SOUTHERN MICHIGAN BANCORP INC - Annual Report: 2010 (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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes           No        

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, 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):

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, computed by reference to the average bid and asked price of the common stock, as of June 30, 2010 was $25,765,437.

The number of shares outstanding of the registrant's common stock, $2.50 par value, as of March 14, 2011, was 2,340,339 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", "plan" or "strategy" that an event or trend "may", "should", "will", "is likely", or is "probably" to occur or "continue", has "begun" or "is scheduled" or "on track" or that the Company or its management "anticipates", "believes", "estimates", "plans", "forecasts", "intends", "predicts", "projects", or "expects" a particular result, or is "committed", "confident", "optimistic" or has an "opinion" that an event will occur, or other words or phrases such as "ongoing", "future", "signs", "efforts", "tend", "exploring", "appearing", "until", "near term", "going forward", "starting" and variations of such words and similar expressions.Such statements are based upon current beliefs and expectations and involve substantial risks and uncertainties which could cause actual results to differ materially from those expressed or implied by such forward-looking statements. These statements include, among others, statements related to real estate valuation, future levels of non-performing loans, the rate of asset dispositions, dividends, future growth and funding sources, future liquidity levels, future profitability levels, the effects on earnings of changes in interest rates and the future level of other revenue sources. Management's determination of the provision and allowance for loan losses, the appropriate carrying value of intangible assets (including goodwill and mortgage servicing rights), deferred tax assets and other real estate owned, the fair value of investment securities (including whether any impairment on any investment security is temporary or other-than-temporary and the amount of any impairment), and management's assumptions concerning pension and other postretirement benefit plans involves judgments that are inherently forward-looking. All statements with references to future time periods are forward-looking. All of the information concerning interest rate sensitivity is forward-looking. Our ability to successfully implement new programs and initiatives, increase efficiencies, respond to declines in collateral values and credit quality, maintain our current level of deposits and other sources of funding, and improve profitability is not entirely within our control and is not assured. The future effect of changes in the real estate, financial and credit markets and the national and regional economy on the banking industry, generally, and Southern Michigan Bancorp, Inc., specifically, are also inherently uncertain. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("risk factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements.

          Risk factors include, but are not limited to, the risk factors described in "Item 1A - Risk Factors" of this report. 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

          As used in this report, the terms "Southern," the "Company," "we," "our," or "us" mean Southern Michigan Bancorp, Inc. and its subsidiaries, unless the context indicates another meaning.

General

          Southern Michigan Bancorp, Inc. is a bank holding company registered under the Bank Holding Company Act of 1956. 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" or "the Bank"), which it did in November 1982. Southern is also the parent company of Southern Michigan Bancorp Capital Trust I, a Delaware statutory trust. Southern Michigan Bank is the parent company of FNB Financial Services, Inc., a Michigan corporation.

          Our business, which we conduct primarily through the Bank, is concentrated in a single industry segment - 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. We operate 17 banking offices located in Athens, Battle Creek, Camden, Cassopolis, Centreville, Coldwater, Constantine, Hillsdale, Marshall, Mendon, Tekonsha, Three Rivers, and Union City, Michigan.

          On December 1, 2007, we completed the acquisition of FNB Financial Corporation ("FNB") and its subsidiary bank, FNB Financial. On April 24, 2009, FNB Financial was consolidated with and into the Bank.

          At December 31, 2010, on a consolidated basis, we had assets of $493.9 million, deposits of $409.9 million, a net loan portfolio of $303.8 million, trust assets under management totaling $215.0 million, and shareholders' equity of $47.8 million. Additional information about our consolidated financial condition as of December 31, 2010 and 2009 and the results of our operations for the three years ended December 31, 2010, may be found throughout this report, including in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and in the consolidated financial statements and related notes, which information is here incorporated by reference.

          We have no material foreign loans, assets or activities. No material part of our business is dependent on a single customer or very few customers, the loss of which would have a material adverse effect on us.

