SOUTHERN MICHIGAN BANCORP INC - Annual Report: 2008 (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     

The aggregate market value of the common stock held by non-affiliates of the Registrant as of June 30, 2008 was $35,210,241.

The number of shares outstanding of the Registrant's Common Stock, $2.50 par value, as of March 13, 2009, was 2,323,970 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 in Part I, Item 1 is forward-looking. Management's determination of the provision and allowance for loan losses and other accounting estimates, such as the carrying value of goodwill and mortgage servicing rights, involve 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; changes in value and credit quality of investment securities; 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. 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" "our" 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, 2008, Southern, on a consolidated basis, had shareholders' equity of $44.4 million.

          Southern Michigan Bank and FNB Financial intend to unite under a single charter and single name: Southern Michigan Bank & Trust. The banks received approval from the Federal Deposit Insurance Corporation ("FDIC") on March 23, 2009 to combine under a single charter. The banks expect to complete the transition process to a single charter and a single name during the second quarter of 2009.

          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, 2008, on a consolidated basis, we had assets of $475.0 million, deposits of $394.0 million, a net loan portfolio of $328.2 million, and had trust assets totaling $194.1 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. Many of our non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and banks. Such non-bank competitors may, as a result, have certain advantages over us in providing some services. 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:

          Federal law generally prohibits a bank from making any capital distribution (including payment of a dividend) or paying any management fee to its parent company if the depository institution would thereafter be undercapitalized. The FDIC may prevent an insured bank from paying dividends if the bank is in default of payment of any assessment due to the FDIC. In addition, the FDIC may prohibit the payment of dividends by a bank, if such payment is determined, by reason of the financial conditions of the bank, to be an unsafe and unsound banking practice. Additional information on restrictions on payment of dividends by the banks may be found under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note Q of our consolidated financial statements, which information is here incorporated by reference.

          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 Regulation ("OFIR") deems a bank subsidiary's capital to be impaired, OFIR 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 Board and the FDIC have established guidelines for risk-based capital by bank holding companies and banks. These guidelines establish a risk-adjusted ratio relating capital to risk-weighted assets and off-balance-sheet exposures. These capital guidelines primarily define the components of capital, categorize assets into different risk classes, and include certain off-balance-sheet items in the calculation of capital requirements.

          The FDIC Improvement Act of 1991 established a system of prompt corrective action to resolve the problems of undercapitalized financial institutions. Under this system, federal banking regulators have established five capital categories, well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, in which all institutions are placed. The federal banking agencies have also specified by regulation the relevant capital levels for each of the categories.

          Federal banking regulators are required to take specified mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Subject to a narrow exception, the banking regulator must generally appoint a receiver or conservator for an institution that is critically undercapitalized. An institution in any of the under-capitalized categories is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. An undercapitalized institution is also generally prohibited from paying any dividends, increasing its average total assets, making acquisitions, establishing any branches or engaging in any new line of business, except under an accepted capital restoration plan or with FDIC approval.

          Failure to meet capital guidelines could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits, and other restrictions on its business. In addition, such a bank would generally not receive regulatory approval of any application that requires the consideration of capital adequacy, such as a branch or merger application, unless the bank could demonstrate a reasonable plan to meet the capital requirement within a reasonable period of time.

          As of the date of this report, the capital ratios of Southern and the banks exceed the regulatory guidelines for "well-capitalized" institutions. Note V of our consolidated financial statements provides additional information regarding Southern's capital ratios, and is here incorporated by reference.

          The Banks

          Southern Michigan Bank and FNB Financial are chartered under Michigan law and are subject to regulation by OFIR. 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 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.

          Pursuant to the Federal Deposit Insurance Reform Act of 2005, the FDIC modified its method of calculating FDIC insurance assessments effective November 2006, and provided credits to certain banks for the calendar year 2007, to be applied to future assessments. Both the banks had earned assessment credits.  These changes have allowed the banks to partially offset their FDIC insurance assessments for 2007 and much of 2008 using credits they have earned. Credits at both banks were used up during 2008. The assessment methodology allows the FDIC to set its assessment rates in the future in connection with declines in the insurance funds or increases in the amount of insurance coverage. An increase in the assessment rate could have a material adverse effect on Southern's earnings, depending on the amount of the increase.

