SOUTHERN MICHIGAN BANCORP INC - Quarter Report: 2011 June (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2011


o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from ____________ to ____________

Commission File Number: 000-49772

SOUTHERN MICHIGAN BANCORP, INC.

(Exact Name of Registrant as Specified in its Charter)


Michigan (State or Other Jurisdiction of Incorporation or Organization)		38-2407501 (I.R.S. Employer Identification No.)

51 West Pearl Street Coldwater, Michigan (Address of Principal Executive Offices)		49036 (Zip Code)

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

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 þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, 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 þ No o

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


Large accelerated filer o		Accelerated filer o		Non-accelerated filer o (Do not check if a smaller reporting company)		Smaller reporting company þ

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

The number of shares outstanding of the Registrant’s Common Stock, $2.50 par value, as of August 12, 2011, was 2,358,599 shares.

TABLE OF CONTENTS


Part I. Financial Information
	Item 1. Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 4. Controls and Procedures
Part II. Other Information
	Item 6. Exhibits
Signatures
EX-31.1
EX-31.2
EX-32
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT
EX-101 DEFINITION LINKBASE DOCUMENT

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 may be identified by words or phrases such as “outlook”, “plan”, or “strategy” that an event or trend “may”, “should”, “will”, “is likely”, or is “probable” to occur or “continue”, has “begun” or “is scheduled” or “on track” or that the Company or its management “anticipates”, “believes”, “estimates”, “plans”, “forecasts”, “intends”, “predicts”, “projects”, or “expects” a particular result, or is “committed”, “confident”, “optimistic” or has an “opinion” that an event will occur, or other words or phrases such as “ongoing”, “future”, “judgment”, “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, dividends, future growth and funding sources, future liquidity levels, the availability of sources of liquidity, future profitability levels, the effects on earnings of changes in interest rates and other revenue sources, and the effects of existing or new laws or regulations (or interpretations thereof). All statements with references to future time periods are forward-looking. 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, and the fair value of investment securities (including whether any impairment on any investment security is temporary or other-than-temporary and the amount of any impairment) involves judgments that are inherently forward-looking. All of the information concerning interest rate sensitivity is forward-looking. Management’s assumptions regarding pension and other post retirement plans involve judgments that are inherently forward-looking. Our ability to sell other real estate at carrying value or at all, 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. Actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. 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.

Risk factors include, but are not limited to, the risk factors described in “Item 1A — Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2010. 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.

Part I. Financial Information

Item 1. Financial Statements

Southern Michigan Bancorp, Inc.
Unaudited Interim Financial Statements

Consolidated Balance Sheets (Unaudited)
(In thousands, except share data)


	June 30,			December 31,
	2011			2010
ASSETS
Cash and cash equivalents	$	44,935		$	78,833
Federal funds sold		312			275
Securities available for sale		88,015			59,228
Loans held for sale		608			2,637
Loans, net of allowance for loan losses of $5,402 - 2011 ($5,694 - 2010)		300,219			303,830
Premises and equipment, net		12,397			12,599
Accrued interest receivable		2,053			2,107
Net cash surrender value of life insurance		10,129			9,965
Goodwill		13,422			13,422
Other intangible assets, net		1,836			2,005
Other assets		7,394			8,979

TOTAL ASSETS	$	481,320		$	493,880


LIABILITIES
Deposits:
Non-interest bearing	$	60,911		$	59,942
Interest bearing		336,204			349,959

Total deposits		397,115			409,901

Securities sold under agreements to repurchase and overnight borrowings		15,171			15,027
Accrued expenses and other liabilities		4,077			4,476
Other borrowings		8,676			10,079
Subordinated debentures		5,155			5,155
Common stock subject to repurchase obligation in Employee Stock Ownership Plan, shares outstanding — 110,506 in 2011 (107,627 shares in 2010)		1,381			1,399

Total liabilities		431,575			446,037


SHAREHOLDERS’ EQUITY
Preferred stock, 100,000 shares authorized; none issued or outstanding		—			—
Common stock, $2.50 par value:
Authorized - 4,000,000 shares Issued — 2,358,599 shares in 2011 (2,340,717 shares in 2010) Outstanding (other than ESOP shares) — 2,248,093 shares in 2011 (2,233,090 shares in 2010)		5,620			5,583
Additional paid-in capital		18,084			18,033
Retained earnings		25,967			24,692
Accumulated other comprehensive income (loss), net		339			(168	)
Unearned Employee Stock Ownership Plan shares		(265	)		(297	)

Total shareholders’ equity		49,745			47,843

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	481,320		$	493,880

See accompanying notes to interim consolidated financial statements.

Southern Michigan Bancorp, Inc.
Consolidated Statements of Income (Unaudited)
(In thousands, except per share data)


	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2011		2010		2011		2010
Interest income:
Loans, including fees	$	4,386	$	4,748	$	8,847	$	9,549
Securities:
Taxable		171		142		309		323
Tax-exempt		218		198		434		402
Other		47		34		98		57

Total interest income		4,822		5,122		9,688		10,331


Interest expense:
Deposits		803		934		1,647		1,935
Other		148		175		307		343

Total interest expense		951		1,109		1,954		2,278

Net interest income		3,871		4,013		7,734		8,053
Provision for loan losses		375		150		500		350

Net interest income after provision for loan losses		3,496		3,863		7,234		7,703

Non-interest income:
Service charges on deposit accounts		568		612		1,079		1,182
Trust fees		293		243		568		496
Net gains on security calls and sales		—		207		2		207
Net gains on loan sales		205		161		522		281
Earnings on life insurance assets		84		76		164		150
Gain on life insurance proceeds		—		—		—		156
Income from loan servicing		128		85		225		163
ATM and debit card fee income		257		218		492		425
Other		119		112		257		278

Total non-interest income		1,654		1,714		3,309		3,338


Non-interest expense:
Salaries and employee benefits		2,346		2,437		4,884		4,938
Occupancy, net		336		363		709		744
Equipment		204		233		407		454
Printing, postage and supplies		102		146		243		291
Telecommunication expenses		98		96		197		174
Professional and outside services		199		232		420		525
FDIC assessments		110		147		275		316
Software maintenance		110		97		215		208
Amortization of other intangibles		84		88		169		175
Expenses relating to OREO property		86		154		131		352
ATM expenses		92		83		174		164
Other		421		481		820		906

Total non-interest expense		4,188		4,557		8,644		9,247

INCOME BEFORE INCOME TAXES		962		1,020		1,899		1,794
Federal income tax provision		200		217		389		289

NET INCOME	$	762	$	803	$	1,510	$	1,505

Basic Earnings Per Common Share	$	0.33	$	0.35	$	0.65	$	0.65

Diluted Earnings Per Common Share		0.33		0.35		0.65		0.65

Dividends Declared Per Common Share		0.05		0.05		0.10		0.10

See accompanying notes to interim consolidated financial statements.

