SOUTHERN MICHIGAN BANCORP INC - Annual Report: 2007 (Form 10-K)

Commission File Number: 000-49772

Southern Michigan Bancorp, Inc.
(Exact Name of Registrant as Specified in its Charter)

(517) 279-5500
(Registrant's Telephone Number, Including Area Code)

Securities Registered Pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Securities Exchange Act of 1934:

None
(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes           No   X  

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes           No   X  

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes   X     No        

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained in this form, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ( X )

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer           Accelerated filer           Non-accelerated filer           Smaller Reporting Company   X  

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

As of December 1, 2007, the date of completion of the Registrant's initial public offering, the aggregate market value of common stock held by non-affiliates of the Registrant was $46,011,255. This amount is computed by reference to a price of $21.75 per share for the Registrant's common stock, which was the price at which the Registrant's common stock was last sold as of December 1, 2007.

The number of shares outstanding of the Registrant's Common Stock, $2.50 par value, as of March 14, 2008, was 2,307,924 shares.

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 Southern Michigan Bancorp, Inc. Forward-looking statements are identifiable by words or phrases such as "outlook," or "strategy" that an event or trend "may," "should," "will," or "is likely" to occur or "continue" or "is scheduled" or "on track" or that Southern Michigan Bancorp, Inc. or its management "anticipates," "believes," "estimates," "plans," "forecasts," "intends," "predicts," "projects," or "expects" a particular result, or is "confident" or "optimistic" that an event will occur, and variations of such words and similar expressions. All of the information concerning interest rate sensitivity is forward-looking. Management's determination of the provision and allowance for loan losses involves judgments that are inherently forward-looking. 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.

          Risk factors include, but are not limited to, the risk factors described in "Item 1A - Risk Factors" of this report; the timing and level of asset growth; changes in banking laws and regulations; changes in tax laws; changes in prices, levies and assessments; the impact of technological advances and issues; governmental and regulatory policy changes; opportunities for acquisitions and the effective completion of acquisitions and integration of acquired entities; the possibility that anticipated cost savings and revenue enhancements from acquisitions, restructurings, reorganizations and bank consolidations may not be realized at amounts projected, at all or within expected time frames; the local and global effects of the ongoing war on terrorism and other military actions, including actions in Iraq; and current uncertainties and fluctuations in the financial markets and stocks of financial services providers due to concerns about credit availability and concerns about the Michigan economy in particular. 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.

          This section is intended to provide meaningful cautionary statements. This should not be construed as a complete list of all economic, competitive, governmental, technological, and other factors that could adversely affect our expected consolidated financial position, results of operations or liquidity. We undertake no obligation to update or revise our forward-looking statements to reflect developments that occur or information obtained after the date of this report.

PART I

General

          Southern Michigan Bancorp, Inc. ("Southern," the "Company," "We," or "Us") is a bank holding company registered under the Bank Holding Company Act of 1956, as amended. Southern was incorporated on March 1, 1982, as a Michigan corporation. Southern was formed to create a bank holding company for the purpose of acquiring all of the capital stock of Southern Michigan Bank & Trust, a Michigan state-chartered bank ("Southern Michigan Bank") (formerly Southern Michigan National Bank), which it did in November 1982. Southern is also the parent company of FNB Financial, a Michigan state-chartered bank (formerly The First National Bank of Three Rivers), which it acquired on December 1, 2007, and Southern Michigan Bancorp Capital Trust I, a Delaware statutory trust. At December 31, 2007, Southern, on a consolidated basis, had shareholders' equity of $44.2 million.

          Southern Michigan Bank is the parent company of SMB Mortgage Company, a Michigan corporation, and SMB&T Financial Services, Inc., a Michigan corporation. FNB Financial is the parent company of FNB Financial Services, Inc., a Michigan corporation.

          Through our bank subsidiaries, we operate 18 banking offices located in Athens, Battle Creek, Camden, Cassopolis, Centreville, Coldwater, Constantine, Hillsdale, Marshall, Mendon, North Adams, Tekonsha, Three Rivers, and Union City, Michigan. At December 31, 2007, on a consolidated basis, we had assets of $480.2 million, deposits of $399.2 million, a net loan portfolio of $330.8 million, and had trust assets totaling $203.4 million.

          Our business, which we conduct primarily through our bank subsidiaries, is commercial banking. We offer a variety of deposit, payment, credit and other financial services to all types of customers. These services include time, savings, and demand deposits, safe deposit services, and automated teller machine services. Loans, including both commercial and consumer, are extended primarily on a secured basis to corporations, partnerships and individuals. Commercial lending covers such categories as business, industry, agricultural, construction, inventory and real estate. Consumer lending covers direct and indirect loans to purchasers of residential real property and consumer goods. We offer trust and investment services, which include investment management, trustee services, IRA rollovers and retirement plans, institutional and personal custody, estate settlement, wealth management, estate planning assistance, wealth transfer planning assistance, charitable gift planning assistance, and cash management custody. No material part of our business is dependent upon a single customer or very few customers, the loss of which would have a material adverse effect on us.

Competition

          Our business is highly competitive. We face significant competition from commercial banks, saving and loan associations, credit unions, commercial and consumer finance companies, insurance companies and leasing companies. We also face competition from money market mutual funds, investment and brokerage firms and nonfinancial institutions, which provide many of the financial services we offer. The principal methods of competition that we face are price (interest rates paid on deposits, interest rates charged on borrowings and fees charged for services) and service (convenience and quality of services rendered to customers).

Supervision and Regulation

          We are extensively regulated and are subject to a comprehensive regulatory framework that imposes restrictions on our activities, minimum capital requirements, lending and deposit restrictions, and numerous other requirements. This system of regulation is primarily intended for the protection of depositors, federal deposit insurance funds and the banking system as a whole, rather than for the protection of shareholders and creditors. Many of these laws and regulations have undergone significant change in recent years and are likely to change in the future. Future legislative or regulatory change, or changes in enforcement practices or court rulings, may have a significant and potentially adverse impact on our operations and financial condition. Our non-bank subsidiaries are also subject to various federal and state laws and regulations.

          Southern

          Southern is subject to supervision and regulation by the Federal Reserve System. Our activities are generally limited to owning or controlling banks and engaging in such other activities as the Federal Reserve System may determine to be closely related to banking. Prior approval of the Federal Reserve System, and in some cases various other government agencies, is required for us to acquire control of any additional bank holding companies, banks or other operating subsidiaries. We are subject to periodic examination by the Federal Reserve System, and are required to file with the Federal Reserve System periodic reports of our operations and such additional information as the Federal Reserve System may require.

          Southern is a legal entity separate and distinct from our bank subsidiaries. There are legal limitations on the extent to which our bank subsidiaries may lend or otherwise supply funds to us. Payment of dividends to us by our bank subsidiaries, our principal source of funds, is subject to various state and federal regulatory limitations. Under the Michigan Banking Code of 1999, a subsidiary bank's ability to pay dividends to us is subject to the following restrictions:

          Under Federal Reserve System policy, we are expected to act as a source of financial strength to our bank subsidiaries and to commit resources to support both banks. In addition, if the Michigan Office of Financial and Insurance Services ("OFIS") deems a bank subsidiary's capital to be impaired, OFIS may require the bank to restore its capital by a special assessment on us as the bank's only shareholder. If we failed to pay any assessment, our directors would be required, under Michigan law, to sell the shares of the bank's stock owned by us to the highest bidder at either a public or private auction and use the proceeds of the sale to restore the bank's capital.