          During 2008, the banks paid $45,000 in Financing Corporation ("FICO") assessments related to outstanding FICO bonds to the FDIC as collection agent. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings and Loan Insurance Corporation. FICO assessments will continue in the future for the banks.

          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 FACT Act, the Gramm-Leach-Bliley Act, the Sarbanes-Oxley Act, The Bank Secrecy Act, 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 Office of Financial and Insurance Regulation, (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. A Michigan bank holding company may acquire a non-Michigan bank and a non-Michigan bank holding company may acquire a Michigan bank.

          Recent Developments

          In February of 2009, the FDIC announced a one-time special fee on banks of 20 cents per $100 in domestic deposits to replenish the DIF. The special fee is payable on September 30, 2009. In March 2009, the FDIC announced that it would consider reducing the special fee to approximately 10 cents per $100 in domestic deposits if Congress authorizes the FDIC to borrow more money from the Department of the Treasury. If the special fee remains at 20 cents per $100 in domestic deposits, the banks will have to pay the FDIC an aggregate special fee of approximately $788,000.

          On October 14, 2008, the FDIC announced the Temporary Liquidity Guarantee Program, under which the FDIC would offer a guarantee of certain financial institution indebtedness in exchange for an insurance premium to be paid to the FDIC by issuing financial institutions. The Temporary Liquidity Guarantee Program consists of two components: the Debt Guarantee Program and the Transaction Account Guarantee Program. Under the Debt Guarantee Program, the FDIC will guarantee the payment of certain newly-issued senior debt until the debt matures or June 30, 2012, whichever occurs earlier. Under the Transaction Account Guarantee Program, the FDIC will guarantee certain non-interest bearing transaction accounts until December 31, 2009. Financial institutions had until December 5, 2008 to opt out of these two programs. Southern did not opt out of either program. Southern had no senior unsecured debt at September 30, 2008. As a result, Southern's limit under the Debt Guarantee Program is $8,500,000, which is based on 2% of consolidated total liabilities at September 30, 2008. The limit on FDIC insured deposits was temporarily increased to $250,000 through December 31, 2009. These developments will cause the premiums assessed to Southern by the FDIC to increase.

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, 2008, Southern Michigan Bank employed 156 total employees and 148 full-time equivalent employees and FNB Financial employed 58 total employees and 54 full-time equivalent employees. Southern's only employees as of the same date were its four executive officers (all of whom are also employed by Southern Michigan Bank).

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 2008 and 2007 includes information for FNB Financial Corporation from the date of acquisition. Any comparison of information from 2008 or 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 (amortized cost) of securities categorized by type at December 31 was as follows:

          At the end of 2008 and 2007, the market value of securities issued by the State of Michigan and all its political subdivisions totaled $16,872,000 and $20,900,000, respectively. No other securities of any state (including all its political subdivisions) were greater than 10% of equity.

          Presented below is the fair value of securities as of December 31, 2008 and 2007, a schedule of maturities of securities as of December 31, 2008, and the weighted average yields of securities as of December 31, 2008.

______________

          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, 2008. 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, 2008.

          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, 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 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, requiring 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. 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 or vacation expenses, and other consumer purposes. Consumer loans may be secured, other than by real estate, or unsecured, generally requiring 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 collectability 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, 2008, there were $22.1 million of loans where some concern existed as to the borrowers' abilities to comply with original loan terms. We allocated $3,308,444 in the aggregate for loan losses for nonperforming and potential problem loans as of December 31, 2008. However, our allowance for loan losses is also available for potential problem loans.

          Loan Concentrations

          As of December 31, 2008, 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 listing 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.

          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 to the presentation of statistical information 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 thereon for the respective years.

          The following table illustrates the maturities of time deposits issued in denominations of $100,000 or more as of December 31, 2008.

(Dollars in thousands)

          Return on Equity and Assets

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

Risks Related to Southern's Business

Difficult market conditions have adversely affected the financial services industry.

          The capital and credit markets have been experiencing unprecedented volatility and disruption for more than twelve months. In recent months, the volatility and disruption has reached unprecedented levels. Dramatic declines in the housing market, falling home prices, increased foreclosures and unemployment have negatively impacted the credit performance of mortgage loans and resulted in significant write-downs of asset values by financial institutions. These write-downs have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. Reflecting concern about the stability of the financial markets generally and the strength of counterparties, many lenders and institutional investors have reduced or ceased providing funding to borrowers, including to other financial institutions. This market turmoil and tightening of credit have led to an increased level of commercial and consumer delinquencies, lack of consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets has adversely affected Southern's business, results of operations and financial condition. Southern does not expect that the difficult conditions in the financial markets are likely to improve in the near future.  A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on Southern and others in the financial institutions industry. If current levels of market disruption and volatility continue or worsen, there can be no assurance that Southern will not experience an adverse effect, which may be material, on its ability to access capital and on its business, results of operations and financial condition.