Southern Michigan Bancorp, Inc.
Consolidated Statements of Changes in Shareholders’ Equity
(In thousands, except number of shares and per share data)
For the Six Months Ended June 30, 2011 and 2010


										Accumulated
										Other
				Additional						Comprehensive			Unearned
	Common			Paid-In			Retained			Income (Loss),			ESOP
	Stock			Capital			Earnings			Net			Shares			Total
Balance at January 1, 2010	$	5,553		$	18,363		$	22,062		$	193		$	(437	)	$	45,734

Comprehensive income:
Net income								1,505									1,505
Net change in other comprehensive income items											(119	)					(119	)

Total comprehensive income																	1,386
Cash dividends declared — $.10 per share								(234	)								(234	)
Issuance of restricted stock (18,325 shares of common stock at $10.10 per share)		46			(46	)											—
Vesting of restricted stock					37												37
Forfeiture of restricted stock (1,018 shares)		(2	)		2												—
Change in common stock subject to repurchase		(9	)		(338	)											(347	)
Reduction of ESOP obligation														59			59
Stock option expense					38												38

Balance at June 30, 2010	$	5,588		$	18,056		$	23,333		$	74		$	(378	)	$	46,673


Balance at January 1, 2011	$	5,583		$	18,033		$	24,692		$	(168	)	$	(297	)	$	47,843

Comprehensive income:
Net income								1,510									1,510
Net change in other comprehensive income items											507						507

Total comprehensive income																	2,017
Cash dividends declared — $.10 per share								(235	)								(235	)
Vesting of restricted stock					40												40
Forfeiture of restricted stock (643 shares)		(2	)		2												—
Change in common stock subject to repurchase		(7	)		25												18
Issuance of restricted stock (18,525 shares of common stock at $12.70)		46			(46	)											—
Reduction of ESOP obligation														32			32
Stock option expense					30												30

Balance at June 30, 2011	$	5,620		$	18,084		$	25,967		$	339		$	(265	)	$	49,745

See accompanying notes to interim consolidated financial statements.

SOUTHERN MICHIGAN BANCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(Dollars in thousands)


	Six Months Ended June 30,
	2011			2010
Operating Activities
Net income	$	1,510		$	1,505
Adjustments to reconcile net income to net cash from operating activities:
Provision for loan losses		500			350
Depreciation		448			505
Net amortization of investment securities		229			253
Loans originated for sale		(16,608	)		(13,167	)
Proceeds on loans sold		19,159			12,613
Net gains on loan sales		(522	)		(281	)
Gain on life insurance proceeds		—			(156	)
Stock option and restricted stock grant compensation expense		70			75
Net gains on security calls and sales		(2	)		(207	)
Net loss from sale or write down of other real estate owned and repossessed assets		105			269
Amortization of other intangible assets		169			175
Net loss on disposal of premises and equipment		7			5
Net change in obligation under ESOP		32			59
Net change in:
Accrued interest receivable		54			164
Cash surrender value		(164	)		(150	)
Other assets		905			159
Accrued expenses and other liabilities		(399	)		471

Net cash from operating activities		5,493			2,642


Investing Activities
Activity in available for sale securities:
Proceeds on securities sold		—			7,445
Proceeds from maturities and calls		17,490			19,401
Purchases		(45,736	)		(25,196	)
Net change in federal funds sold		(37	)		653
Loan originations and payments, net		3,003			7,909
Proceeds from life insurance		—			421
Proceeds from sale of other real estate owned and repossessed assets		422			459
Proceeds from sale of equipment		57			2
Additions to premises and equipment		(310	)		(483	)

Net cash from investing activities		(25,111	)		10,611


Financing Activities
Net change in deposits		(12,786	)		4,831
Net change in securities sold under agreements to repurchase and overnight borrowings		144			100
Proceeds from other borrowings		—			5,000
Repayments of other borrowings		(1,403	)		(5,341	)
Cash dividends paid		(235	)		(234	)

Net cash from financing activities		(14,280	)		4,356

Net change in cash and cash equivalents		(33,898	)		17,609
Beginning cash and cash equivalents		78,833			24,814

Ending cash and cash equivalents	$	44,935		$	42,423


Cash paid for interest	$	1,970		$	2,326
Cash paid for income taxes		200			70
Transfers from loans to other real estate owned		108			355

See accompanying notes to interim consolidated financial statements.

SOUTHERN MICHIGAN BANCORP, INC.
NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE A — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation: The consolidated financial statements include the accounts of Southern Michigan Bancorp, Inc. (the Company) and its wholly-owned subsidiary, Southern Michigan Bank & Trust (SMB&T), after elimination of significant inter-company balances and transactions. SMB&T owns FNB Financial Services, which conducts a brokerage business and is consolidated into SMB&T’s financial statements. During 2004, the Company formed a special purpose trust, Southern Michigan Bancorp Capital Trust I, for the sole purpose of issuing trust preferred securities. Under accounting principles generally accepted in the United States of America, the trust is not consolidated into the financial statements of the Company.

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions for Form 10-Q and Rule 8-03 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments considered necessary in order to make the financial statements not misleading have been included. Operating results for the six months ended June 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.

The accompanying consolidated financial statements should be read in conjunction with the consolidated financial statements and related footnotes of the Company for December 31, 2010 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, filed with the Securities and Exchange Commission on March 28, 2011.

Loans: Loans are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and an allowance for loan losses. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt, typically when payments are past due over 90 days, unless the loan is both well secured and in the process of collection. Past due status is based on the contractual terms of the loan. All interest accrued but not received for these loans is reversed against interest income. Payments received on such loans are reported as principal reductions until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest contractually due are brought current and future payments are reasonably assured.

Allowance for Loan Losses: The allowance for loan losses is a valuation allowance for probable incurred credit losses, increased by the provision for loan losses and decreased by charge-offs less recoveries. Estimating the risk of loss and the amount of loss on any loan is necessarily subjective. Accordingly, management estimates the allowance balance based on past loan loss experience, nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, information in regulatory examination reports, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired.

Consumer loans are typically charged-off no later than 120 days past due. Real estate mortgage loans in the process of collection are charged-off on or before they become 365 days past due. Commercial loans are charged-off promptly upon the determination that all or a portion of any loan balance is uncollectible. In all cases, loans are placed on nonaccrual status or charged-off at an earlier date if collection of principal or interest is considered doubtful.

Impaired Loans: Loan impairment is reported when full payment under the loan terms is not expected. Impairment is evaluated in total for smaller-balance loans of similar nature such as residential mortgage and consumer loans and on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s effective interest rate or at the fair value of collateral if repayment is expected solely from the collateral. Loans are evaluated for impairment when payments are delayed, typically 90 days or more, or when it is probable that all principal and interest amounts

will not be collected according to the original terms of the loan. Loans for which the terms have been modified and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and are classified as impaired. All nonaccrual loans have also been determined by the Company to meet the definition of an impaired loan.

Reclassifications

Some items in the prior period consolidated financial statements have been reclassified to conform to the current year presentation.

NOTE B — NEW ACCOUNTING PRONOUNCEMENTS

Adoption of New Accounting Standards: In July 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses which increases disclosures made about the credit quality of loans and the allowance for credit losses. The disclosures provide additional information about the nature of credit risk inherent in the Company’s loans, how credit risk is analyzed and assessed, and the reasons for the change in the allowance for loan losses. The expanded disclosure requirements of ASU 2010-20 were disclosed in the Company’s December 31, 2010 consolidated financial statements. Other required disclosures about activity that occurs during an interim reporting period are effective for periods beginning on or after December 15, 2010, and are disclosed for the period ended June 30, 2011 in Note D.