          The Federal Reserve System uses capital adequacy guidelines in its examination and regulation of bank holding companies. If capital falls below minimum guidelines, a bank holding company may, among other items, be denied approval to acquire or establish additional banks or non-bank businesses. As of the date of this report, Southern and its bank subsidiaries are "well-capitalized" under the capital adequacy guidelines.

          The Banks

          Southern Michigan Bank and FNB Financial are chartered under Michigan law and are subject to regulation by OFIS. Michigan banking laws place restrictions on various aspects of banking, including permitted activities, loan interest rates, branching, payment of dividends, and capital and surplus requirements.

          The banks' deposits are insured by the Federal Deposit Insurance Corporation ("FDIC") to the extent provided by law. From time to time, the banks are required to pay deposit insurance premiums to the Deposit Insurance Fund ("DIF"). The amount of the premiums varies and are generally determined by the FDIC based on the balance of insured deposits and the amount of risk each institution poses to the DIF. Both banks are members of the Federal Home Loan Bank system. This provides certain advantages to them, including favorable borrowing rates for certain funds.

          Banks are subject to a number of federal and state laws and regulations, which have a material impact on their business. These include, among others, minimum capital requirements, state usury laws, state laws relating to fiduciaries, the Truth in Lending Act, the Truth in Savings Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Expedited Funds Availability Act, the Community Reinvestment Act, the Real Estate Settlement Procedures Act, the USA PATRIOT Act, The Bank Secrecy Act, Office of Foreign Assets Control regulations, electronic funds transfer laws, redlining laws, predatory lending laws, antitrust laws, environmental laws, money laundering laws and privacy laws. The instruments of monetary policy of authorities, such as the Federal Reserve System, may influence the growth and distribution of bank loans, investments and deposits, and may also affect interest rates on loans and deposits. These policies may have a significant effect on the operating results of banks.

          Bank holding companies may acquire banks and other bank holding companies located in any state in the United States without regard to geographic restrictions or reciprocity requirements imposed by state banking law. Banks may also establish interstate branch networks through acquisitions of and mergers with other banks. The establishment of de novo interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is allowed only if specifically authorized by state law.

          Michigan banking laws do not significantly restrict interstate banking. The Michigan Banking Code of 1999 permits, in appropriate circumstances and with the approval of the OFIS, (1) acquisition of Michigan banks by FDIC-insured banks, savings banks or savings and loan associations located in other states, (2) sale by a Michigan bank of branches to an FDIC-insured bank, savings bank or savings and loan association located in a state in which a Michigan bank could purchase branches of the purchasing entity, (3) consolidation of Michigan banks and FDIC-insured banks, savings banks or savings and loan associations located in other states having laws permitting such consolidation, (4) establishment of branches in Michigan by FDIC-insured banks located in other states, the District of Columbia or U.S. territories or protectorates having laws permitting a Michigan bank to establish a branch in such jurisdiction, and (5) establishment by foreign banks of branches located in Michigan.

Environmental Regulations

          In our business, we hold title on a temporary or permanent basis, to a number of parcels of real property. These include properties owned for branch offices and other business purposes and properties taken in or in lieu of

foreclosure to satisfy loans in default. Under current federal laws, present and past owners of real property are exposed to liability for the cost of cleanup of contamination on or originating from those properties, even if they are wholly innocent of the actions that caused the contamination. These liabilities can be material and can exceed the value of the contaminated property. Although management is currently aware of no such environmental liabilities attributable to us or any of our properties, any such liabilities could have a material adverse effect on our capital expenditures, earnings, or competitive position.

Employees

          As of December 31, 2007, Southern Michigan Bank employed 150 total employees and 142 full-time equivalent employees and FNB Financial employed 66 total employees and 60 full-time equivalent employees. Southern's only employees as of the same date were its five executive officers (four of whom are also employed by Southern Michigan Bank and one of whom is also employed by FNB Financial).

Statistical Information

          Additional statistical information describing our business appears in the following pages and in Management's Discussion and Analysis of Financial Condition and Results of Operations and in our consolidated financial statements and related notes contained in this report.

          Southern acquired FNB Financial Corporation on December 1, 2007. Statistical information presented for 2007 includes information for FNB Financial Corporation from the date of acquisition. Any comparison of information from 2007 to information in previous years must consider that information for FNB Financial Corporation is not included in information presented for periods before December 1, 2007.

          Securities Portfolio

          The book value of securities categorized by type at December 31 was as follows:

          At the end of 2007 and 2006, the market value of securities issued by the State of Michigan and all its political subdivisions held by us totaled $20,900,000 and $11,383,000, respectively. No other securities of any single issuer held by us were greater than 10% of shareholders' equity.

          Presented below is the fair value of securities as of December 31, 2007 and 2006, a schedule of maturities of securities as of December 31, 2007, and the weighted average yields of securities as of December 31, 2007.

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          The weighted average interest rates are based on coupon rates for securities purchased at par value and on effective interest rates considering amortization or accretion if the securities were purchased at a premium or discount.

          Loan Portfolio

          Our combined loan portfolio, categorized by loan type (excluding loans held for sale) as of December 31 is presented below.

          We have no foreign loans.

          Maturities and Sensitivities of Loans to Changes in Interest Rates

          The following schedule presents the maturities of loans (excluding residential real estate and consumer loans) as of December 31, 2007. All loans over one year in maturity (excluding residential real estate and consumer loans) are also presented, classified according to the sensitivity to changes in interest rates as of December 31, 2007.

          Risk Elements

          The objective of our credit risk strategy is to quantify and manage credit risk on an aggregate portfolio basis, and to limit the risk of loss resulting from an individual customer default. This strategy has not changed over the past three years. Such strategy is based on three core principles: conservatism, diversification and monitoring. We believe that effective credit risk management begins with conservative lending practices. These practices include conservative underwriting, documentation, monitoring, and collection standards. Our credit risk strategy also emphasizes diversification on an industry and customer level, regular credit examinations, and monthly management reviews of large credit exposures and credits experiencing deterioration of credit quality. Lending activities are centralized, with lending officers delegated specific authority amounts. We have annual independent reviews of the quality of our underwriting and documentation and the accuracy of risk grades.

          Our credit review process and overall assessment of required allowances are based on ongoing quarterly assessments of the probable estimated losses inherent in our loan portfolio. We use these assessments to promptly identify potential problem loans within the portfolio, to maintain an adequate allowance for losses, and take any necessary charge-offs. In addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review includes the use of a risk grading system.

          Loan originations are developed from a number of sources, including continuing business with depositors, borrowers and real estate developers, advertisements, solicitations by lending staff, walk-in customers, director referrals, and loan participations purchased from other financial institutions.