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. 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.

Southern could be adversely affected by the soundness of other financial institutions, including defaults by larger financial institutions.

          Southern's ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of credit, trading, clearing, counterparty or other relationships between financial institutions. Southern has exposure to many different industries and counterparties, and Southern routinely executes transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by Southern or by other institutions. This is sometimes referred to as "systemic risk" and may adversely affect financial intermediaries, such as clearing agencies, clearing houses, banks, securities firms and exchanges, with which Southern interacts on a daily basis, and therefore could adversely affect Southern.

          Many of these transactions expose Southern to credit risk in the event of default of a counterparty. In addition, Southern's credit risk may be exacerbated when the collateral held by Southern cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure due to Southern. There is no assurance that any such losses would not materially and adversely affect Southern's business, results of operations or financial condition.

Southern is subject to lending risk, which could materially adversely affect the Southern's results of operations and financial condition.

          There are inherent risks associated with the Southern's lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where Southern operates. Increases in interest rates or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans, which could have a material adverse effect on the Southern's results of operations and financial condition. Southern is subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject

Southern to regulatory enforcement action that could result in the assessment of significant civil money penalties against Southern.

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.

Southern is subject to interest rate risk, which may negatively affect Southern's earnings and the value of its assets.

          Southern's earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets, such as loans and securities, and interest expense paid on interest-bearing liabilities, such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond Southern's control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, could influence the interest Southern receives on loans and securities and the amount of interest it pays on deposits and borrowings. Such changes could also affect Southern's ability to originate loans and obtain deposits and the fair value of Southern's financial assets and liabilities. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, Southern's net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.

Southern's banks are subject to liquidity risk in their operations, which could adversely affect their ability to fund various obligations.

          Liquidity risk is the possibility of being unable to meet obligations as they come due, capitalize on growth opportunities as they arise, or pay regular dividends because of an inability to liquidate assets or obtain adequate funding on a timely basis, at a reasonable cost and within acceptable risk tolerances.  Liquidity is required to fund various obligations, including credit obligations to borrowers, mortgage originations, withdrawals by depositors, repayment of debt, dividends to the banks' shareholder, operating expenses and capital expenditures.  Liquidity is derived primarily from retail deposit growth and retention, principal and interest payments on loans and investment securities, net cash provided from operation and access to other funding sources.  Liquidity is essential to the banks' respective business. The banks must maintain sufficient funds to respond to the needs of depositors and borrowers. An inability to raise funds through deposits, borrowings, the sale or pledging as collateral of loans and other assets could have a material adverse effect on the banks' liquidity. The banks' access to funding sources in amounts adequate to finance their activities could be impaired by factors that affect the banks specifically or the financial services industry in general. Factors that could detrimentally impact the banks' access to liquidity sources include a decrease in the level of the banks' business activity due to a market down turn or regulatory action that limits or eliminates the banks' access to alternate funding sources. The banks' ability to borrow could also be impaired by factors that are nonspecific to the banks, such as severe disruption of the financial markets or negative expectations about the prospects for the financial services industry as a whole, as evidenced by recent turmoil in the domestic and worldwide credit markets.

Restrictions on Southern's banks' ability to pay dividends could subject Southern to liquidity risk.

          Southern's principal source of funds to pay cash dividends and to fund its corporate obligations is the earnings of and dividends paid by its subsidiary banks. Southern's corporate obligations include its obligation to pay interest and principal when and as due under its bank credit agreement, which is secured by a pledge of all of the stock of the banks, and its obligation to pay interest and principal when due under its junior subordinated debt securities. If the banks are unable to pay cash dividends to Southern in an amount sufficient to fund these obligations and Southern is unable to access liquidity from other sources, Southern may be unable to continue dividends and satisfy its other financial obligations.

The total impact on Southern of the Emergency Economic Stabilization Act of 2008 and its implementing regulations cannot be predicted at this time.