In December 2010, the FASB issued ASU No. 2010-29 “Business Combinations (Topic 805) — Disclosure of Supplementary Pro Forma Information for Business Combinations.” If a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. ASU 2010-29 also expands the supplementary pro forma disclosures. ASU 2010-29 is effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. ASU 2010-29 will only affect the Company if there are future business combinations.

In December 2010, the FASB issued ASU No. 2010-28 “Intangibles — Goodwill and Other (Topic 350) - When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” ASU 2010-28 affects all entities that have recognized goodwill and have one or more reporting units whose carrying amount for purposes of performing Step 1 of the goodwill impairment test is zero or negative. ASU 2010-28 is effective for fiscal years and interim periods within those years, beginning after December 15, 2010. ASU 2010-28 did not have an impact on the Company’s financial condition, results of operations, or disclosures for the period ended June 30, 2011 because the most recent Step 1 goodwill impairment test was performed as of November 30, 2010 and did not result in a negative carrying amount.

In April 2011, FASB issued ASU No. 2011-02 “Receivables (Topic 310) — A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.” ASU 2011-02 clarifies whether loan modifications constitute troubled debt restructuring. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. ASU 2011-02 is effective for the first interim and annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. ASU 2011-02 did not have any impact on the Company’s financial condition or results of operations.

In May 2011, FASB issued ASU No. 2011-04 “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. The amendments in ASU 2011-04 generally represent clarifications of Topic 820, but also include some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. ASU 2011-04 results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRSs. The amendments in ASU 2011-04 are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011 and early application is not permitted. The Company will adopt the methodologies prescribed by

ASU 2011-04 by the date required, and does not anticipate the ASU will have a material effect on its financial position or results of operations.

In June 2011, FASB issued ASU No. 2011-05 “Amendments to Topic 220, Comprehensive Income”. Under the amendments in ASU 2011-05, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Either option requires the entity to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments in ASU 2011-05 do not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income.

The amendments in ASU 2011-05 should be applied retrospectively. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted and the amendments do not require any transition disclosures. The Company does not anticipate early adoption of ASU 2011-05.

NOTE C — EARNINGS PER SHARE

Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. ESOP shares are considered outstanding for this calculation unless unearned. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options. Earnings and dividends per common share are restated for all stock splits and stock dividends through the date of issue of the financial statements.

A reconciliation of the numerators and denominators of basic and diluted earnings per share for the three and six month periods ended June 30, 2011 and 2010 is as follows (dollars in thousands, except per share data):


	Three Months		Three Months		Six Months		Six Months
	Ended		Ended		Ended		Ended
	June 30,		June 30,		June 30,		June 30,
	2011		2010		2011		2010
Basic earnings per share:
Net income	$	762	$	803	$	1,510	$	1,505


Weighted average common shares outstanding		2,344,838		2,340,717		2,342,964		2,338,437

Less unallocated ESOP shares		21,962		28,181		22,915		28,600


Weighted average common shares outstanding for basic earnings per share		2,322,876		2,312,536		2,320,049		2,309,837

Basic earnings per share	$	0.33	$	0.35	$	0.65	$	0.65


Diluted earnings per share:
Net income	$	762	$	803	$	1,510	$	1,505


Weighted average common shares outstanding for basic earnings per share		2,322,876		2,312,536		2,320,049		2,309,837

Add: Dilutive effect of assumed exercise of stock options		4,397		3,520		4,565		2,954


Weighted average common and dilutive potential common shares outstanding		2,327,273		2,316,056		2,324,614		2,312,791


Diluted earnings per share	$	0.33	$	0.35	$	0.65	$	0.65

Stock option awards that were anti-dilutive, and therefore not included in the computation of earnings per share, were as follows: 191,886 and 197,702 as of June 30, 2011 and 2010, respectively.

NOTE D — ALLOWANCE FOR LOAN LOSSES

In evaluating the allowance for loan losses, loans are analyzed based on the department originating the loan, which in some instances may be different than how the (commercial, mortgage or consumer) loans are categorized for regulatory reporting purposes. Required disclosures about activity in the allowance for loan losses for reporting periods subsequent to December 15, 2010 are provided below for the six months ended June 30, 2011. The following is an analysis of the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of and for the six month period ended June 30, 2011 and as of December 31, 2010, as well as summary activity in the allowance for loan losses for the quarter ended June 30, 2010 (in thousands):


	2011
										Real
	Commercial						Real Estate			Estate
June 30, 2011	including						Mortgage			Mortgage
Allowance for Loan Losses:	CRE			Consumer			1^st Lien			Junior Lien			Total			2010
Balance at January 1	$	4,239		$	86		$	1,211		$	158		$	5,694		$	6,075
Provision for loan losses		175			31			149			145			500			350
Loans charged off		(523	)		(40	)		(241	)		(105	)		(909	)		(799	)
Recoveries		101			5			8			3			117			100

Balance at June 30	$	3,992		$	82		$	1,127		$	201		$	5,402		$	5,726


Ending balance individually evaluated for impairment	$	817			—		$	232		$	13		$	1,062


Ending balance collectively evaluated for impairment	$	3,175		$	82		$	895		$	188		$	4,340


Total Loans:
Ending balance	$	216,699		$	8,512		$	67,036		$	13,374		$	305,621


Ending balance individually evaluated for impairment	$	7,071		$	39		$	3,041		$	44		$	10,195


Ending balance collectively evaluated for impairment	$	209,628		$	8,473		$	63,995		$	13,330		$	295,426

Commercial loans also include demand deposit loan account charge-offs and recoveries amounting to $78,000 and $42,000, respectively, for the six months ended June 30, 2011.


							Real
							Estate
	Commercial				Real Estate		Mortgage
December 31, 2010	including				Mortgage		Junior
Allowance for Loan Losses:	CRE		Consumer		1^st Lien		Lien		Total
Ending balance individually evaluated for impairment	$	867		—	$	300	$	4	$	1,171

Ending balance collectively evaluated for impairment	$	3,372	$	87	$	911	$	153	$	4,523


Total	$	4,239	$	87	$	1,211	$	157	$	5,694


Total Loans:
Ending balance	$	216,401	$	9,849	$	69,437	$	13,837	$	309,524


Ending balance individually evaluated for impairment	$	7,676	$	87	$	2,881	$	122	$	10,766


Ending balance collectively evaluated for impairment	$	208,725	$	9,762	$	66,556	$	13,715	$	298,758

The following tables present loans individually evaluated for impairment by class of loans as of June 30, 2011 and December 31, 2010 (in thousands):


	Unpaid		Allowance for
	Principal		Loan Losses
June 30, 2011	Balance		Allocated
With no related allowance recorded:
Commercial	$	118	$	—
Real estate — commercial		2,900		—
Real estate — construction		157		—
Consumer		39		—
Real estate mortgage		2,296		—

With an allowance recorded:
Commercial		863		157
Real estate — commercial		1,525		407
Real estate — construction		79		4
Consumer		—		—
Real estate mortgage		2,218		494


Total	$	10,195	$	1,062


	Unpaid		Allowance for
	Principal		Loan Losses
December 31, 2010	Balance		Allocated
With no related allowance recorded:
	$
Commercial		608	$	—
Real estate — commercial		2,685		—
Real estate — construction		—		—
Consumer		87		—
Real estate mortgage		2,495		—