          Commercial and agricultural loans. We make loans for commercial purposes to sole proprietorships, partnerships, corporations and other business enterprises. We make agricultural loans for the purpose of financing agricultural production, including all costs associated with growing crops or raising livestock. Commercial and agricultural loans may be secured, other than by real estate, or unsecured, and require repayment in one single payment or on an installment repayment schedule. Commercial and agricultural loans generally have final maturities of five years or less and are made with either fixed interest rates or rates that adjust based upon the national prime rate in effect at the time of the rate change.

          Commercial and agricultural lending involves certain risks relating to changes in local and national economic conditions and the resulting effect on commercial or agricultural borrowers. Such loans are subject to greater risk of default during periods of adverse economic conditions. Because such loans may be secured by equipment, inventory, accounts receivable and other non-real estate assets, the collateral may not be sufficient to

ensure full payment of the loan in the event of a default. To reduce such risk, we may obtain the personal guarantees of one or more of the principals of the borrowers.

          Real estate - residential loans. We make residential real estate loans secured by first mortgages on one-to-four family residences, with a majority being single family residences. These loans are typically limited in relationship to the appraised value of the real estate and improvements at the time of origination of the loan.

          Real estate - commercial loans. We make non-residential real estate loans secured by first mortgages and/or junior mortgages on non-residential real estate, including retail stores, office buildings, warehouses, apartment buildings, and other commercial properties. These loans typically have a higher degree of risk than residential lending. The increased risk is due primarily to the dependence of the borrower on the cash flow from the property or the business operated on the property to service the loan.

          Real estate - construction loans. Construction loans are made to finance land development before erecting new structures and to finance the construction of new buildings or additions to existing buildings. Many of the construction loans we make are to owner occupants for the construction of single family homes. Other loans we make are to builders and developers for various projects.

          Consumer loans. We make a variety of consumer loans to individuals for family, household, and other personal purposes. We make these loans for the purpose of financing the purchase of vehicles or furniture, educational expenses, medical expenses, vacation expenses, and other consumer purposes. Consumer loans may be secured, other than by real estate, or unsecured, and generally require repayment on an installment repayment schedule.

          The following loans were classified as nonperforming as of December 31:

          A loan is placed on nonaccrual status at the point in time at which the collectibility of principal or interest is considered doubtful. The table below illustrates interest forgone and interest recorded on nonperforming loans for the years presented.

          Potential Problem Loans

          At December 31, 2007, there were $17.3 million of loans not disclosed above where some concern existed as to the borrowers' abilities to comply with original loan terms. We allocated $1,013,137 in the aggregate for loan losses for nonperforming and potential problem loans as of December 31, 2007. However, our allowance for loan losses is also available for potential problem loans.

          Loan Concentrations

          As of December 31, 2007, there was no concentration of loans exceeding 10% of total loans that is not otherwise disclosed as a category of loans in the loan portfolio listed in Note E to the consolidated financial statements.

          Summary of Loan Loss Experience

          The following schedule presents a summary of activity in the allowance for loan losses for the periods shown and the percentage of net charge-offs during each period to average gross loans outstanding during the period.

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           The following schedule presents an allocation of the allowance for loan losses to the various loan categories as of December 31 of each year presented.

          The Securities and Exchange Commission's guide on statistical disclosure by bank holding companies provides for a break down of the allowance for loan losses into major loan categories. We allocate the allowance among the various categories through an analysis of the loan portfolio composition, prior loan loss experience, evaluation of those loans identified as being probable problems in collection, results of examination by regulatory agencies and current economic conditions. The entire allowance is available to absorb any losses without regard to the category or categories in which the charged off loans are classified.

          The following schedule presents the stratification of the loan portfolio by category, based on the amount of loans outstanding as a percentage of total loans for the respective years ended December 31.

          Deposits

          The following schedule presents the average deposit balances by category and the average rates paid by category for the respective years.

          The following table illustrates the maturities of certificates of deposits issued in denominations of $100,000 or more as of December 31, 2007.

(Dollars in thousands)

          Return on Equity and Assets

          The following schedule presents ratios for the years ended December 31:

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Risks Associated with Southern Common Stock

There is not an active public trading market for Southern common stock.

          Southern common stock is traded in the OTC Bulletin Board market. Transactions in the stock are relatively infrequent. Southern does not expect an active trading market for Southern common stock to develop in the near future.

Southern's ability to pay dividends is limited and Southern may be unable to pay future dividends.

          Southern's ability to pay dividends is limited by regulatory restrictions and the need to maintain sufficient consolidated capital. The ability of Southern's subsidiary banks to pay dividends to Southern is limited by their obligations to maintain sufficient capital and by other general restrictions on dividends that are applicable to banks. If Southern or its subsidiary banks do not satisfy these regulatory requirements, Southern would be unable to continue to pay dividends on its common stock.

Southern may issue additional shares of its common stock in the future, which would dilute a shareholder's ownership of Southern common stock if the shareholder did not, or was not permitted to, invest in the additional issuances.

          Southern's articles of incorporation authorize its board of directors, without shareholder approval, to, among other things, issue additional common stock. The issuance of any additional shares of Southern common stock could be substantially dilutive to a shareholder's ownership of Southern common stock. To the extent that Southern issues stock appreciation rights, options or warrants to purchase Southern common stock in the future and those stock appreciation rights, options or warrants are exercised, Southern's shareholders may experience further dilution. Holders of shares of Southern common stock have no preemptive rights that entitle holders to purchase their pro rata share of any offering of shares of any class or series and, therefore, Southern's shareholders may not be permitted to invest in future issuances of Southern common stock.

Southern may issue debt and equity securities that are senior to Southern common stock as to distributions and in liquidation, which could negatively affect the value of Southern common stock.

          In the future, Southern may attempt to increase its capital resources by entering into debt or debt-like financing that is unsecured or secured by all or up to all of Southern's assets, or issuing debt or equity securities, which could include issuances of secured or unsecured commercial paper, medium-term notes, senior notes, subordinated notes, preferred stock or common stock. In the event of Southern's liquidation, its lenders and holders

of its debt securities would receive a distribution of Southern's available assets before distributions to the holders of Southern common stock. Because Southern's decision to incur debt and issue securities in future offerings will depend on market conditions and other factors beyond Southern's control, Southern cannot predict or estimate the amount, timing or nature of its future offerings and debt financings. Further, market conditions could require Southern to accept less favorable terms for the issuance of its securities in the future. Thus, shareholders bear the risk of Southern's future offerings reducing the value of their shares of Southern common stock and diluting their interest in Southern.

Unless a shareholder obtains prior consent from Southern, the shareholder will not be permitted to transfer to another party the shareholder's shares of Southern common stock if the party who would receive the shares would own of record fewer than 100 shares of Southern common stock.

          Southern's articles of incorporation provide that a shareholder may not transfer shares of Southern common stock without the consent of Southern, if, as a result of an attempted transfer, the party who would receive the shares would own fewer than 100 shares of Southern common stock. "Transfer" means any type of disposition, including a sale, gift, contribution, pledge, or other action that results in a change of record ownership of any share of Southern common stock. Southern may withhold its consent in its discretion. This restriction will limit the transferability of shares of Southern common stock and, unless a shareholder obtains Southern's prior consent, the shareholder will be prohibited from transferring fewer than 100 shares of Southern common stock if the party who would receive the shares would own of record fewer than 100 shares of Southern common stock.