          Our headquarters and administrative offices are located at 51 West Pearl Street, Coldwater, Michigan 49036, and our telephone number is (517) 279-5500. Our internet website address is www.smb-t.com. The information on our website address is not incorporated by reference into this report, and the information on the website is not part of this report.

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, dividend 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 of Southern. 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 changes, 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.

          Recent Regulatory Developments

          Dodd-Frank Act: The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act"), was signed into law by President Obama on July 21, 2010. The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States, establishes the new federal Bureau of Consumer Financial Protection ("BCFP"), and will require the BCFP and other federal agencies to implement many new and significant rules and regulations. At this time, it is difficult to predict the extent to which the Dodd-Frank Act or the resulting rules and regulations will impact the Company's business. Compliance with these new laws and regulations will likely result in additional costs, which could be significant and could adversely impact the Company's results of operations, financial condition or liquidity.

          Deposit Insurance: The FDIC has finalized changes to its deposit insurance assessment base effective April 1, 2011, which will use average assets as the base instead of quarterly deposits. Additional information about these changes may be found below under the heading "Southern Michigan Bank."

          On November 12, 2009, the FDIC adopted a final rule on assessment regulations to require depository institutions to prepay their quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012, on December 30, 2009. The projected assessment base for each quarter represents the September 30, 2009 assessment base increased quarterly by a 5 percent annual growth rate. This rule resulted in a prepaid assessment for the Bank of $1.6 million and $2.2 million at December 31, 2010 and 2009, respectively.

          As a result of provisions of the Dodd-Frank Act, all funds in a "noninterest-bearing transaction account" are insured in full by the FDIC from December 31, 2010, through December 31, 2012. This temporary unlimited coverage is in addition to, and separate from, the general FDIC deposit insurance coverage of up to $250,000 available to depositors. The increase in maximum deposit insurance coverage to $250,000 was made permanent under the Dodd-Frank Act.

          Debit Card Interchange Fees and Routing: The Federal Reserve Board on December 16, 2010 issued a proposal to implement a provision in the Dodd-Frank Act that requires it to set debit-card interchange fees so they are "reasonable and proportional" to the cost of the transaction. If finalized as proposed, the rule could result in a significant reduction in banks' debit-card interchange revenue. Though the rule technically does not apply to institutions with less than $10 billion, there is concern that the price controls will harm community banks, such as Southern Michigan Bank, which will be pressured by the marketplace to lower their own interchange rates.

          Overdraft Protection Rules: On November 24, 2010, the FDIC issued final guidance to address the risks associated with overdraft payment programs. The guidance is intended to ensure robust oversight of automated overdraft programs offered by certain FDIC-insured institutions. The final guidance provides information to assist FDIC-supervised institutions in identifying, managing and mitigating risks associated with overdraft payment programs, including risks that could result in serious financial harm to certain consumers. The guidance focuses on automated overdraft programs and encourages banks to offer less costly alternatives if, for example, a borrower overdraws his or her account on more than six occasions where a fee is charged in a rolling twelve-month period. Additionally, to avoid reputational and other risks, the FDIC expects institutions to institute appropriate daily limits on customer costs and ensure that transactions are not processed in a manner designed to maximize the cost to consumers, such as by processing checks from the largest to the smallest. We are currently evaluating our alternatives with regard to this guidance, and have not yet determined the potential impact on our financial statements.

          In addition, the U.S. Government, the Federal Reserve, the Department of the Treasury, the FDIC and other governmental and regulatory bodies have taken, or may be considering taking, other actions to address the financial crisis. There can be no assurance, however, as to the actual impact of these actions on the financial markets and their potential impact on our business.

          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.

          Under Federal Reserve System policy, we are expected to act as a source of financial strength to the Bank and to commit resources to support the Bank. In addition, if the Michigan Office of Financial and Insurance Regulation ("OFIR") deems the Bank'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.