With an allowance recorded:
Commercial		588		99
Real estate — commercial		1,823		413
Real estate — construction		583		173
Consumer		—		—
Real estate mortgage		1,897		486


Total	$	10,766	$	1,171

The following table presents the aging of the recorded investment in past due and nonaccrual loans for the year to date periods ended June 30, 2011 and December 31, 2010 by class of loans (in thousands):


					Greater than				Loans Not
			60-89		90 Days Past		Total Past		Past Due
	30-59 Days		Days Past		Due & Non		Due &Non		or Non
June 30, 2011	Past Due		Due		Accrual		Accrual		Accrual		Total
Commercial	$	57	$	—	$	436	$	493	$	55,533	$	56,026
Real estate — commercial		51		—		3,288		3,339		136,772		140,111
Real estate — construction		134		—		236		370		11,809		12,179
Consumer		65		12		40		117		8,726		8,843
Real estate mortgage		499		—		2,534		3,033		85,429		88,462


Total	$	806	$	12	$	6,534	$	7,352	$	298,269	$	305,621


					Greater than				Loans Not
			60-89		90 Days Past		Total Past		Past Due
	30-59 Days		Days Past		Due & Non		Due &Non		or Non
December 31, 2010	Past Due		Due		Accrual		Accrual		Accrual		Total
Commercial	$	277	$	20	$	217	$	514	$	58,249	$	58,763
Real estate — commercial		184		—		2,295		2,479		133,892		136,371
Real estate — construction		—		—		583		583		10,552		11,135
Consumer		62		—		87		149		10,004		10,153
Real estate mortgage		737		28		2,112		2,877		90,225		93,102


Total	$	1,260	$	48	$	5,294	$	6,602	$	302,922	$	309,524

Troubled Debt Restructurings:

The Company has allocated $311,000 and $379,000 of specific reserves to customers whose loan terms have been modified as of June 30, 2011 and December 31, 2010, respectively. The Company intends to lend no additional amounts to these customers.

Credit Quality Indicators:

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt, such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes all loans from the commercial loan department. This analysis is performed at least annually. The Company uses the following definitions for risk ratings:

Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date.

Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans.

As of June 30, 2011 and December 31, 2010, based on the most recent analysis performed, the risk category of loans by class of loans was as follows (in thousands):


			Special						Not Risk
June 30, 2011	Pass		Mention		Substandard		Doubtful		Rated		Total
Commercial	$	42,916	$	8,161	$	4,949	$	—	$	—	$	56,026
Real estate — commercial		116,789		14,199		8,199		368		556		140,111
Real estate — construction		6,504		1,045		625		—		4,005		12,179
Real estate — mortgage		7,435		1,147		3,263		—		76,617		88,462
Consumer		—		—		—		—		8,843		8,843


Total	$	173,644	$	24,552	$	17,036	$	368	$	90,021	$	305,621


			Special						Not Risk
December 31, 2010	Pass		Mention		Substandard		Doubtful		Rated		Total
Commercial	$	44,819	$	12,821	$	1,123	$	—	$	—	$	58,763
Real estate — commercial		110,384		19,054		6,311		370		252		136,371
Real estate — construction		2,371		1,047		4,630		—		3,087		11,135
Real estate — mortgage		7,096		2,892		2,700		—		80,414		93,102
Consumer		—		—		—		—		10,153		10,153


Total	$	164,670	$	35,814	$	14,764	$	370	$	93,906	$	309,524

NOTE E — STOCK OPTIONS

Shareholders of the Company approved a stock option plan in April 2000 and a stock incentive plan in June 2005. The plans authorized the Company to issue up to 115,500 and 157,500 shares, respectively. In May 2008, shareholders of the Company ratified amendments to the Stock Incentive Plan of 2005, which among other things increased the authorized shares for issuance from 157,500 to 300,000. On March 20, 2010, the April 2000 stock option plan terminated. As of June 30, 2011, there were 99,007 shares available for future issuance under the 2005 plan.

A summary of stock option activity is as follows for the six months ended June 30, 2011:


			Weighted Average
	Shares		Price
Outstanding at beginning of year		218,977	$	21.29
Granted		8,075		12.70
Exercised		—		—
Forfeited		6,026		18.23

Outstanding at June 30, 2011		221,026	$	21.06


Options exercisable at June 30, 2011		141,276	$	20.85

The Company recorded compensation expense of $30,000 and $38,000, respectively, related to stock options during the six month periods ended June 30, 2011 and 2010.

Restricted Stock — Shares of restricted stock may also be granted under the Stock Incentive Plan of 2005. Compensation expense is recognized over the vesting period of the shares based on the market value of the shares on the grant date. All shares of restricted stock issued and outstanding vest 20% per year over five years. Compensation expense related to the award of shares of restricted stock was $40,000 and $37,000, respectively, during the six months ended June 30, 2011 and 2010. As of June 30, 2011, there was $440,000 of total unrecognized compensation expense related to non-vested shares of restricted stock granted under the plan, which is expected to be recognized over a weighted average period of 4.0 years.


				Weighted
				Average
				Grant
				Date Fair
	Shares			Value
Nonvested at January 1, 2011		30,593		$	10.46
Granted		18,525			12.70
Vested		(7,166	)		11.24
Forfeited		(643	)		10.17

Nonvested at June 30, 2011		41,309		$	11.33

NOTE F — FAIR VALUE INFORMATION

The following methods and assumptions were used by the Company in estimating fair values for financial instruments:

Cash and cash equivalents and federal funds sold: The carrying amount reported in the balance sheet approximates fair value.

Securities available for sale: Fair values for securities available for sale are based on quoted market prices, where available. For all other securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the securities’ terms and conditions, among other things.

Loans and loans held for sale, net: For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans are estimated using discounted cash flows analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The allowance for loan losses is considered to be a reasonable estimate of discount for credit quality concerns.

Accrued interest receivable: The carrying amount reported in the balance sheet approximates fair value.

Off-balance-sheet financial instruments: The estimated fair value of off-balance-sheet financial instruments is based on current fees or costs that would be charged to enter or terminate the arrangements. The estimated fair value is not considered to be significant for this presentation.

Deposits: The fair values disclosed for demand deposits (e.g., interest and non-interest checking, passbook savings, and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of expected monthly maturities on time deposits.

Securities sold under agreements to repurchase and overnight borrowings: The carrying amount reported in the balance sheet approximates fair value.

Other borrowings: The fair value of other borrowings is estimated using discounted cash flows analysis based on the current incremental borrowing rate for similar types of borrowing arrangements.

Subordinated debentures: The carrying amount reported in the balance sheet approximates fair value of the variable-rate subordinated debentures.

Accrued interest payable: The carrying amount reported in the balance sheet approximates fair value.

While these estimates of fair value are based on management’s judgment of appropriate factors, there is no assurance that if the Company had disposed of such items at June 30, 2011 or December 31, 2010, the estimated fair values would have been realized. Market values may differ depending on various circumstances not taken into consideration in this methodology. The estimated fair values at June 30, 2011 and December 31, 2010, should not be considered to apply at subsequent dates.