Risks Related to Southern's Business

The integration of FNB Financial Corporation into Southern may be more difficult, costly, or time-consuming than we expect.

          Before completion of the merger of FNB Financial Corporation into Southern, each company operated independently. It is possible that the integration process post-merger could result in the loss of key employees or disruption of either or both of the banks' ongoing business or inconsistencies in standards, procedures and policies that would adversely affect the banks' ability to maintain relationships with clients and employees or to achieve the anticipated benefits of the merger. If Southern has difficulties with the integration process, Southern might not achieve the economic benefits expected to result from the merger. As with any merger of banking institutions, the merger may also result in business disruptions that cause either or both of the banks to lose customers or cause customers to remove their deposits or loans from the banks and move their business to competing financial institutions.

          Southern believes it has reasonably estimated the likely costs of integrating the operations of FNB into Southern and the incremental costs of operating as a combined organization. However, it is possible that unexpected transaction costs, such as taxes, or unexpected future operating expenses, such as increased personnel costs or increased taxes, and other types of unanticipated adverse developments, could have an adverse effect on the results of operations and financial condition of Southern. If unexpected costs are incurred, the merger could have a significant dilutive effect on Southern's earnings per share. In other words, if Southern incurs such unexpected costs and expenses as a result of the merger, Southern believes that the earnings per share of Southern common stock could be less than they would have been if the merger had not been completed.

          Efforts by management to integrate FNB Financial Corporation into Southern could distract management from the other business and operations of Southern. Any such distraction on the part of management, if significant, could affect its ability to manage existing business and develop new business and adversely affect the business and earnings of Southern.

If Southern's allowance for loan losses is not sufficient to cover actual loan losses, Southern's earnings could decrease.

          Southern's loan customers may not repay their loans according to the terms of these loans, and the collateral securing the payment of these loans may be insufficient to assure repayment. Southern may experience significant loan losses, which could have a material adverse effect on its operating results and financial condition. Southern's management makes various assumptions and judgments about the collectibility of Southern's loan portfolio, including the creditworthiness of its borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of Southern's loans. Southern maintains an allowance for loan losses to cover loan losses that may occur. In determining the size of the allowance, Southern relies on an analysis of its loan portfolio based on

historical loss experience, volume and types of loans, trends in classification, volume and trends in delinquencies and non-accruals, national and local economic conditions, and other pertinent information. As Southern expands into new markets, its determination of the size of the allowance could be understated due to Southern's lack of familiarity with market-specific factors.

          If Southern's assumptions are wrong, its current allowance may not be sufficient to cover loan losses, and adjustments may be necessary to allow for different economic conditions or adverse developments in Southern's loan portfolio. Material increases to Southern's allowance would materially decrease its net income.

          In certain situations, where collection efforts are unsuccessful or acceptable work-out arrangements cannot be reached, Southern may have to write off certain loans in whole or in part. In such situations, Southern may acquire real estate or other assets, if any, which secure the loans through foreclosure or other similar available remedies. In such cases, the amount owed under the defaulted loan often exceeds the value of the assets acquired.

          In addition, federal and state regulators periodically review Southern's allowance for loan losses and may require Southern to increase its provision for loan losses or recognize further loan charge-offs based on judgments different than those of Southern's management. Any increase in Southern's allowance for loan losses or loan charge-offs as required by these regulatory agencies could have a negative effect on Southern's operating results.

Losses on loans acquired as a result of the merger could result in a decrease in Southern's earnings.

          As a result of the merger of FNB Financial Corporation into Southern, Southern acquired FNB Financial and its entire loan portfolio. FNB Financial's loans were not underwritten and administered under the supervision of Southern's management or under Southern's loan policies, and future loan loss development on the acquired loan portfolio may be different, and may be less favorable, than Southern's historical loan loss experience. FNB Financial's recent historical loan loss experience has been less favorable than Southern's. Thus, it is possible that the merger will result in Southern being forced to increase its consolidated provisions for loan losses in the future resulting in a decrease in Southern's earnings.

Southern's loan portfolio includes a substantial percentage of commercial and industrial loans, which may be subject to greater risks than those related to residential loans.

          Southern's loan portfolio includes a substantial percentage of commercial and industrial loans. Commercial and industrial loans generally carry larger loan balances and involve a greater degree of financial and credit risks than home equity loans or residential mortgage loans. Any significant failure to pay on time by Southern's customers would hurt Southern's earnings. The increased financial and credit risk associated with these types of loans is a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the size of loan balances, the effects of general economic conditions on income-producing properties, and the increased difficulty of evaluating and monitoring these types of loans. The repayment of loans secured by commercial real estate is typically dependent upon the successful operation of the related real estate or commercial project. If the cash flow from the project is reduced, the borrower's ability to repay the loan may be impaired. This cash flow shortage may result in the failure to make loan payments. In such cases, Southern may be compelled to modify the terms of the loan. In addition, the nature of these loans is such that they are generally less predictable and more difficult to evaluate and monitor. As a result, repayment of these loans may, to a greater extent than residential loans, be subject to adverse conditions in the real estate market or economy.

Prepayments of loans may negatively impact Southern's business.

          Generally, customers of Southern may prepay the principal amount of their outstanding loans at any time. The speed at which such prepayments occur, as well as the size of such prepayments, are within such customers' discretion. If customers prepay the principal amount of their loans, and Southern is unable to lend those funds to other borrowers or invest the funds at the same or higher interest rates, Southern's interest income will be reduced. A significant reduction in interest income could have a negative impact on Southern's results of operations and financial condition.

Changes in interest rates may negatively affect Southern's earnings and the value of its assets.

          Changes in interest rates may affect Southern's level of interest income, the primary component of its gross revenue, and the level of its interest expense, Southern's largest recurring expenditure. Changes in prevailing interest rates are not within our control and could adversely affect our financial condition and results of operations.

Loss of Southern's Chief Executive Officer or other executive officers could adversely affect its business.

          Southern's success is dependent upon the continued service and skills of its executive officers and senior management. If Southern loses the services of these key personnel, it could have a negative impact on Southern's business because of their skills, years of industry experience and the difficulty of promptly finding qualified replacement personnel. The services of John H. Castle, Southern's Chairman and Chief Executive Officer; Kurt G. Miller, Southern's President; Richard E. Dyer, Southern's Executive Vice President; and Danice L. Chartrand, Southern's Chief Financial Officer; would be particularly difficult to replace.

Southern's continued growth may require it to raise additional capital in the future, but that capital might not be available on acceptable terms when it is needed.

          Southern is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations. Southern expects that it may need to raise additional capital to support its continued growth. Southern's ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside Southern's control, and on its financial performance. Southern cannot assure you of its ability to raise additional capital on terms acceptable to Southern. If Southern cannot raise additional capital when needed, its ability to further expand its operations through organic growth and acquisitions could be materially impaired.

Southern's business is subject to the success of the local economies where it operates.