          The programs established or to be established under the Emergency Economic Stabilization Act of 2008 ("EESA") and the Troubled Assets Relief Program ("TARP") could have adverse effects upon Southern. Southern may face increased regulation in its industry. Compliance with such regulation may increase Southern's costs and limit Southern's ability to pursue business opportunities. Also, participation in specific programs may subject Southern to additional restrictions. The overall effects of participating in such programs and the extent of Southern's participation in such programs cannot reliably be determined at this time.

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, 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 maintain its regulatory capital at desired levels or 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 maintain assets at current levels or 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 may see substantially higher deposit insurance premiums in the future which may negatively impact future earnings.

          Recent insured institution failures, as well as deterioration in banking and economic conditions, have significantly increased FDIC loss provisions, resulting in a decline in the designated reserve ratio to historical lows. The FDIC expects a higher rate of insured institution failures in the next few years compared to recent years; thus, the reserve ratio may continue to decline.  In addition, the limit on FDIC coverage was temporarily increased to $250,000 through December 31, 2009. These developments will cause the premiums assessed to Southern by the FDIC to increase.

          Southern is a participant in the FDIC Temporary Liquidity Guarantee Program. Participating in this program will likely require the payment of additional insurance premiums to the FDIC.

          In February of 2009, the FDIC announced a one-time special fee on banks of 20 cents per $100 in domestic deposits to replenish the DIF. The special fee is payable on September 30, 2009. In March 2009, the FDIC announced that it would consider reducing the special fee to approximately 10 cents per $100 in domestic deposits if Congress authorizes the FDIC to borrow more money from the Department of the Treasury. If the special fee remains at 20 cents per $100 in domestic deposits, the banks will have to pay the FDIC an aggregate special fee of approximately $788,000.

          Further, depending upon any future losses that the FDIC insurance fund may suffer, there can be no assurance that there will not be additional premium increases in order to replenish the fund. The FDIC may need to set a higher base rate schedule based on future financial institution failures and updated failure and loss projections. Potentially higher FDIC assessment rates than those currently projected could have an adverse impact on the Southern's results of operations.

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.

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.

          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 with FNB Financial. Southern will incur substantial additional expenses to comply with these laws and regulations that may adversely affect 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 managing the operations of Southern. 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 was the depository bank in connection with certain bond offerings underwritten by Alanar, Inc. Southern Michigan Bank also was 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 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 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. 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 Part I, Item 3 of this report.

If Southern is required to write down goodwill and other intangible assets, 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 and other intangible assets on Southern's consolidated balance sheets. The amount of the purchase price that was allocated to goodwill and other intangible assets was determined by the excess of the purchase price over the fair value of the net identifiable assets acquired. Southern is required to conduct an annual review to determine whether goodwill and other identifiable intangible assets are 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.

Changes in accounting standards could impact Southern's reported earnings.

          Current accounting and tax rules, standards, policies and interpretations influence the methods by which financial institutions conduct business and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies and interpretations are constantly evolving and may change significantly over time. Events that may not have a direct impact on Southern, such as bankruptcy of major U.S. companies, have resulted in legislators, regulators, and authoritative bodies, such as the Financial Accounting Standards Board, the Securities Exchange Commission, the Public Company Accounting Oversight Board and various taxing authorities, responding by adopting and/or proposing substantive revision to laws, regulations, rules, standards, policies and interpretations. New accounting pronouncements and varying interpretations of accounting pronouncements have occurred and may occur in the future. Southern's financial condition and results of operations may be adversely affected by a change in accounting standards.

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. Additional information on restrictions on payment of dividends by the banks may be found under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note Q of our consolidated financial statements, which information is here incorporated by reference.

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 will 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.

          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

          As of March 13, 2009, 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 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 served 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 was 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.

          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."

          On August 28, 2007, the court approved a plan for future 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. The receiver continues to administer the receivership assets pursuant to court approved plans for the receivership.

          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, 2008.

PART II

          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 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 13, 2009, there were 2,323,970 shares of Southern common stock issued and outstanding. As of March 13, 2009, there were 428 holders of record of shares of Southern common stock.