In addition, other assets and liabilities that are not defined as financial instruments are not included in the following disclosures, such as property and equipment. Also, non-financial instruments typically not recognized in financial statements may have value but are not included in the following disclosures. These include, among other items, the estimated earnings power of core deposit accounts, trained work force, customer goodwill and similar items.

The estimated fair values of the Company’s financial instruments are as follows (in thousands):


	June 30, 2011						December 31, 2010
	Carrying			Fair			Carrying			Fair
	Amount			Value			Amount			Value
Financial assets:
Cash and cash equivalents	$	44,935		$	44,935		$	78,833		$	78,833
Federal funds sold		312			312			275			275
Securities available for sale		88,015			88,015			59,228			59,228
Loans held for sale		608			608			2,637			2,637
Loans, net of allowance for loan losses		300,219			303,684			303,830			307,946
Accrued interest receivable		2,053			2,053			2,107			2,107

Financial liabilities:
Deposits	$	(397,115	)	$	(399,537	)	$	(409,901	)	$	(406,143	)
Securities sold under agreements to repurchase and overnight borrowings		(15,171	)		(15,171	)		(15,027	)		(15,027	)
Other borrowings		(8,676	)		(8,836	)		(10,079	)		(9,835	)
Subordinated debentures		(5,155	)		(5,155	)		(5,155	)		(5,155	)
Accrued interest payable		(155	)		(155	)		(171	)		(171	)

The preceding table does not include net cash surrender value of life insurance and dividends payable, which are also considered financial instruments. The estimated fair value of such items is considered to be their carrying amount.

The Company also has unrecognized financial instruments, which include commitments to extend credit and standby letters of credit. The estimated fair value of such instruments is considered to be their contract amount.

NOTE G — FAIR VALUE MEASUREMENTS

The Fair Value Measurements Topic of ASC 820-10 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. ASC 820-10-20 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The price in the principal (or most advantageous) market used to measure the fair value of the asset or liability is not adjusted for transaction costs. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets and liabilities; it is not a forced transaction. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact, and (iv) willing to transact.

ASC 820-10 requires the use of valuation techniques that are consistent with the market approach, the income approach, or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. In that regard, ASC Topic 820-10-55 establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows:

Level 1 Inputs - Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

Level 2 Inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.), or inputs that are derived principally from or corroborated by market data by correlation or other means.

Level 3 Inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

A description of the valuation methodologies used for instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, follows. These valuation methodologies were applied to all of the Company’s financial and nonfinancial assets and liabilities carried at fair value.

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality, the company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.

Securities Available for Sale. Securities classified as available for sale are reported at fair value utilizing Level 1,

Level 2 and Level 3 inputs. Unadjusted quoted prices in active markets for identical assets are utilized to determine fair value at the measurement date for Level 1 securities. For all other securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information, and the bond’s terms and conditions, among other things. When there are unobservable inputs, such securities are classified as Level 3.

Securities available for sale classified as Level 3 inputs represent non-publicly traded municipal issues with limited trading activity from entities within the Company’s market area. The fair value of these investments is determined using Level 3 valuation techniques, as there is no market available to price these investments. The method used for determining the fair value for these investments includes a comparison to the fair value of other investment securities valued with Level 2 inputs with similar characteristics (credit, time to maturity, call structure, etc.) and the interest yield curve for comparable debt investments.

Impaired Loans. The Company does not record impaired loans at fair value on a recurring basis. However, periodically, a loan is considered impaired and is reported at the fair value of the underlying collateral, less estimated costs to sell, if repayment is expected solely from the collateral. Impaired loans measured at fair value typically consist of loans on nonaccrual status and loans with a portion of the allowance for loan losses allocated specific to the loan. Some loans may be included in both categories whereas other loans may only be included in one category. Collateral values are estimated using level 2 inputs, including recent appraisals, and Level 3 inputs based on customized discounting criteria. Due to the significance of the level 3 inputs, impaired loans have been classified as level 3.

Other Real Estate Owned (OREO). The Company values OREO at the fair value of the underlying collateral less expected selling costs. Collateral values are estimated primarily using appraisals and reflect a market value approach.

The following table summarizes financial and nonfinancial assets (there were no financial or nonfinancial liabilities) measured at fair value as of June 30, 2011 and December 31, 2010, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value (in thousands):


	Level 1		Level 2		Level 3		Total
June 30, 2011	Inputs		Inputs		Inputs		Fair Value
Available for Sale Securities:
U.S. Treasury and Federal agencies	$	34,539	$	—	$	—	$	34,539
U.S. Government sponsored entities		24,163		—		—		24,163
State and political subdivisions		—		26,039		2,728		28,767
Mortgage backed securities		—		546		—		546

Total available-for-sale securities	$	58,702	$	26,585	$	2,728	$	88,015

Nonrecurring:
Impaired loans	$	—	$	—	$	9,133	$	9,133

Other real estate owned	$	—	$	—	$	863	$	863

Impaired loans are reported net of a $1,062,000 allowance for loan losses.


	Level 1		Level 2		Level 3		Total
December 31, 2010	Inputs		Inputs		Inputs		Fair Value
Available for Sale Securities:
U.S. Treasury and Federal agencies	$	24,106	$	—	$	—	$	24,106
U.S. Government sponsored entities		6,678		—		—		6,678
State and political subdivisions		—		22,378		2,992		25,370
Asset-backed securities		2,476		—		—		2,476
Mortgage backed securities		—		548		—		548

Total available-for-sale securities	$	33,260	$	22,976	$	2,992	$	59,228

Nonrecurring:
Impaired loans	$	—	$	—	$	9,595	$	9,595

Other real estate owned	$	—	$	—	$	1,247	$	1,247

Impaired loans are reported net of a $1,171,000 allowance for loan losses.

The following is a reconciliation of the beginning and ending balances of securities available for sale which are measured at fair value on a recurring basis using significant unobservable (Level 3) inputs during the six month period ended June 30, 2011 (in thousands):


Balance at January 1, 2011	$	2,992
Net maturities and calls		(597	)
Transfers into Level 3		—
Purchases		207
Unrealized net gains included in other comprehensive income		126


Balance at June 30, 2011	$	2,728

NOTE H — SUBSEQUENT EVENTS

Management evaluated subsequent events through the date the financial statements were issued. Events or transactions occurring after June 30, 2011, but prior to when the financial statements were issued, that provided additional evidence about conditions that existed at June 30, 2011, have been recognized in the financial statements for the six month period ended June 30, 2011. Events or transactions that provided evidence about conditions that did not exist at June 30, 2011, but arose before the financial statements were issued, have not been recognized in the financial statements for the six month period ended June 30, 2011.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion provides information about the consolidated financial condition and results of operations of the Company and its subsidiary, Southern Michigan Bank & Trust (SMB&T) for the three and six month periods ended June 30, 2011 and 2010.

Executive Summary

Net income for the three and six month periods ended June 30, 2011 was $762,000 and $1,510,000 respectively, compared to $803,000 and $1,505,000, respectively, for the same periods in 2010. Earnings per share were $0.33 and $0.65, respectively, for the three and six month periods ended June 30, 2011, compared to $0.35 and $0.65, respectively, for the same periods in 2010. Return on average assets was 0.61% for the first six months of 2011 compared to 0.64% for the first six months of 2010. Return on average shareholders’ equity was 6.17% for the first six months of 2011 compared to 6.48% for the same period in 2010.