          Southern's success significantly depends upon the economy, population, income levels, deposits and housing starts in the southwest Michigan market. If this market does not grow or if prevailing economic conditions locally or nationally are unfavorable, Southern's business may be adversely affected. Adverse economic conditions in southwest Michigan, including the loss of certain significant employers, could reduce Southern's growth rate, affect the ability of its customers to repay their loans to Southern, and generally adversely affect Southern's financial condition and results of operations. Southern is less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of diversified economies.

          Any adverse market or economic conditions in Michigan may disproportionately increase the risk that Southern's borrowers are unable to make their loan payments. In addition, the market value of the real estate securing loans as collateral could be adversely affected by unfavorable changes in market and economic conditions. A sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in the State of Michigan could adversely affect the value of Southern's assets, revenues, results of operations and financial condition.

          Commercial banks and other financial institutions are affected by economic and political conditions, both domestic and international, and by governmental monetary policies. Conditions such as inflation, recession, unemployment, high interest rates, short money supply, scarce natural resources, international disorders, terrorism and other factors beyond Southern's control may adversely affect profitability.

Southern's recent operating results may not be indicative of its future operating results.

          Southern may not be able to sustain its historical rate of growth or may not even be able to grow its business at all. In the future, Southern may not have the benefit of a favorable interest rate environment, a strong residential mortgage market, or the ability to find suitable candidates for acquisition. Various factors, such as economic conditions, regulatory and legislative considerations and competition, may also impede or prohibit Southern's ability to expand its market presence. If Southern experiences a significant decrease in its historical rate of growth, Southern's results of operations and financial condition may be adversely affected due to a high percentage of its operating costs being fixed expenses.

Competition from competing financial institutions and other financial service providers may adversely affect Southern's profitability.

          The banking business is highly competitive and Southern experiences competition in each of its markets from many other financial institutions. Southern competes with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other super-regional, national and international financial institutions that operate offices in Southern's primary market areas and elsewhere. In addition, some of the

institutions that Southern competes against are not subject to the same regulatory restrictions as Southern, and accordingly, may have certain, inherent, cost advantages.

          Southern competes with these institutions both in attracting deposits and in making loans. Price competition for loans might result in Southern originating fewer loans, or earning less on its loans, and price competition for deposits might result in a decrease in Southern's total deposits or higher rates on its deposits. In addition, Southern has to attract its customer base from other existing financial institutions and from new residents. Many of Southern's competitors are larger financial institutions. While Southern believes it can and does successfully compete with these other financial institutions in its primary markets, Southern may face a competitive disadvantage as a result of its smaller size, lack of geographic diversification, and inability to spread its marketing costs across a broader market. Although Southern competes by concentrating its marketing efforts in its primary markets with local advertisements, personal contacts, and greater flexibility and responsiveness in working with local customers, Southern can give no assurance that this strategy will be successful.

Compliance with the Securities Exchange Act of 1934 may adversely effect Southern's earnings.

          As a result of the merger, Southern is subject to the Securities Exchange Act of 1934, the Sarbanes-Oxley Act of 2002, and other laws, rules and regulations applicable to registered companies that were not applicable to Southern before the merger. Southern will incur substantial additional expenses to comply with these laws and regulations that may adversely effect its earnings when compared to prior periods. Complying with these laws and regulations will require substantial time and attention of Southern's board of directors and management, reducing the time and attention they will have available for integrating FNB Financial Corporation's business and operations and managing the combined organization. Companies that are subject to these laws and regulations are also believed to be subject to a greater risk of litigation and liability than companies that are not.

Southern is subject to extensive regulation that could limit or restrict its activities.

          Southern operates in a highly regulated industry and is subject to examination, supervision, and comprehensive regulation by various federal and state agencies. Southern's compliance with these regulations is costly and restricts certain of its activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices. Southern is also subject to capitalization guidelines established by its regulators, which require Southern to maintain adequate capital to support its growth.

          The laws and regulations applicable to the banking industry could change at any time, and Southern cannot predict the effects of these changes on its business and profitability. Because government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, Southern's cost of compliance could adversely affect its ability to operate profitably.

Future claims could be made against Southern or Southern Michigan Bank related to their relationship with Alanar, Inc. and its affiliates.

          Southern Michigan Bank previously served as indenture trustee and also is the depository bank in connection with certain bond offerings underwritten by Alanar, Inc. Southern Michigan Bank also is party to an agreement with Guardian Services, LLC, an affiliate of Alanar, Inc., to provide fiduciary oversight services related to the custodianship of certain individual retirement accounts that invested in bonds underwritten by Alanar, Inc. On July 26, 2005, the SEC obtained a court order freezing all assets under the control of Alanar, Inc., Guardian Services, LLC, and their affiliates, including all accounts at Southern Michigan Bank. Alanar, Inc., Guardian Services, LLC, and their affiliates have been under court-appointed monitorship since July 26, 2005 and in receivership since December 20, 2005. The SEC and the receiver have alleged that Alanar, Inc., Guardian Services, LLC, and their affiliates engaged in fraud and other improper conduct to hide bond defaults in connection with over 340 bond offerings. Southern Michigan Bank has not served as indenture trustee since November 16, 2006, when the court approved the removal of Southern Michigan Bank as trustee so that the receiver could assume this role to promote efficiency in the administration of the receivership. On August 28, 2007, the court approved a plan of receivership pursuant to which another bank is eventually expected to serve as the depository bank for the bond issuances and Southern Michigan Bank's agreement with Guardian Services, LLC related to the individual retirement accounts will eventually be terminated. Upon the occurrence of these events, it is expected that Southern Michigan Bank will not have any further relationship with Alanar or its affiliates. No claims with respect to this matter have been filed against Southern or Southern Michigan Bank by any person or entity. There can be no assurance,

however, that Southern or Southern Michigan Bank will not be subject to future claims arising out of their relationship with Alanar, Inc. and Guardian Services, LLC. Protracted litigation or an adverse decision or settlement of any such action or proceeding could have a material adverse effect on the financial position, business, prospects, and results of operation of Southern or Southern Michigan Bank. For more information, see "Legal Proceedings-Alanar, Inc." on page 76.

If Southern is required to write down goodwill, its financial condition and results of operations would be negatively affected.

          A substantial portion of the value of the merger consideration paid in connection with the merger of FNB Financial Corporation was allocated to goodwill on Southern's consolidated balance sheets. The amount of the purchase price that is allocated to goodwill is determined by the excess of the purchase price over the fair value of net identifiable assets acquired. Southern is required to conduct an annual review to determine whether goodwill is impaired.

          Goodwill is tested for impairment annually in the fourth quarter. An impairment test also could be triggered between annual testing dates if an event occurs or circumstances change that would more likely than not reduce the fair value below the carrying amount. Examples of those events or circumstances would include a significant adverse change in business climate; a significant unanticipated loss of clients/assets under management; an unanticipated loss of key personnel; a sustained period of poor investment performance; a significant loss of deposits or loans; a significant reduction in profitability; or a significant change in loan credit quality.

          Southern cannot assure you that it will not be required to take an impairment charge in the future. Any material impairment charge would have a negative effect on Southern's financial results and shareholders' equity.

