the state law limitations, the Bank is restricted from paying dividends to the Company in excess of retained earnings.  In 2021, the Bank paid dividends to the Company totaling $33.1 million.  In the same period, the Company paid $10.9 million in dividends to its shareholders and $20.6 million to redeem outstanding trust preferred securities.  On February 23, 2022, the Bank paid a dividend totaling $2.9 million to the Company in anticipation of the common share cash dividend of $0.08 per share paid on February 24, 2022 to shareholders of record on February 10, 2022.  The cash distributed for this cash dividend payment totaled $2.7 million.   On May 25, 2022, the Bank paid a dividend totaling $2.8 million to the Company in anticipation of the common share cash dividend of $0.08 per share paid on May 26, 2022 to shareholders of record on May 12, 2022.  The cash distributed for this cash dividend payment totaled $2.7 million.   The Company retained the remaining balance in each period for general corporate purposes.  At June 30, 2022, the Bank had a retained earnings balance of $90.4 million.
 
The Company’s cash balance at June 30, 2022 was $7.7 million.  The Company believes that it has sufficient liquidity to meet its cash flow obligations.
 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES:
 
To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information.  These estimates and assumptions affect the amounts reported in the financial statements and future results could differ.  The allowance for loan losses, other real estate owned valuation, loss contingencies, revenue recognition and income taxes are deemed critical due to the required level of management judgment and the use of estimates, making them particularly subject to change.
 
Our methodology for determining the allowance for loan losses and the related provision for loan losses is described above in the "Allowance for Loan Losses" discussion.  This area of accounting requires significant judgment due to the number of factors which can influence the collectability of a loan.  Unanticipated changes in these factors could significantly change the level of the allowance for loan losses and the related provision for loan losses.  Although, based upon our internal analysis, and in our judgment, we believe that we have provided an adequate allowance for loan losses, there can be no assurance that our analysis has properly identified all of the probable losses in our loan portfolio.  As a result, we could record future provisions for loan losses that may be significantly different than the levels that we recorded in the first six months of 2022.
 
Assets acquired through or instead of foreclosure, primarily other real estate owned, are initially recorded at fair value less estimated costs to sell when acquired, establishing a new cost basis.  New real estate appraisals are generally obtained at the time of foreclosure and are used to establish fair value.  If fair value declines, a valuation allowance is recorded through expense.  Estimating the initial and ongoing fair value of these properties involves a number of factors and judgments including holding time, costs to complete, holding costs, discount rate, absorption and other factors.
 
Loss contingencies are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated.  This, too, is an accounting area that involves significant judgment.  Although, based upon our judgment, internal analysis, and consultations with legal counsel we believe that we have properly accounted for loss contingencies, future changes in the status of such contingencies could result in a significant change in the level of contingent liabilities and a related impact to operating earnings.

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Noninterest revenue is recognized in accordance with contractual requirements and as we fulfill our obligations under contractual terms.  Most of our noninterest revenue comes from services that are transaction based and such revenue is recognized as the related service is provided.
 
Our accounting for income taxes involves the valuation of deferred tax assets and liabilities primarily associated with differences in the timing of the recognition of revenues and expenses for financial reporting and tax purposes.  At June 30, 2022, we had gross deferred tax assets of $8.4 million and gross deferred tax liabilities of $1.9 million resulting in a net deferred tax asset of $6.5 million.  Accounting standards require that companies assess whether a valuation allowance should be established against their deferred tax assets based on the consideration of all available evidence using a "more likely than not" standard.  We concluded at June 30, 2022 that no valuation allowance on our net deferred tax asset was required.  Changes in tax laws, changes in tax rates, changes in ownership and our future level of earnings can impact the ultimate realization of our net deferred tax asset.

Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
 
Our primary market risk exposure is interest rate risk and, to a lesser extent, liquidity risk. All of our transactions are denominated in U.S. dollars with no specific foreign exchange exposure. Macatawa Bank has only limited agricultural-related loan assets, and therefore has no significant exposure to changes in commodity prices.
 
Our balance sheet has sensitivity, in various categories of assets and liabilities, to changes in prevailing rates in the U.S. for prime rate, mortgage rates, U.S. Treasury rates and various money market indexes. Our asset/liability management process aids us in providing liquidity while maintaining a balance between interest earning assets and interest bearing liabilities.
 
We utilize a simulation model as our primary tool to assess the direction and magnitude of variations in net interest income and the economic value of equity (“EVE”) resulting from potential changes in market interest rates. Key assumptions in the model include contractual cash flows and maturities of interest-sensitive assets and interest-sensitive liabilities, prepayment speeds on certain assets, and changes in market conditions impacting loan and deposit pricing. We also include pricing floors on discretionary priced liability products which limit how low various checking and savings products could go under declining interest rates. These floors reflect our pricing philosophy in response to changing interest rates.
 
We forecast the next twelve months of net interest income under an assumed environment of gradual changes in market interest rates under various scenarios. The resulting change in net interest income is an indication of the sensitivity of our earnings to directional changes in market interest rates. The simulation also measures the change in EVE, or the net present value of our assets and liabilities, under an immediate shift, or shock, in interest rates under various scenarios, as calculated by discounting the estimated future cash flows using market-based discount rates.
 