Total consolidated assets at June 30, 2011 were $481.3 million compared to $493.9 million at December 31, 2010. Total deposits at June 30, 2011 were $397.1 million compared to $409.9 million at December

31, 2010. Total shareholders’ equity was $49.7 million at June 30, 2011 compared to $47.8 million at December 31, 2010.

Results of Operations

Net Interest Income

The Company derives the greatest portion of its income from net interest income. Net interest margin for the six month period ended June 30, 2011 was 3.59% compared to 4.02% for the same period of 2010, a decrease of 43 basis points. Average loan balances for the first six months of 2011 declined $18.8 million compared to the same period of 2010, while the average balance in the lower yielding category federal funds sold and other increased $21.7 million and taxable securities increased $23.9 million . This overall increase in lower yielding assets resulted in a 65 basis point reduction in total interest earning asset yield. This reduction was partially offset as the Company was able to lower its cost of funds by 23 basis points during the first half of 2011 compared to the same period of 2010.

The following tables provide information regarding interest income and expense for the six-month periods ended June 30, 2011 and 2010, respectively. Table 1 shows the year-to-date daily average balances for interest earning assets and interest bearing liabilities, interest earned or paid, and the annualized effective rate. Table 2 shows the effect on interest income and expense of changes in volume and interest rates on a tax equivalent basis.

Table 1 — Average Balances and Tax Equivalent Interest Rates

(Dollars in Thousands):


	June 30, 2011								June 30, 2010
	Average					Yield/			Average					Yield/
	Balance			Interest		Rate			Balance			Interest		Rate
ASSETS
Interest earning assets:
Loans(1)(2)(3)	$	308,030		$	8,854		5.75	%	$	326,834		$	9,602		5.88	%
Federal funds sold and other(6)		55,639			98		.35			33,929			57		.34
Taxable securities(4)		55,170			309		1.12			31,296			323		2.06
Tax-exempt securities(1)		24,555			657		5.35			21,616			609		5.64

Total interest earning assets		443,394			9,918		4.47			413,675			10,591		5.12

Non-interest earning assets:
Cash and due from banks		11,472								10,600
Other assets(5)		48,337								50,117
Less allowance for loan losses		(5,538	)							(5,943	)


Total assets	$	497,665							$	468,449


Interest bearing liabilities:
Demand deposits	$	165,873			239		.29	%	$	144,819			256		.35	%
Savings deposits		50,519			23		.09			47,119			41		.17
Time deposits		133,377			1,385		2.08			134,413			1,638		2.44
Securities sold under agreements to repurchase and federal funds purchased		16,262			25		.31			15,397			21		.27
Other borrowings		9,337			206		4.41			13,964			246		3.52
Subordinated debentures		5,155			76		2.95			5,155			76		2.95

Total interest bearing liabilities		380,523			1,954		1.03			360,867			2,278		1.26

Non-interest bearing liabilities:
Demand deposits		63,212								56,146
Other		3,594								3,868
Common stock subject to repurchase obligation		1,390								1,118
Shareholders’ equity		48,946								46,450

Total liabilities and shareholders’ equity	$	497,665							$	468,449

Net interest income				$	7,964							$	8,313

Interest rate spread							3.44	%							3.86	%

Net yield on interest earning assets							3.59	%							4.02	%


(1)		Includes tax equivalent adjustment of interest (assuming a 34% tax rate) for securities and loans of $223,000 and $7,000, respectively, for 2011 and $207,000 and $53,000, respectively, for 2010.

(2)		Average balance includes average non-accrual loan balances of $5,919,000 in 2011 and $7,365,000 in 2010.

(3)		Interest income includes loan fees of $249,000 in 2011 and $251,000 in 2010.

(4)		Average balance includes average unrealized gain of $349,000 in 2011 and $627,000 in 2010 on available for sale securities.

(5)		Includes $15,352,000 in 2011 and $15,700,000 in 2010 relating to goodwill and other intangible assets.

(6)		Includes $52,363,000 in 2011 and $28,521,000 in 2010 of federal reserve deposit accounts.

Table 2 — Changes in Tax-Equivalent Net Interest Income

(Dollars in Thousands)


	Six Months Ended June 30									Six Months Ended June 30
	2011 Over 2010									2010 Over 2009
	Increase (Decrease) Due To									Increase (Decrease) Due To
	Rate			Volume			Net			Rate			Volume			Net
Interest income on:
Loans	$	(204	)	$	(544	)	$	(748	)	$	(152	)	$	(219	)	$	(371	)
Taxable securities		(190	)		176			(14	)		(223	)		(121	)		(344	)
Tax-exempt securities		(32	)		80			48			(17	)		(60	)		(77	)
Federal funds sold		3			38			41			9			28			37


Total interest earning assets	$	(423	)	$	(250	)	$	(673	)	$	(383	)	$	(372	)	$	(755	)


Interest expense on:

Demand deposits	$	(51	)	$	34		$	(17	)	$	(93	)	$	5		$	(88	)
Savings deposits		(21	)		3			(18	)		(11	)		(6	)		(17	)
Time deposits		(240	)		(13	)		(253	)		(410	)		17			(393	)
Securities sold under agreements to repurchase and federal funds purchased		3			1			4			(2	)		1			(1	)
Other borrowings		53			(93	)		(40	)		(114	)		97			(17	)
Subordinated debentures		—			—			—			(41	)		—			(41	)


Total interest bearing liabilities	$	(256	)	$	(68	)	$	(324	)	$	(671	)	$	114		$	(557	)


Net interest income	$	(167	)	$	(182	)	$	(349	)	$	288		$	(486	)	$	(198	)

Tax equivalent net interest income decreased $349,000, or 4.2%, in the first six months of 2011 compared to the same period in 2010. This was a result of an $182,000 net decrease due to volume changes comparing the first six months of 2011 with the first six months of 2010 on a tax equivalent basis and a $167,000 net decrease due to rate changes for the same comparable period.

The presentation of net interest income on a tax equivalent basis is not in accordance with generally accepted accounting principles (“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 net interest income on a tax equivalent basis were $230,000 and $260,000, respectively, for the six months ended June 30, 2011 and 2010. These adjustments were computed using a 34% federal income tax rate.

Provision for Loan Losses

The provision for loan losses is based on an analysis of additions to the allowance for loan losses believed to be appropriate. The provision is charged to income to bring the allowance for loan losses to a level believed adequate by management to absorb probable incurred losses in the loan portfolio. Some factors considered by management in determining the level at which the allowance is maintained include specific credit reviews, historical loan loss experience, current economic conditions and trends, results of examinations by regulatory agencies and the volume, growth and composition of the loan portfolio. The provision is adjusted quarterly, if necessary, to reflect changes in the factors above, and actual charge-off experience and any known losses.

The provision for loan losses for the three and six month periods ended June 30, 2011 was $375,000 and $500,000, respectively, compared to a provision for loan losses in the three and six month periods of 2010 of $150,000 and $350,000, respectively.

The allowance for loan losses was 1.77% of total loans at June 30, 2011 compared to 1.84% at December 31, 2010 and 1.77% at June 30, 2010.