Environmental liability associated with commercial lending could result in losses.

          In the course of its business, Southern may acquire, through foreclosure, properties securing loans it has originated or purchased that are in default. Particularly in commercial real estate lending, there is a risk that hazardous substances could be discovered on these properties. In this event, Southern might be required to remove these substances from the affected properties at Southern's sole cost and expense. The cost of this removal could substantially exceed the value of affected properties. Southern may not have adequate remedies against the prior owner or other responsible parties and could find it difficult or impossible to sell the affected properties. These events could have an adverse effect on Southern's business, results of operations and financial condition.

Attractive acquisition opportunities may not be available to Southern in the future, which may negatively impact Southern's ability to grow its business and effectively compete in existing and new markets.

          Southern will continue to consider the acquisition of other businesses. However, Southern may not have the opportunity to make suitable acquisitions on favorable terms in the future. Southern expects that other banking and financial companies, many of which have significantly greater resources than Southern does, will compete with Southern to acquire compatible businesses. This competition could increase prices for acquisitions that Southern might likely pursue. Also, acquisitions of regulated businesses, such as banks, are subject to various regulatory approvals. Failure to maintain regulatory compliance with the various regulations applicable to Southern could make regulatory approvals difficult to obtain. If Southern fails to receive the appropriate regulatory approvals, Southern will not be able to consummate an acquisition that Southern believes is in its best interests.

Southern may face risks with respect to future expansion and acquisitions or mergers, which include substantial acquisition costs, an inability to effectively integrate an acquired business into Southern's operations, lower than anticipated profit levels, and economic dilution to shareholders.

          Southern may seek to acquire other financial institutions or parts of those institutions and may engage in de novo branch expansion in the future. Southern may also consider and enter into new lines of business or offer new products or services. Southern may incur substantial costs to expand. An expansion may not result in the levels of profits it seeks or levels of profits comparable to or better than Southern's historical experience. Integration efforts for any future mergers or acquisitions may not be successful, which could have a material adverse effect on Southern's operations and financial condition. Also, Southern may issue equity securities, including Southern common stock and securities convertible into shares of Southern common stock, in connection with future acquisitions, which could cause ownership and economic dilution to its current shareholders.

          None.

Our offices are as follows:

Southern's, Southern Michigan Bank's, and the SMB Mortgage Company's main office:
   51 West Pearl Street, Coldwater, Michigan
   Office is owned by Southern Michigan Bank and comprises 27,945 square feet.

Southern Michigan Bank's branch office:
   2 West Chicago Street, Coldwater, Michigan
   Office is owned by Southern and comprises 16,848 square feet.

Southern Michigan Bank's branch office (drive-thru only):
   441 East Chicago Street, Coldwater, Michigan
   Office is owned by Southern Michigan Bank and comprises 990 square feet.

Southern Michigan Bank's branch office:
   10 East Carlson, Hillsdale, Michigan
   Office is owned by Southern Michigan Bank and comprises 4,353 square feet.

Southern Michigan Bank's branch office:
   202 North Main, Tekonsha, Michigan
   Office is owned by Southern Michigan Bank and comprises 2,928 square feet.

Southern Michigan Bank's branch office:
   5350 East Beckley Road, Battle Creek, Michigan
   Office is owned by Southern and comprises 14,274 square feet.

Southern Michigan Bank's branch office:
   1110 West Michigan Avenue, Marshall, Michigan
   Office is owned by Southern Michigan Bank and comprises 8,788 square feet.

Southern Michigan Bank's branch office:
   225 North Broadway, Union City, Michigan
   Office is owned by Southern Michigan Bank and comprises 4,542 square feet.

Southern Michigan Bank's branch office:
   102 East Main Street, North Adams, Michigan
   Office is owned by Southern Michigan Bank and comprises 1,292 square feet.

Southern Michigan Bank's branch office:
   100 West Burr Oak, Athens, Michigan
   Office is owned by Southern Michigan Bank and comprises 2,120 square feet.

Southern Michigan Bank's branch office:
   107 North Main Street, Camden, Michigan
   Office is owned by Southern Michigan Bank and comprises 2,375 square feet.

FNB Financial's and FNB Financial Services' main office:
   88 North Main Street, Three Rivers, Michigan
   Office is owned by FNB Financial and comprises approximately 14,256 square feet.

FNB Financial's branch office:
   1200 North Main Street, Three Rivers, Michigan
   Office is owned by FNB Financial and comprises approximately 3,321 square feet.

FNB Financial's branch office:
   225 U.S. 131, Three Rivers, Michigan
   Office is owned by FNB Financial and comprises approximately 900 square feet.

FNB Financial's branch office:
   901 East State Street, Cassopolis, Michigan
   Office is leased by FNB Financial and comprises approximately 220 square feet.

FNB Financial's branch office:
   235 East Main Street, Centreville, Michigan
   Office is owned by FNB Financial and comprises approximately 1,945 square feet.

FNB Financial's branch office:
   345 North Washington Street, Constantine, Michigan
   Office is owned by FNB Financial and comprises approximately 2,400 square feet.

FNB Financial's branch office:
   136 North Nottawa Road, Mendon, Michigan
   Office is owned by FNB Financial and comprises approximately 2,700 square feet.

FNB Financial's loan production office:
   212 South Front Street, Dowagiac, Michigan
   Office is leased by FNB Financial and comprises approximately 2,900 square feet.

          As of March 14, 2008, there are no significant pending legal proceedings to which we are a party or to which any of our properties are subject, except for legal proceedings arising in the ordinary course of business. In the opinion of management, resolution of pending legal proceedings will not have a material effect on the consolidated financial condition of Southern.

Alanar, Inc.

          From approximately December 2001 through November 16, 2006, Southern Michigan Bank served as the indenture trustee on 49 bond offerings that were underwritten by Alanar, Inc. ("Alanar"), an Indiana broker-dealer firm specializing in bond offerings by churches. Southern Michigan Bank also serves as the depository bank in connection with these 49 offerings, as well as an additional 35 bond offerings underwritten by Alanar for which Southern Michigan Bank was not the indenture trustee. Southern Michigan Bank also is party to an agreement dated December 27, 2000 with Guardian Services, LLC ("Guardian"), an affiliate of Alanar, pursuant to which Southern Michigan Bank agreed to provide fiduciary oversight services to Guardian and Guardian agreed to provide accounting, reporting and custodial services for individual retirement accounts.

          On July 26, 2005, the SEC obtained a court order freezing all assets under the control of Alanar, Guardian and their affiliates, including all accounts at Southern Michigan Bank. On October 5, 2005, the SEC issued an order finding that the defendants made misrepresentations to investors and misused investment proceeds from church bond issuances and the sale of bond investment fund units. The SEC revoked Alanar's registration as a broker and dealer and barred certain control persons from associating with any broker or dealer.