The following table shows the impact of changes in interest rates on net interest income over the next twelve months and EVE based on our balance sheet as of June 30, 2022 (dollars in thousands):

Interest Rate Scenario
 
Economic
Value of
Equity
   
Percent
Change
   
Net Interest
Income
   
Percent
Change
 
Interest rates up 200 basis points
 
$
386,896
     
(1.84
)%
 
$
80,374
     
5.67
%
Interest rates up 100 basis points
   
389,272
     
(1.24
)
   
77,835
     
2.33
 
No change
   
394,164
     
     
76,064
     
 
Interest rates down 100 basis points
   
374,406
     
(5.01
)
   
69,758
     
(8.29
)
Interest rates down 200 basis points
   
345,688
     
(12.30
)
   
63,861
     
(16.04
)

If interest rates were to increase, this analysis suggests that we are positioned for an improvement in net interest income over the next twelve months.  If interest rates were to decrease, this analysis suggests we would experience a reduction in net interest income over the next twelve months.
 
We also forecast the impact of immediate and parallel interest rate shocks on net interest income under various scenarios to measure the sensitivity of our earnings under extreme conditions.
 
The quarterly simulation analysis is monitored against acceptable interest rate risk parameters by the Asset/Liability Committee and reported to the Board of Directors.

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In addition to changes in interest rates, the level of future net interest income is also dependent on a number of other variables, including: the growth, composition and absolute levels of loans, deposits, and other earning assets and interest-bearing liabilities; economic and competitive conditions; potential changes in lending, investing and deposit gathering strategies; and client preferences.
 
Item 4:
CONTROLS AND PROCEDURES
 
(a)
Evaluation of Disclosure Controls and Procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e) as of June 30, 2022, the end of the period covered by this report.
 
In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as the Company's are designed to do, and management necessarily was required to apply its judgment in evaluating whether the benefits of the controls and procedures that the Company adopts outweigh their costs.
 
Our CEO and CFO, after evaluating the effectiveness of the Company's disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered by this report, have concluded that the Company's disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms.
 
(b)
Changes in Internal Controls. During the period covered by this report, there have been no changes in the Company’s internal control over financial reporting that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.

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PART II – OTHER INFORMATION

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

The following table provides information regarding the Company’s purchase of its own common stock during the second quarter of 2022.  All employee transactions are under stock compensation plans.  These include shares of Macatawa Bank Corporation common stock surrendered to satisfy tax withholding obligations that occur upon the vesting of restricted shares.  The value of the shares withheld is determined based on the closing price of Macatawa Bank Corporation common stock at the date of vesting.  The Company has no publicly announced repurchase plans or programs.

   
Total
Number of
Shares
Purchased
   
Average
Price Paid
Per Share
 
Period
           
April 1 - April 30, 2022
           
Employee Transactions
   
   
$
 
May 1 - May 31, 2022
               
Employee Transactions
   
   
$
 
June 1 - June 30, 2022
               
Employee Transactions
   
815
   
$
8.68
 
Total for Second Quarter ended June 30, 2022
               
Employee Transactions
   
815
   
$
8.68
 

Item 6.
EXHIBITS.

    3.1
Restated Articles of Incorporation. Previously filed with the Commission on October 27, 2016 in Macatawa Bank Corporation’s Quarterly Report on Form 10-Q, Exhibit 3.1. Here incorporated by reference.
    3.2
Bylaws. Previously filed with the Commission on February 19, 2015 in Macatawa Bank Corporation's Annual Report on Form 10-K for the year ended December 31, 2014, Exhibit 3.2. Here incorporated by reference.
    4.1
Restated Articles of Incorporation. Exhibit 3.1 is here incorporated by reference.
    4.2
Bylaws. Exhibit 3.2 is here incorporated by reference.
    4.3
Long-Term Debt. The registrant has outstanding long-term debt which at the time of this report does not exceed 10% of the registrant's total consolidated assets. The registrant agrees to furnish copies of the agreements defining the rights of holders of such long-term debt to the SEC upon request.
31.1
31.2
32.1
101.INS
Inline XBRL Instance Document
101.SCH
Inline XBRL Taxonomy Extension Schema Document
101.CAL
Inline XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF
Inline XBRL Taxonomy Extension Definition Linkbase Document
101.LAB
Inline XBRL Taxonomy Extension Label Linkbase Document
101.PRE
Inline XBRL Taxonomy Extension Presentation Linkbase Document
104
Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101)

-55-

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.

 
MACATAWA BANK CORPORATION
   
 
/s/ Ronald L. Haan
 
Ronald L. Haan
 
Chief Executive Officer
 
(Principal Executive Officer)
   
 
/s/ Jon W. Swets
 
Jon W. Swets
 
Senior Vice President and
 
Chief Financial Officer
 
(Principal Financial and Accounting Officer)
   
Dated: July 28, 2022


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