Charge-offs and recoveries for respective loan categories for the six months ended June 30, 2011 and 2010 were as follows:

(Dollars in Thousands)


	June 30, 2011				June 30, 2010
	Charge-offs		Recoveries		Charge-offs		Recoveries
Commercial	$	446	$	59	$	245	$	23
Residential real estate		346		12		401		27
Consumer		117		46		153		50

Total	$	909	$	117	$	799	$	100

Net charge-offs in the first six months of 2011 were $792,000, or 0.52%, of loans on an annualized basis. Net charge-offs in the first six months of 2010 were $699,000, or 0.43%, of loans on an annualized basis.

Non-interest income

Non-interest income for the three month periods ended June 30, 2011 and 2010 was $1,654,000 and $1,714,000, respectively. Non-interest income for the six month periods ended June 30, 2011 and 2010 was $3,309,000 and $3,338,000, respectively.

Trust fees increased 20.6%, or $50,000, in the second quarter of 2011 compared to the second quarter of 2010. Trust fees increased $72,000, or 14.5%, in the first six months of 2011 compared to the same period in 2010. Changes to the trust department fee structure and new account relationships are the primary causes for the increase.

Net gains on loan sales increased 27.3%, or $44,000, in the second quarter of 2011 compared to the second quarter of 2010. Net gains on loan sales increased 85.8%, or $241,000, in the first six months of 2011 compared to the same period in 2010. Fixed rate long term residential mortgages are generally sold in the secondary market, while adjustable rate mortgages are retained in the loan portfolio. An increase in mortgage lending staff during the second half of 2010 resulted in higher production volumes in the second quarter and first six months of 2011 as compared to the same periods of 2010.

Income from loan servicing increased 50.6%, or $43,000, in the second quarter of 2011 compared to the second quarter of 2010. Income from loan servicing increased 38.0%, or $62,000, in the first six months of 2011 compared to the same period in 2010. Increased balances in loans sold in the secondary market in the second half of 2010 and the first half of 2011 resulted in higher loan servicing income.

During the first quarter of 2010, the Company recorded a $156,000 gain from life insurance proceeds. During the second quarter of 2010, the Company recorded income on security calls and sales of $207,000.

Non-interest expense

Non-interest expense for the three month period ended June 30, 2011 was $4,188,000 compared to $4,557,000 for the same period in 2010, a decrease of 8.1% or $369,000. Non-interest expense for the six month periods ended June 30, 2011 and 2009 was $8,644,000 and $9,247,000, respectively.

Professional and outside services decreased $33,000, or 14.2% and $105,000 or 20.0%, respectively in the second quarter and first six months of 2011 as compared to 2010. Collection related legal fees decreased $77,000 as foreclosure activity and collection activity involving litigation slowed during the first six months of 2011.

Expenses relating to OREO property decreased $68,000 or 44.2% and $221,000 or 62.8%, respectively in the second quarter and first six months of 2011 as compared to the same periods of 2010. Property expenses are down as the Company had fewer OREO properties during this period than the same period of 2010.

Federal income taxes

The Company had an income tax provision of $389,000 for the six months ended June 30, 2011 compared to $289,000 for the comparable period of 2010. The $156,000 gain on life insurance proceeds was a non-taxable event which, along with tax-exempt income from securities and loans, reduced the effective tax rate at June 30, 2010 to 16.1%. The effective tax rate for the six month period ended June 30, 2011 was 20.5%. Tax-exempt income continues to have a major impact on the Company’s tax provision and effective tax rate. The benefit offsetting lower coupon rates on municipal instruments is the nontaxable feature of the income earned on such investments. This resulted in a lower effective tax rate and reduced the federal income tax provision.

Financial Condition

Assets

Total assets at June 30, 2011 were $481.3 million, a decrease of $12.6 million compared to December 31, 2010. Cash and cash equivalents totaled $44.9 million at June 30, 2011, a decrease of $33.9 million compared to December 31, 2010. The decrease was primarily due to excess cash being invested in securities. Securities available-for-sale totaled $88.0 million at June 30, 2011, an increase of $28.8 million compared to December 31, 2010. Gross loans totaled $305.6 million at June 30, 2011, a decrease of $3.9 million, or 1.3%, compared to December 31, 2010.

Nonperforming assets

Nonperforming assets include non-accrual loans, loans modified under troubled debt restructurings, accruing loans past due 90 days or more, and other real estate owned, which includes real estate acquired through foreclosure and in lieu of foreclosure.

A loan generally is classified as nonaccrual when full collectability of principal or interest is doubtful or a loan becomes 90 days past due as to principal or interest, unless management determines that the estimated net realizable value of the collateral is sufficient to cover the principal balance and accrued interest. When interest accruals are discontinued, unpaid interest is reversed. Nonperforming loans are returned to performing status when the loan is brought current and has performed in accordance with contract terms for a period of time.

In the course of working with borrowers, the Company may choose to restructure the contractual terms of certain loans. The Company attempts to work-out an alternative payment schedule with the borrower in order to optimize collectability of the loan. Any loans that are modified are reviewed by the Company to identify if a troubled debt restructuring (“TDR”) has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Company grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status and the restructuring of the loan may include the transfer of assets from the borrower to satisfy the debt, a modification of loan terms, or a combination of the two.

The following table sets forth the aggregate amount of nonperforming assets in each of the following categories:

(Dollars in thousands)


	6/30/11			12/31/10			6/30/10
Nonaccrual loans:
Commercial and commercial real estate	$	3,971		$	3,755		$	5,740
Real estate mortgage		1,943			1,451			1,858
Consumer		39			87			80

		5,953			5,293			7,678

Loans contractually past due 90 days or more and still on accrual:
Commercial and commercial real estate		370			1			701
Real estate mortgage		212			—			—
Consumer		—			—			—

		582			1			701

Accruing loans modified under troubled debt restructurings:
Commercial and commercial real estate		1,959			1,745			819
Real estate mortgage		1,143			1,552			697
Consumer		—			—			—

		3,102			3,297			1,516


Total nonperforming loans		9,637			8,591			9,895
Other real estate		863			1,247			831


Total nonperforming assets	$	10,500		$	9,838		$	10,726

Nonperforming loans to total loans		3.15	%		2.78	%		3.05	%

Nonperforming assets to total assets		2.18	%		1.99	%		2.29	%

The balance of nonaccrual restructured loans, which is included in nonaccrual loans, was $1,628,000 at June 30, 2011, $1,375,000 at December 31, 2010 and $2,699,000 at June 30, 2010.

Nonperforming loans are subject to continuous monitoring by management and estimated losses are specifically allocated for in the allowance for loan losses where appropriate. At June 30, 2011, December 31, 2010 and June 30, 2010, the Company had loans of $10.2 million, $10.8 million and $10.1 million, respectively, which were considered impaired.

In management’s evaluation of the loan portfolio risks, any significant future increases in nonperforming loans is dependent to a large extent on the economic environment. In a deteriorating or uncertain economy, management applies more conservative assumptions when assessing the future prospects of borrowers and when estimating collateral values.