          Southern is a legal entity separate and distinct from the Bank. There are legal limitations on the extent to which the Bank may lend or otherwise supply funds to us, which indirectly limit our ability to pay dividends to our shareholders. Payment of dividends to us by the Bank, our principal source of funds, is subject to various state and federal regulatory limitations. Under the Michigan Banking Code of 1999, the 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.

          In a policy statement, the Federal Reserve Board has expressed its view that a bank holding company should not pay cash dividends if its net income available to shareholders for the past four quarters, net of dividends paid during that period, is not sufficient to fully fund the dividends, its prospective rate of earnings retention is not consistent with capital needs and overall current and prospective financial condition, or it will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. The Federal Reserve Board also possesses enforcement powers over bank holding companies and their non-bank subsidiaries to prevent or remedy actions that represent unsafe or unsound practices or violations of applicable statutes and regulations. Among these powers is the ability to proscribe the payment of dividends by banks and bank holding companies. Additional information on restrictions on payment of dividends by us and the Bank 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.

          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 the Bank exceeded the minimum thresholds to be categorized as "well-capitalized" under applicable regulations. Note V of our consolidated financial statements provides additional information regarding our capital ratios, and is here incorporated by reference.

          Southern Michigan Bank

          Southern Michigan Bank is chartered under Michigan law and is 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 Bank's deposits are insured by the FDIC to the extent provided by law. From time to time, the Bank is required to pay deposit insurance premiums to the Deposit Insurance Fund ("DIF"). The FDIC has finalized changes to its deposit insurance assessment base effective April 1, 2011, which will use average assets as the base instead of quarterly deposits. Under this new calculation, most well-capitalized banks will pay 5 to 9 basis points annually, increasing to 35 basis points for banks that post significant supervisory concerns. This base rate may be adjusted for the level of unsecured debt and brokered deposits, resulting in adjusted rates ranging from 2.5 to 9 basis points annually for most well-capitalized banks to 30 to 45 basis points for banks that pose significant supervisory concerns. We estimate our annual assessment rate under these new guidelines to be 8 basis points.

          The Bank is a member of the Federal Home Loan Bank system. This provides certain advantages, including favorable borrowing rates for certain funds.

          During 2010, the Bank paid $40,000 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 Bank.

          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 Dodd-Frank Act, 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.

Environmental Regulations

          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, 2010, Southern Michigan Bank employed 204 total employees equaling 196 full-time equivalent employees. Southern's only employees as of the same date were its three executive officers (all of whom were 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 2007 includes information for FNB Financial Corporation from the date of acquisition. Any comparison of statistical information for periods after December 1, 2007 to periods before December 1, 2007 must consider that

information for FNB Financial Corporation is not included in information presented for periods before December 1, 2007.

          Securities Portfolio

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

(Dollars in thousands)

          At the end of 2010 and 2009, the market value of securities issued by the State of Michigan and all its political subdivisions totaled $19,903,000 and $15,466,000, respectively. No other securities held of any other single issuer were greater than 10% of shareholders' equity.

          Presented below is the fair value of securities as of December 31, 2010 and 2009, a schedule of maturities of securities as of December 31, 2010, and the weighted average yields of securities as of December 31, 2010.

(Dollars in thousands)

______________

          The weighted average yields 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.

(Dollars in thousands)

          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, 2010. 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, 2010.

(Dollars in thousands)

          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 five years and 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 allowance for losses we believe to be adequate 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, 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 - 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 - 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 - 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 were classified as non-accrual, past due and restructured loans as of December 31:

(Dollars in thousands)

          A loan is placed on nonaccrual status at the point in time at which the collectability of principal or interest is considered in doubt, typically when payments are past due over 90 days, unless the loan is both well-secured and in the process of collection. The table below illustrates interest forgone and interest recorded on nonperforming loans for the years presented.