          Alanar, Guardian and their affiliates have been under court-appointed monitorship since July 26, 2005 and in receivership since December 20, 2005. The receiver has asserted that Alanar, Guardian and their affiliates operated a Ponzi scheme by improperly using the various accounts to make payments to investors in other bond offerings, to pay other defaulted bonds and to trade in securities in a commingled investment account. The receiver

has alleged that Alanar failed to perform an independent credit analysis of the churches before issuance of the bonds, but was able to hide a high rate of bond defaults by using improper transfers between the various accounts so that new investor money was allegedly used to pay returns to old investors. The receiver has further asserted that Alanar sold the bonds for the churches by focusing on the elderly and other unsophisticated investors who had a desire to help in the financing of churches. Sales were accomplished through prospectuses and placement memoranda prepared by Alanar that allegedly violated the securities laws by failing to disclose the roles and relationships of the paying agents, indenture trustees, registrars and other parties; the conflicts of interest and compensation of Alanar and its affiliates; and the multiple improper uses of funds in the alleged Ponzi scheme.

          According to the receiver's reports, as of April 30, 2007, there was a total of approximately $139,500,000 in outstanding principal and $59,300,000 in past due interest on all the bonds related to the Alanar receivership matter. Of this total indebtedness for all Alanar-related bonds, approximately $28,700,000 in principal and $6,000,000 in interest (18% of the total indebtedness) related to bonds for which Southern Michigan Bank previously served as the indenture trustee and for which the issuers had not made payments into their bond repayment accounts sufficient to pay their bond indebtedness completely. Of this $28,700,000 in principal indebtedness, the receiver's reports show that 11 issuers representing approximately $11,000,000 (38%) in combined bond principal were in default before the SEC action in July 2005. As discussed above, the receiver has asserted that Alanar was able to hide past bond defaults by using improper transfers between the various accounts so that new investor money was allegedly used to pay returns to old investors. Following the SEC action and the resulting appointment of the receiver with control over all accounts for the potential benefit of the receivership estate, some bond issuers ceased making their scheduled payments into their bond repayment accounts, while other bond issuers have continued to make these payments. However, all bond issuances are currently in default because all bondholders have not been paid since the accounts were frozen by court order on July 26, 2005.

          Under the stated terms of the trust indentures in each of these offerings, Southern Michigan Bank had no contractual duties to perform as indenture trustee until it received written notice of an event of default on the bonds. Following the SEC action in 2005 freezing all bond offering accounts, Southern Michigan Bank demanded information from Alanar and its affiliates serving as the registrars, paying agents and servicing agents for the bonds. Southern Michigan Bank also began corresponding with bond issuers to provide notice of important events and to obtain information from them, including information about their plans for repayment of their bondholders. In March 2006, the court amended its receivership order to provide the receiver with exclusive authority to correspond with bond issuers and bondholders and to prohibit others from doing so. In June 2006, the receiver filed a motion to have Southern Michigan Bank removed as indenture trustee for the purpose of avoiding inefficiencies and duplication of effort by both the receiver and Southern Michigan Bank. On November 17, 2006, pursuant to the receiver's unopposed motion, the court approved the removal of Southern Michigan Bank as indenture trustee for all bond offerings based upon the court's finding that "in light of the terms of the Receivership Order, as amended, [Southern Michigan Bank] is incapable of acting as trustee." At present, Southern Michigan Bank continues as the depository bank for the bond offering accounts, all of which are under the exclusive control of the receiver.

          According to the receiver's reports, there are 840 individual retirement accounts serviced by Guardian. The receiver's report of February 2006 indicates that these IRA accounts, combined with fifty 401(k) accounts also serviced by Guardian, together held approximately $1,400,000 in cash and approximately $12,000,000 in Alanar-related bond investment funds. Although the current total portfolio value of the IRAs is unknown, the last report received from Guardian prior to the receivership reported a total portfolio value of $35,800,000 in 790 individual retirement accounts as of December 31, 2004. On June 15, 2006, the receiver petitioned the court for authorization to permit distributions and roll-overs of all cash amounts and all investments such as mutual funds and real estate investment trusts that were unrelated to Alanar. The receiver stated that the forensic accounting reports "reveal that there is no evidence of any inappropriate commingling, misapplication or raiding of the cash deposits or non-Alanar related investments in these IRAs." On June 19, 2006, the court authorized these distributions. Subsequent reports of the receiver indicate that approximately $1,300,000 in cash has been distributed from the IRA and 401(k) accounts. The accounts continue to hold church bonds, bond investment fund units and any undistributed cash.

          On August 28, 2007, the court approved a plan for distribution of the receivership assets. The court also issued certain findings of fact and conclusions of law, including finding that the offering documents prepared by Alanar to sell the bonds contained misrepresentations and omissions of material facts necessary for investors to make informed investment decisions. The court also found that there was inappropriate manipulation and commingling of funds, and that the failure to disclose this manipulation and commingling had all the essential elements of a Ponzi scheme. Under the receivership plan approved by the court, all investors in the bond investment funds will be subject

to common pooling, but there will be a period of seven and one-half months (or perhaps longer, if extended by the court) for each of the individual bond issuances to be categorized based upon demonstrated ability to repay their bondholders. The timing for future distributions to bondholders and the scope of potential pooling of assets will depend upon the particular category assigned to a bond issuance by the receiver. Some bond issuances could be released from the receivership, some could be granted up to two years to achieve successful rehabilitation and others could be subject to immediate collection activity by the receiver. As to certain bond categories, a bank has been selected to serve as successor trustee and another bank to serve as successor bond registrar, transfer agent, paying agent and depository bank.

          As discussed above, Southern Michigan Bank has not served as indenture trustee since November 16, 2006, when the court approved the removal of Southern Michigan Bank so that the receiver could assume this role as the successor trustee to promote efficiency in the administration of the receivership. Under the receivership plan approved on August 28, 2007, the receiver will eventually name a new successor indenture trustee, as well as another bank to serve as the successor depository bank for the bond issuances. The plan also requires Southern Michigan Bank's agreement with Guardian related to the IRAs to be terminated within seven and one-half months (unless extended by the court). Upon the occurrence of these events, it is expected that Southern Michigan Bank will not have any further relationship with Alanar or its affiliates.

          No claims have been filed against Southern or Southern Michigan Bank by any bondholder, bond issuer, individual retirement account holder, the receiver, any governmental agency or any other person related to Southern Michigan Bank's former role as indenture trustee or Southern Michigan Bank's role as depository bank or in any other capacity related to these matters. There can be no assurance, however, that Southern or Southern Michigan Bank will not be subject to future claims, actions, suits or proceedings, including potential claims that our conduct was in breach of contractual, fiduciary or other duties or applicable statutes or regulations, or that, if made, Southern or Southern Michigan Bank would be successful in defending such claims. Protracted litigation or an adverse decision or settlement of any such action or proceeding could have a material adverse effect on the financial position, business, prospects and results of operations of Southern or Southern Michigan Bank.

          We did not submit any matters to a vote of the security holders of Southern during the fiscal quarter ended December 31, 2007.

PART II

Market for and Dividends on Southern Common Stock

          Southern common stock is quoted on the OTC Bulletin Board under the symbol "SOMC.OB." Trading activity in our common stock is relatively infrequent. Our trading volume and recent share price information can be viewed under the symbol "SOMC.OB" on certain financial websites.