          The following table summarizes cash dividends declared per share of Southern common stock during 2008 and 2007:

          Southern's principal source of funds to pay cash dividends is the earnings of and dividends paid by our subsidiary banks. The banks are restricted in their ability to pay cash dividends under current laws and regulations For additional information on restrictions on dividends, see Management's Discussion and Analysis of Financial Condition and Results of Operations and Note Q to the Southern consolidated financial statements, which information is here incorporated by reference. Limitations on the ability of our subsidiary banks to pay cash dividends to Southern could limit Southern's ability to pay dividends in the future. On March 19, 2009, Southern announced that its board of directors declared a quarterly dividend of $0.05 per share payable April 17, 2009 to shareholders of record on April 3, 2009. This reflects a decrease from $0.20 per share paid in the fourth quarter of 2008. This action will enable Southern to retain an additional $1.4 million in common equity per year.

          Information regarding the equity compensation plans both approved and not approved by shareholders at December 31, 2008 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 2004 through 2008. 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 Michigan Bancorp, Inc. ("Southern"), and its wholly-owned subsidiaries, Southern Michigan Bank & Trust ("SMB&T") and FNB Financial ("FNB"). This discussion should be read in conjunction with the consolidated financial statements and related footnotes.

Acquisition of FNB Financial Corporation

          On December 1, 2007, Southern acquired FNB Financial Corporation. The 2008 results of operations include twelve months of combined financial results while the 2007 results of operations include one month of combined financial results after the close of the acquisition. The 2008 and 2007 year end balance sheets include all of the assets acquired and liabilities assumed from FNB Financial Corporation. Therefore, a comparison of 2008 to 2007 results of operations and 2007 to 2006 financial condition and results of operations is materially affected as a result of the acquisition. For more detailed information concerning the acquisition, see Note C to the consolidated financial statements.

Recent Market Developments

          The global and U.S. economies are experiencing significantly reduced business activity as a result of, among other factors, disruptions in the financial system during the past year. Dramatic declines in the housing market during the past year, along with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs, initially of residential-related loans and mortgage-backed securities, spreading to credit default swaps and other derivative securities, have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail.

          Reflecting concern about the stability of the financial markets, many national and regional lenders have reduced, and in some cases, ceased to provide funding to borrowers, including other financial institutions. The availability of credit, confidence in the financial sector, and level of volatility in the financial markets have been significantly adversely affected as a result. In recent months, volatility and disruption in the capital and credit

markets have reached unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit capacity for certain issuers without regard to those issuers' underlying financial strength.

Results of Operations

          Southern's net income for 2008 was $813,000 compared to $4,133,000 in 2007, a decrease of $3,320,000, or 80.3%. Provision for loan losses in the amount of $5,080,000 was expensed in 2008; up from $745,000 in 2007. Non-interest income of Southern, including gain on loan sales, increased 50.4% to $6,417,000 in 2008. Non-interest expense of $19,024,000 in 2008 was 47.9% higher than the 2007 costs.

          Results of operations can be measured by various ratio analyses. Two widely recognized performance indicators are return on equity and return on assets. Southern's return on average equity was 1.77% in 2008, 12.72% in 2007 and 14.54% in 2006. The return on average assets was 0.17% in 2008, 1.18% in 2007 and 1.25% in 2006.

          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 2008, Southern's net interest margin (FTE) was 4.36% compared to 4.83% for 2007 and 5.05% for 2006. 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. Through December 2008, the Federal Reserve had decreased the overnight borrowing rate 5%, to its lowest level of all time, a range of 0% to .25%. Southern's interest rate spread and margin both decreased as yields on earning assets decreased 1.24%, from 7.55% to 6.31% while deposit yields were down 1.02%, from 3.22% to 2.20%.

          Despite the lower net interest margin in 2008 and 2007, net interest income increased during both years by $3,055,000 and $508,000, respectively. The increase in both years primarily resulted from the acquisition of FNB.

          The 2008 increase was a result of $2,606,000 improvement in interest income and $449,000 reduction of interest expense. The increase in interest income was the result of $104.1 million of additional average earning assets which was enough to overcome the large rate decrease. Despite adding $103.6 million of average interest bearing deposits, interest expense decreased $449,000 in 2008 as Southern closely monitored deposit rates.

          The 2007 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 $23.7 million of additional earning assets. Approximately $10.5 million of the increase in average earning assets was a result of the

acquisition of FNB. 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%. This increase in average rate also contributed to the increase in interest income. The increase in interest expense partially offset the 2007 interest income.

          The following table presents a summary of net interest income (FTE) for 2008, 2007 and 2006.

Table 1.  Average Balances and Tax Equivalent Interest Rates