(Dollars in thousands)

          Potential Problem Loans

          At December 31, 2010, there were $47.2 million of loans where known information about possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms. We allocated $1,171,000 in the aggregate for loan losses for nonperforming and potential problem loans as of December 31, 2010. However, our entire allowance for loan losses is also available for potential problem loans.

          Loan Concentrations

          As of December 31, 2010, there was no concentration of loans exceeding 10% of total loans which are not otherwise disclosed as a category of loans pursuant to Item III.A. of Industry Guide 3.

          Other Interest Bearing Assets

          As of December 31, 2010, we had no interest bearing assets that would be required to be disclosed pursuant to Item III.C.1. or 2. if such assets were loans.

          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.

(Dollars in thousands)

          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.

(Dollars in thousands)

          The Securities and Exchange Commission's Industry Guide 3 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.

(Dollars in thousands)

          The following table illustrates the maturities of time deposits issued in denominations of $100,000 or more as of December 31, 2010.

(Dollars in thousands)

          We have no foreign deposits.

          Return on Equity and Assets

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

          Short Term Borrowings

          The information in Note J of the consolidated financial statements is here incorporated by reference.

Risks Related to Southern's Business

The economic conditions in the State of Michigan could have a material adverse effect on our results of operations and financial condition.

          Our success depends primarily on the general economic conditions in the State of Michigan and the specific local markets in which we operate. Unlike larger national or other regional banks that are more geographically diversified, we provide banking and financial services to customers primarily in southwest Michigan. The local economic conditions in this area has a significant impact on the demand for our products and services as well as the ability of our customers to repay loans, the value of the collateral securing loans and the stability of our deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities, financial, or credit markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on our results of operations and financial condition.

Difficult market conditions have adversely affected the financial services industry.

          The capital and credit markets have been experiencing unprecedented volatility and disruption for an extended period of time. Dramatic declines in the housing market, falling home prices, increased foreclosures and unemployment have negatively impacted the credit performance of mortgage loans and construction and development 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 commercial borrowers and lack of confidence in the financial markets has adversely affected our business, results of operations and financial condition. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. If current levels of market disruption and volatility continue or

worsen, there can be no assurance that we will not experience adverse effects, which may be material, on our ability to access capital and on our business, results of operations and financial condition.

Restrictions on the Bank's ability to pay dividends subjects Southern Michigan Bancorp to liquidity risk.

          Southern Michigan Bancorp's principal source of funds to pay cash dividends and to fund its corporate obligations is the earnings of and dividends paid by the Bank. Southern Michigan Bancorp'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 Bank, and its obligation to pay interest and principal when due under its junior subordinated debt securities. If the Bank is unable to pay cash dividends to Southern Michigan Bancorp in an amount sufficient to fund these obligations and Southern Michigan Bancorp is unable to access liquidity from other sources, it may be unable to pay dividends and satisfy its other financial obligations. As of December 31, 2010, the Bank could pay $4.0 million of dividends to Southern Michigan Bancorp without prior regulatory approval and Southern Michigan Bancorp had limited liquid assets. Additional information related to our liquidity position may be found in Notes Q and R to the consolidated financial statements.

If the condition of the Bank's loan portfolio worsens, its ability to borrow funds from the Federal Home Loan Bank and Federal Reserve Bank could be adversely affected, which could materially adversely affect the Bank's liquidity position.

          As part of its liquidity management, the Bank borrows funds from the Federal Home Loan Bank and has the ability to borrow from the Federal Reserve Bank. Borrowed funds are collateralized by certain investment securities and qualifying residential and commercial real estate loans. The Bank is permitted to borrow an amount of funds up to a certain percentage of the total investment securities and loans pledged as collateral. The Federal Home Loan Bank and Federal Reserve Bank will not accept as collateral any loan that is rated as a 5 (special mention) or worse on our internal loan grading system. If the quality of the Bank's loan portfolio worsens, the Bank could have fewer loans eligible to be pledged as collateral for borrowed funds, reducing the total amount of available funds that the Bank is permitted to borrow. A reduction in the total amount of the available funds that the Bank is permitted to borrow from the Federal Home Loan Bank and Federal Reserve Bank could materially adversely affect the Bank's liquidity position.