          The range of high and low bid prices for shares of Southern common stock (adjusted to account for a 5% stock dividend declared in February 2006) for each quarterly period during the past two years is as follows:

          The prices listed above are OTC Bulletin Board quotations. They reflect inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions.

          As of March 14, 2008, there were 2,307,924 shares of Southern common stock issued and outstanding. As of March 14, 2008, there were 453 record holders of shares of Southern common stock.

          The following table summarizes cash dividends declared per share of Southern common stock during 2007 and 2006:

          Southern's principal source of funds to pay cash dividends is the earnings and dividends paid by our subsidiary banks. The banks are restricted in their ability to pay cash dividends under current laws and regulations. (See Management's Discussion and Analysis of Financial Condition and Results of Operations and Note Q to the Southern consolidated financial statements). Based on information presently available, management expects Southern to declare and pay regular quarterly cash dividends in 2008.

          Information regarding the equity compensation plans both approved and not approved by shareholders at December 31, 2007 is included in Item 12 of this report and is here incorporated by reference.

          The following table shows summarized historical consolidated financial data for Southern. The table is unaudited. The information in the table is derived from Southern's audited financial statements for 2003 through 2007. This information is only a summary. You should read it in conjunction with the consolidated financial statements, related notes, Management's Discussion and Analysis of Financial Condition and Results of Operations, and other information included in this report.

          The following discussion is designed to provide a review of the consolidated financial condition and results of operations of Southern and its wholly-owned subsidiaries, Southern Michigan Bank and FNB Financial. This discussion should be read in conjunction with the consolidated financial statements and related footnotes.

Critical Accounting Policies

          The discussion and analysis of the financial condition and results of operations are based upon Southern's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires Southern to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.

          Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially could result in materially different results under different assumptions and conditions.

          Allowance for Loan Losses

          The allowance for loan losses is maintained at a level management believes is adequate to absorb probable incurred credit losses inherent in Southern's loan portfolio. Accounting for loan classifications, accrual status and determination of the allowance for loan losses is based on regulatory guidance. This guidance includes, but is not limited to, generally accepted accounting principles, the uniform retail credit classification and account management policy issued by the Federal Financial Institutions Examination Council, and the joint policy statement on the allowance for loan losses methodologies also issued by the Federal Financial Institutions Examination Council. Using this guidance, management estimates the allowance balance based on past loan loss experience, nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, information in regulatory examination reports, and other factors. Many of the factors listed are inherently subjective, and requires the use of significant management estimates.

          Mortgage Servicing Rights

          Mortgage servicing rights represent the estimated value of servicing loans that are sold with servicing retained by Southern. Servicing rights are expensed in proportion to, and over the period of, estimated net servicing revenues. Management's accounting treatment of loan servicing rights is estimated utilizing a discounted cash flow model to determine the value of its servicing rights. The valuation model utilizes mortgage prepayment speeds, the remaining life of the mortgage pool, delinquency rates, our cost to service loans, and other factors to determine the cash flow that we will receive from serving each grouping of loans. These cash flows are then discounted based on current interest rate assumptions to arrive at the fair value for the right to service those loans.

          Acquisition Intangibles

          Generally accepted accounting principles require a determination of the fair value of all of the assets and liabilities of an acquired entity, and recording of their fair value on the date of acquisition. A variety of means are employed in determination of fair value, including the use of discounted cash flow analysis, market comparisons, and projected future revenue streams. Once valuations have been adjusted, the net difference between the price paid for the acquired company and the value of its balance sheet is recorded as goodwill. Goodwill is subject to an impairment analysis, performed at least annually.

Merger with FNB Financial Corporation

          On December 1, 2007, Southern merged with FNB Financial Corporation. The 2007 results of operations include one month of combined financial results after the close of the merger and the 2007 year end balance sheet includes all of the assets acquired and liabilities assumed from FNB Financial Corporation. Therefore, a comparison of 2007 and 2006 financial condition and results of operations is materially affected as a result of the merger. For more detailed information concerning the merger, see Note C to the consolidated financial statements.

Results of Operations

          Southern's net income for 2007 was $4,133,000, a 3.1% improvement from 2006. Provision for loan losses in the amount of $745,000 was expensed in 2007; up from $500,000 in 2006. Non-interest income of Southern, including gain on loan sales, increased 4.0% to $4,268,000 in 2007. Non-interest expense of $12,860,000 in 2007 was 2.1% higher than the 2006 costs.

          Results of operations can be measured by various ratio analyses. Two widely recognized performance indicators are return on equity and the return on assets. Southern's return on average equity was 12.72% in 2007, 14.54% in 2006 and 14.81% in 2005. The return on average assets was 1.18% in 2007, 1.25% in 2006 and 1.19% in 2005.

          Net Interest Income

          Interest income is the total amount earned on funds invested in loans, investment securities and federal funds sold. Interest expense is the amount of interest paid on interest bearing checking and savings accounts, time deposits, short term advances, subordinated debentures and other long-term borrowings. Net interest income, on a fully taxable equivalent (FTE) basis, is the difference between interest income and interest expense adjusted for the tax benefit received on tax-exempt loan and investment securities. Net interest margin is calculated by dividing net interest income (FTE) by average interest earning assets. Net interest spread is the difference between the average

yield on interest earning assets and the average cost of interest bearing liabilities. Because non-interest bearing sources of funds also support earning assets, the net interest margin exceeds the net interest spread.

          Net interest income is the most important source of Southern's earnings. Changes in Southern's net interest income are influenced by a number of factors, including changes in the level of interest earning assets, changes in the mix of interest earning assets and interest bearing liabilities, the level and direction of interest rates and the steepness of the yield curve.

          For 2007, Southern's net interest margin (FTE) was 4.83% compared to 5.05% for 2006 and 4.73% in 2005. Beginning in 2004 and continuing in 2005 and the first six months of 2006, the Federal Reserve increased rates 25 basis points 17 different times. From mid 2006 through August 2007 the prime rate remained steady. Beginning with a 50 basis point drop in September 2007, the Federal Reserve began a campaign of decreasing overnight borrowing rates to stimulate the economy. In both October and December rates were dropped an additional 25 basis points, for a 100 basis point total drop in 2007. Even as overnight borrowing rates began to decline, many larger banks continued to pay relatively high rates for deposits as they looked for sources of funding their loan commitments.

          Despite the lower net interest margin in 2007, net interest income increased during the year by $508,000. The increase was a result of a $2,187,000 improvement in interest income partially offset by an increase in interest expense of $1,679,000. The increase in interest income was primarily a result of $24.9 million of additional earning assets. Approximately $10.5 million of the increase in average earning assets was a result of the merger with FNB Financial Corporation. The average rate realized on earning assets in 2007 was 7.55%, an increase of 13 basis points from the 2006 results of 7.42%, and 97 basis points higher than the 6.58% realized in 2005. This increase in average rates also contributed to the increase in interest income.

          Increases in interest expense partially offset the interest income. Deposit rate increases that went into effect during the last half of 2006 impacted the full year of interest expense of 2007.          

          The following table presents a summary of net interest income (FTE) for 2007, 2006 and 2005.

Table 1. Average Balances and Tax Equivalent Interest Rates