Liabilities

Deposits totaled $397.1 million at June 30, 2011, a decrease of $12.8 million, or 3.1%, from December 31, 2010. The majority of deposits are derived from core client sources, relating to long term relationships with local individuals, businesses and public clients. A small amount of brokered deposits are maintained, but are not used to support growth. The Company closed three branches during late 2010 and early 2011. Two of the locations are supported by other branch facilities in near proximity. One location, Cassopolis, was located outside of the Company’s primary market area. Deposit reductions from this location since December 31, 2010 totaled $5.2 million. In addition, the Company made the strategic decision based on current liquidity levels to reduce certificate of deposit rates and specials. As a result, certificate balances from non-core customers have declined in the first six months of 2011.

Shareholders’ equity

Total shareholders’ equity amounted to $49.7 million at June 30, 2011, an increase of $1.9 million from December 31, 2010. The increase was primarily attributable to the net income for the period, less dividends to shareholders, and an increase in accumulated other comprehensive income due to the increase in market value of securities held for sale.

The following table summarizes the Company’s regulatory capital ratios as of June 30, 2011 and December 31, 2010:


							Minimum Required for
	June 30, 2011			December 31, 2010			Capital Adequacy Purposes
Total risk-based capital ratio		14.0	%		13.7	%		8.0	%
Tier I capital ratio		12.8	%		12.4	%		4.0	%
Leverage ratio		8.5	%		8.2	%		4.0	%

Liquidity

Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. SMB&T maintains certain levels of liquid assets (the most liquid of which are cash and cash equivalents, federal funds sold and investment securities) in order to meet these demands. Maturing loans and investment securities are the principal sources of asset liquidity. Liquidity is monitored and closely managed by the Asset/Liability Management Committee (ALCO), whose members are comprised of senior management.

SMB&T maintains correspondent accounts with other banks for various purposes. At times, SMB&T is a participant in the federal funds market, either as a borrower or a seller. SMB&T has a $3 million federal funds line available from a correspondent bank. In addition, SMB&T has the ability to borrow $37.8 million from the Federal Home Loan Bank based on collateral pledged, and also has the ability to borrow at the discount window of the Federal Reserve Bank as an additional short term funding source.

The Company’s balances in federal funds sold and short term interest bearing balances with banks were $34.9 million at June 30, 2011, compared to $68.4 million at December 31, 2010 and $32.4 million at June 30, 2010. The Company continues to maintain high levels of liquidity, with investments, federal funds and cash equivalents held to improve the liquidity of the balance sheet during this period of economic uncertainty. The Company expects to maintain higher than normal levels of liquidity until economic conditions improve and more attractive investment opportunities emerge.

The Company’s principal source of funds to pay cash dividends is the earnings and dividends paid by SMB&T. The payment of dividends by SMB&T is subject to legal and regulatory restrictions. At June 30, 2011, using the most restrictive of these restrictions, the aggregate cash dividends that SMB&T could pay the Company without prior regulatory approval was approximately $6 million.

Impact of Inflation and Changing Prices

The majority of assets and liabilities of a financial institution are monetary in nature and therefore differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an important impact on the growth of total assets in the banking industry and the resulting need to increase equity capital at higher than normal rates in order to maintain an appropriate equity-to-assets ratio. Another significant effect of inflation is on other expenses, which tend to rise during periods of general inflation.


Item 4.		Controls and Procedures

An evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 15d — 15(e) under the Exchange Act) as of June 30, 2011. Based on and as of the time of that evaluation, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, concluded that as of the end of the period covered by this report the Company’s disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms and is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

There was no change in the Company’s internal control over financial reporting that occurred during the three months ended June 30, 2011 that has materially affected, or that is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II. Other Information


Item 6.		Exhibits

Exhibits. The following exhibits are filed as part of this report on Form 10-Q:


Exhibit
Number		Document
3.1		Articles of Incorporation of Southern Michigan Bancorp, Inc., as amended. Previously filed with the Commission on July 13, 2007 in Southern Michigan Bancorp Inc.’s Form S-4 Registration Statement, Exhibit 3.1. Here incorporated by reference.

3.2		Amended and Restated Bylaws of Southern Michigan Bancorp, Inc., as amended. Previously filed with the Commission on July 13, 2007 in Southern Michigan Bancorp Inc.’s Form S-4 Registration Statement, Exhibit 3.2. Here incorporated by reference.

4.1		Articles of Incorporation of Southern Michigan Bancorp, Inc., as amended. Exhibit 3.1 is here incorporated by reference.

4.2		Amended and Restated Bylaws of Southern Michigan Bancorp, Inc., as amended. Exhibit 3.2 is here incorporated by reference.

4.3		Long-Term Debt. The registrant has outstanding long-term debt which at the time of this report does not exceed 10% of the registrant’s total consolidated assets. The registrant agrees to furnish copies of the agreements defining the rights of holders of such long-term debt to the Securities and Exchange Commission upon request.

31.1		Certification of Chairman of the Board and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Senior Vice President, Chief Financial Officer, Secretary and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002.

32		Certification pursuant to 18 U.S.C. § 1350.

101.INS		XBRL Instance Document (1)

101.SCH		XBRL Taxonomy Extension Schema Document (1)

101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document (1)

101.LAB		XBRL Taxonomy Extension Label Linkbase Document (1)

101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document (1)

101.DEF		XBRL Taxonomy Extension Definitions Linkbase Document (1)


(1)		As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	SOUTHERN MICHIGAN BANCORP, INC.
Date: August 12, 2011	By:	/s/ John H. Castle
		John H. Castle
		Chairman of the Board and Chief Executive Officer (Principal Executive Officer)


Date: August 12, 2011	By:	/s/ Danice L. Chartrand
		Danice L. Chartrand
		Senior Vice President, Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer)

Exhibit Index


Exhibit
Number		Document
3.1		Articles of Incorporation of Southern Michigan Bancorp, Inc., as amended. Previously filed with the Commission on July 13, 2007 in Southern Michigan Bancorp Inc.’s Form S-4 Registration Statement, Exhibit 3.1. Here incorporated by reference.

3.2		Amended and Restated Bylaws of Southern Michigan Bancorp, Inc., as amended. Previously filed with the Commission on July 13, 2007 in Southern Michigan Bancorp Inc.’s Form S-4 Registration Statement, Exhibit 3.2. Here incorporated by reference.

4.1		Articles of Incorporation of Southern Michigan Bancorp, Inc., as amended. Exhibit 3.1 is here incorporated by reference.

4.2		Amended and Restated Bylaws of Southern Michigan Bancorp, Inc., as amended. Exhibit 3.2 is here incorporated by reference.

4.3		Long-Term Debt. The registrant has outstanding long-term debt which at the time of this report does not exceed 10% of the registrant’s total consolidated assets. The registrant agrees to furnish copies of the agreements defining the rights of holders of such long-term debt to the Securities and Exchange Commission upon request.

31.1		Certification of Chairman of the Board and Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Senior Vice President, Chief Financial Officer, Secretary and Treasurer under Section 302 of the Sarbanes-Oxley Act of 2002.

32		Certification pursuant to 18 U.S.C. § 1350.

101.INS		XBRL Instance Document (1)

101.SCH		XBRL Taxonomy Extension Schema Document (1)

101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document (1)

101.LAB		XBRL Taxonomy Extension Label Linkbase Document (1)

101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document (1)

101.DEF		XBRL Taxonomy Extension Definitions Linkbase Document (1)


(2)		As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934

SOUTHERN MICHIGAN BANCORP INC - Quarter Report: 2011 June (Form 10-Q)

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