We are subject to liquidity risk in our operations, which could adversely affect our ability to fund various obligations.

          Liquidity risk is the possibility of being unable to meet obligations as they come due, pay deposits when withdrawn, capitalize on growth opportunities as they arise, or pay 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 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 our business. We 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 our liquidity. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity due to a market down turn or regulatory action that limits or eliminates our access to alternate funding sources. Our ability to borrow could also be impaired by factors that are nonspecific to us, 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.

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.

          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 and could materially decrease shareholders' equity.

          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 material negative effect on Southern's operating results and shareholders' equity.

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'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.

We may face increasing pressure from historical purchasers of our residential mortgage loans to repurchase those loans or reimburse purchasers for losses related to those loans.

          We generally sell the fixed rate long-term residential mortgage loans we originate on the secondary market and retain adjustable rate mortgage loans for our portfolio. In response to the financial crisis, we believe that purchasers of residential mortgage loans, such as government sponsored entities, are increasing their efforts to seek to require sellers of residential mortgage loans to either repurchase loans previously sold or reimburse purchasers for losses related to loans previously sold when losses are incurred on a loan previously sold due to actual or alleged failure to strictly conform to the purchaser's purchase criteria. As a result, we may face increasing pressure from historical purchasers of our residential mortgage loans to repurchase those loans or reimburse purchasers for losses related to those loans and we may face increasing expenses to defend against such claims. If we are required in the future to repurchase loans previously sold, reimburse purchasers for losses related to loans previously sold, or if we incur increasing expenses to defend against such claims, our financial condition and results of operations would be negatively affected, and would lower our capital ratios as a result of increasing assets and lowering income through expenses and any loss incurred.

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.

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.

Southern may need to raise additional capital in the future, but that capital might not be available on acceptable terms or at all 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 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 or at all. If Southern cannot raise additional capital when needed, its ability to maintain assets at current levels or expand its operations through organic growth and acquisitions could be materially impaired.

The recently enacted Dodd-Frank Act may adversely impact the Company's results of operations, financial condition or liquidity.

          On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act"), was signed into law by President Obama.  The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States, establishes the new federal Bureau of Consumer Financial Protection (the "BCFP"), and will require the BCFP and other federal agencies to implement many new and significant rules and regulations.  At this time, it is difficult to predict the extent to which the Dodd-Frank Act or the resulting rules and regulations will impact our business. Compliance with these new laws and regulations will likely result in additional costs, which could be significant and could adversely impact our results of operations, financial condition or liquidity.

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.

Southern may be required to pay additional insurance premiums to the FDIC, which could negatively impact 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 reserve ratio may continue to decline in the future. In addition, the limit on FDIC coverage has been permanently increased to $250,000. These developments have caused the premiums assessed to Southern by the FDIC to increase. 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 or impose special assessments due to future financial institution failures and updated failure and loss projections. In addition, a decline in the Bank's CAMEL ratings could subject Southern to increased FDIC insurance premiums. Higher FDIC assessment rates would have an adverse impact on Southern's results of operations.

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 different 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.

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, and national 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.

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 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. On October 21, 2010, the Chief Executive Officer of Alanar, Inc. and Guardian Services, LLC was convicted of felony securities fraud. 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. 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.

Evaluation of investment securities for other-than-temporary impairment involves subjective determinations and could materially impact Southern's results of operations and financial condition.

          The evaluation of impairments is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions, the issuer's financial condition or future recovery prospects, the effects of changes in interest rates or credit spreads and the expected recovery period. Estimating future cash flows involves incorporating information received from third-party sources and making internal assumptions and judgments regarding the future performance of the underlying collateral and assessing the probability that an adverse change in future cash flows has occurred. The determination of the amount of other-than-temporary impairments is based upon Southern's periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. Southern's management considers a wide range of factors about the security issuer and uses its reasonable judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for recovery. Inherent in management's evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Impairments to the carrying value of our investment securities may need to be taken in the future, which could have a material adverse effect on our results of operations and financial condition.

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 sheet. The amount of the purchase price that is allocated to goodwill and other intangible assets is determined by the excess of the purchase price over the 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 customers or 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.

If Southern is required to take a valuation allowance with respect to its deferred tax assets, its financial condition and results of operations would be negatively affected.

          Southern's net deferred tax asset was $1.78 million at December 31, 2010. A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. No valuation allowance was considered necessary at December 31, 2010. A valuation allowance of $54,000 was considered necessary at December 31, 2009, as the likelihood of receiving a tax benefit on a portion of the capital loss on the write off of an investment was considered doubtful. If Southern is required in the future to take one or more additional valuation allowances with respect to its deferred tax assets, its financial condition and results of operations would be negatively affected.

If Southern is required to take a valuation allowance with respect to its mortgage servicing rights, its financial condition and results of operations would be negatively affected.

          Southern's mortgage servicing rights were $868,000 at December 31, 2010. No valuation allowance for capitalized mortgage servicing rights was considered necessary at December 31, 2010 or 2009 because the fair value of such rights approximated or exceeded the carrying value. If Southern is required in the future to take a valuation

allowance with respect to its mortgage servicing rights, its financial condition and results of operations would be negatively affected.

We hold general obligation municipal bonds in our investment securities portfolio. If one or more issuers of these bonds were to become insolvent and default on its obligations under the bonds, it could have a negative effect on our financial condition and results of operations.

          Some experts have raised concerns about the financial difficulties that municipalities are experiencing, and the potential for many municipalities to become insolvent. Municipal bonds held by us totaled $ 25.4 million at December 31, 2010, and were issued by different municipalities. We believe the overall credit quality of the municipalities to be good and expect the municipal bonds to continue to perform in accordance with their terms. However, there can be no assurance that the financial conditions of these municipalities will not be materially and adversely affected by future economic conditions. If one or more of the issuers of these bonds were to become insolvent and default on their obligations under the bonds, it could have a negative effect on our financial condition and results of operations.

Southern depends upon the accuracy and completeness of information about customers.

          In deciding whether to extend credit to customers, Southern may rely on information provided to it by its customers, including financial statements and other financial information. Southern may also rely on representations of customers as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. Southern's financial condition and results of operations could be negatively impacted to the extent that Southern extends credit in reliance on financial statements or other information provided by customers that is false or misleading.

Southern may be a defendant in a variety of litigation and other actions, which may have a material adverse effect on Southern's financial condition and results of operations.

          Southern and its subsidiaries may be involved from time to time in a variety of litigation arising out of its business. Southern's insurance may not cover all claims that may be asserted against it, and any claims asserted against it, regardless of merit or eventual outcome, may harm its reputation or cause it to incur unexpected expenses, which could be material in amount. Should the ultimate expenses, judgments or settlements in any litigation exceed Southern's insurance coverage, they could have a material adverse effect on Southern's financial condition and results of operations. In addition, Southern may not be able to obtain appropriate types or levels of insurance in the future, nor may it be able to obtain adequate replacement policies with acceptable terms, if at all. For additional information on legal matters, see Item 3 of this report.

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.

We continually encounter technological change, and we may have fewer resources than our competitors to continue to invest in technological improvements.

          The banking industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. There can be no assurance that we will be able to effectively implement new technology-driven products and services or be successful in marketing such products and services to our customers.

Southern's controls and procedures may fail or be circumvented.

          Management regularly reviews and updates Southern's internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of Southern's controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on Southern's business, results of operations and financial condition.

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. This limited market may affect a shareholder's ability to sell shares on short notice, and the sale of a large number of shares at one time could temporarily depress the market price of our common stock.

The market price of our common stock can be volatile, which may make it more difficult to resell our common stock at a desired time and price.

          Stock price volatility may make it more difficult for a shareholder to resell our common stock when a shareholder wants to and at prices a shareholder finds attractive or at all. Our stock price can fluctuate significantly in response to a variety of factors, regardless of operating results. These factors include, among other things:

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

          Our ability to pay dividends is limited by regulatory restrictions and the need to maintain sufficient consolidated capital. The ability of the Bank to pay dividends to Southern Michigan Bancorp is limited by its obligations to maintain sufficient capital and by other general restrictions on dividends that are applicable to the Bank. If Southern or the Bank do not satisfy these regulatory requirements, Southern Michigan Bancorp would be unable to continue to pay dividends on its common stock. As of December 31, 2010, the Bank was able to pay $4.0 million in dividends to Southern Michigan Bancorp without prior regulatory approval. Additional information on restrictions on payment of dividends by us 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 convertible securities, stock appreciation rights, options or warrants to purchase Southern common stock in the future and those convertible securities, 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.

Our common stock is not insured by any governmental entity.

          Our common stock is not a deposit account or other obligation of any bank and is not insured by the FDIC or any other governmental entity. Investment in our common stock is subject to risk, including possible loss.

If an entity holds as little as a 5% interest in our outstanding securities, that entity could, under certain circumstances, be subject to regulation as a "bank holding company."

          Any entity, including a "group" composed of natural persons, owning or controlling with the power to vote 25% or more of our outstanding securities, or 5% or more if the holder otherwise exercises a "controlling influence" over us, may be subject to regulation as a "bank holding company" in accordance with the Bank Holding Company Act of 1956, as amended (the "BHC Act"). In addition, (i) any bank holding company or foreign bank with a U.S. presence may be required to obtain the approval of the Federal Reserve Board under the BHC Act to acquire or retain 5% or more of our outstanding securities and (ii) any person not otherwise defined as a company by the BHC Act and its implementing regulations may be required to obtain the approval of the Federal Reserve Board under the Change in Bank Control Act of 1978, as amended, to acquire or retain 10% or more of our outstanding securities. Becoming a bank holding company imposes statutory and regulatory restrictions and obligations, such as providing managerial and financial strength for its bank subsidiaries. Regulation as a bank holding company could require the holder to divest all or a portion of the holder's investment in our securities or those nonbanking investments that may be deemed impermissible or incompatible with bank holding company status, such as a material investment in a company unrelated to banking.

          None.

Our offices are as follows:

Southern's and Southern Michigan Bank'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:
   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.

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

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

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

Southern Michigan Bank's branch office:
   117 South Broadway Street, Cassopolis, Michigan
   Office is leased by Southern Michigan Bank and comprises approximately 2,611 square feet

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

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

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

          As of March 28, 2011, there were no material pending legal proceedings to which Southern or any of its subsidiaries were a party or to which any of their properties were subject, other than ordinary routine litigation incidental to the business of Southern and its subsidiaries.

          By SEC rule, Item 4 of Form 10-K has been removed and reserved.

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 25, 2011, there were 2,340,339 shares of Southern common stock issued and outstanding held by 417 holders of record.

          The following table summarizes cash dividends declared per share of Southern common stock during 2010 and 2009:

          Southern Michigan Bancorp's principal source of funds to pay cash dividends is the earnings of and dividends paid by the Bank. The Bank is restricted in its 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 the Bank to pay cash dividends to Southern Michigan Bancorp could limit its ability to pay dividends in the future.

          Information regarding the equity compensation plans both approved and not approved by shareholders at December 31, 2010 is included in Item 12 of this report and is here incorporated by reference.

          The following tables show summarized historical consolidated financial data for Southern. The tables are unaudited. The information in the tables is derived from Southern's audited financial statements for 2006 through 2010. 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 provides a review of the consolidated financial condition and results of operations of Southern Michigan Bancorp, Inc. ("Southern"), and its wholly owned subsidiary, Southern Michigan Bank & Trust ("the Bank") for the periods indicated. This discussion should be read in conjunction with the consolidated financial statements and related notes to the consolidated financial statements.

Overview

          Southern is a Michigan corporation and a bank holding company registered under the Bank Holding Company Act of 1956. Southern wholly owns the Bank and Southern Michigan Bancorp Capital Trust I, a Delaware statutory trust. The Bank wholly owns FNB Financial Services, Inc., a Michigan corporation.

          Our business, which we conduct primarily through the Bank, is concentrated in a single industry segment - 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. We operate 17 banking offices located in Athens, Battle Creek, Camden, Cassopolis, Centreville, Coldwater, Constantine, Hillsdale, Marshall, Mendon, Tekonsha, Three Rivers, and Union City, Michigan.

          On December 1, 2007, we completed the acquisition of FNB Financial Corporation ("FNB") and its subsidiary bank, FNB Financial. On April 24, 2009, FNB Financial was consolidated with and into the Bank.

          At December 31, 2010, on a consolidated basis, we had assets of $493.9 million, deposits of $409.9 million, a net loan portfolio of $303.8 million, trust assets under management totaling $215.0 million, and shareholders' equity of $47.8 million.

Results of Operations

          Southern's net income for 2010 was $3,098,000 compared to $1,936,000 in 2009, an increase of $1,162,000, or 60.02%. Provision for loan losses of $1,375,000 was expensed in 2010, down from $2,725,000 in 2009. Non-interest income increased 0.49% to $7,207,000 in 2010. Non-interest expense decreased 3.75%, or $712,000, to $18,258,000 in 2010.

          Results of operations can be measured by various ratio analyses. Two widely recognized performance indicators are return on average equity and return on average assets. Southern's return on average equity was 6.56% in 2010, 4.29% in 2009 and 1.77% in 2008. The return on average assets was 0.65% in 2010, 0.41% in 2009 and 0.17% in 2008.

          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.

          The presentation of net interest income on a FTE basis is not in accordance with GAAP but is customary in the banking industry. This non-GAAP measure ensures comparability of net interest income arising from both taxable and tax-exempt loans and investment securities. The adjustments to determine tax equivalent net interest income are itemized in Table 1 below.

          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 2010, Southern's net interest margin (FTE) was 3.95% compared to 4.14% for 2009 and 4.36% for 2008. Beginning 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 0.25%. For both 2009 and 2010, these rate decreases impacted Southern's net interest margin. Southern's interest rate spread and margin both further decreased as yields on earning assets decreased 0.44%, from 5.45% in 2009 to 5.01% in 2010, while deposit yields were down 0.27%, from 1.49% in 2009 to 1.22% in 2010.

          In 2010, the lower interest margin was a result of reduced rates for all interest earning asset types and reduced loan and investment volumes partially offset by reduced rates for deposits. The net effect was a decrease of $402,000 in net interest income (FTE) compared to 2009.

          In 2009, the lower interest margin was a result of lower rates being in effect for the entire year and reduced balances in loans and investment securities. The net effect was a decrease of $1,256,000 in net interest income (FTE) compared to 2008.

          Despite the lower net interest margin in 2008, net interest income (FTE) increased during the year by $3,055,000. The increase resulted primarily from the acquisition of FNB. The 2008 increase in net interest income was a result of a $2,606,000 improvement in interest income and a $449,000 reduction of interest expense. The 2008 increase in interest income was the result of a $104.1 million of additional average earning assets, primarily from the acquisition of FNB, which was enough to overcome the rate decrease. Despite adding $103.6 million of average interest bearing liabilities, primarily from the acquisition of FNB, interest expense decreased $449,000 in 2008 as Southern closely monitored deposit rates.

          The following table presents a summary of net interest income (FTE) for 2010, 2009 and 2008.

Table 1. Average Balances and Tax Equivalent Interest Rates