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CHFC > SEC Filings for CHFC > Form 10-Q on 1-Nov-2012All Recent SEC Filings

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Form 10-Q for CHEMICAL FINANCIAL CORP


1-Nov-2012

Quarterly Report


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

The following is management's discussion and analysis of certain significant factors that have affected the financial condition and results of operations of Chemical Financial Corporation (Corporation) during the periods included in the consolidated financial statements included in this report.

Critical Accounting Policies

The Corporation's consolidated financial statements are prepared in accordance with generally accepted accounting principles (GAAP), Securities and Exchange Commission (SEC) rules and interpretive releases and general practices within the industry in which the Corporation operates. Application of these principles requires management to make estimates, assumptions and complex judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments. Actual results could differ significantly from those estimates. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and, as such, have a greater possibility of producing results that could be materially different than originally reported. Management has identified the determination of the allowance for loan losses, accounting for loans acquired in business combinations, pension plan accounting, income and other taxes, fair value measurements and the evaluation of goodwill impairment to be the accounting areas that require the most subjective or complex judgments, and as such, could be most subject to revision as new or additional information becomes available or circumstances change, including overall changes in the economic climate and/or market interest rates. Therefore, management considers them to be critical accounting policies and discusses them directly with the Audit Committee of the board of directors. The Corporation's significant accounting policies are more fully described in Note 1 to the audited consolidated financial statements contained in the Corporation's Annual Report on Form 10-K for the year ended December 31, 2011 and the more significant assumptions and estimates made by management are more fully described in "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies" in the Corporation's Annual Report on Form 10-K for the year ended December 31, 2011. There were no material changes to the Corporation's significant accounting policies or the estimates made pursuant to those policies during the most recent quarter.

Acquisitions
Pending Branch Acquisition

On May 23, 2012, Chemical Bank, the wholly-owned banking subsidiary of the Corporation, entered into a purchase and assumption agreement with Independent Bank, a wholly-owned banking subsidiary of Independent Bank Corporation, to acquire 21 branches located in the Northeastern and Battle Creek regions of Michigan. Under the terms of the agreement, Chemical Bank will assume approximately $420 million in customer deposits at a blended premium of approximately 2.93% and acquire approximately $50 million of loans at a discount of 1.75%. The branch acquisition, which has received regulatory approval, is expected to close during the fourth quarter of 2012. The Corporation expects the branch acquisition to be accretive to earnings per share upon closing, excluding estimated one-time transaction related expenses of $2.9 million, of which $1.1 million of transaction related expenses were incurred during the first nine months of 2012 and $1.8 million are estimated to be incurred during the fourth quarter of 2012. The Corporation anticipates recognizing goodwill of approximately $7 million related to the branch acquisition.

Upon completion of the branch acquisition, the Corporation and Chemical Bank are both expected to remain categorized as well-capitalized under applicable regulatory requirements. Accordingly, the Corporation's management has determined that the Corporation will not need to raise additional capital in conjunction with the branch acquisition. Acquisition of O.A.K. Financial Corporation

On April 30, 2010, the Corporation acquired O.A.K. Financial Corporation (OAK) for total consideration of $83.7 million. OAK, a bank holding company, owned Byron Bank, which provided traditional banking services and products through 14 banking offices serving communities in Ottawa, Allegan and Kent counties in west Michigan. At April 30, 2010, OAK had total assets of $820 million, including total loans of $627 million, and total deposits of $693 million, including brokered deposits of $193 million. The Corporation operated Byron Bank as a separate subsidiary from the acquisition date until July 23, 2010, the date Byron Bank was consolidated with and into Chemical Bank.


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Summary

The Corporation's net income was $13.1 million, or $0.48 per diluted share, in the third quarter of 2012, compared to net income of $13.9 million, or $0.50 per diluted share, in the second quarter of 2012 and net income of $11.6 million, or $0.42 per diluted share, in the third quarter of 2011. The decrease in net income and earnings per share in the third quarter of 2012, compared to the second quarter of 2012, was attributable to lower noninterest income, higher operating expenses and a higher provision for loan losses that was partially offset by higher net interest income. The increase in net income and earnings per share in the third quarter of 2012, compared to the third quarter of 2011, was attributable to a lower provision for loan losses and higher net interest income and noninterest income that was partially offset by higher operating expenses.

Return on average assets, on an annualized basis, was 0.96% in the third quarter of 2012, compared to 1.04% in the second quarter of 2012 and 0.87% in the third quarter of 2011. Return on average equity, on an annualized basis, was 8.8% in the third quarter of 2012, compared to 9.6% in the second quarter of 2012 and 8.0% in the third quarter of 2011.

Financial Condition Total Assets

Total assets were $5.58 billion at September 30, 2012, an increase of $241 million, or 4.5%, from total assets of $5.34 billion at December 31, 2011 and an increase of $141 million, or 2.6%, from total assets of $5.44 billion at September 30, 2011.

Interest-earning assets were $5.24 billion at September 30, 2012, an increase of $256 million, or 5.1%, from interest-earning assets of $4.99 billion at December 31, 2011 and an increase of $160 million, or 3.2%, from interest-earning assets of $5.08 billion at September 30, 2011.

The increases in total assets and interest-earning assets during the nine months ended September 30, 2012 were primarily attributable to growth in loans that was funded by seasonal increases in municipal customer deposits. The increases in total assets and interest-bearing assets during the twelve months ended September 30, 2012 were primarily attributable to loan growth , which was partially offset by a reduction in interest-bearing deposits held at the Federal Reserve Bank.

Investment Securities

The carrying value of investment securities totaled $868.1 million at September 30, 2012, an increase of $17.5 million, or 2.1%, from investment securities of $850.6 million at December 31, 2011 and an increase of $71.2 million, or 8.9%, from investment securities of $796.9 million at September 30, 2011. The increases in investment securities during the nine and twelve month periods ended September 30, 2012 were primarily attributable to the Corporation deploying a portion of its liquidity into investment securities to obtain a higher yield than the 25 basis points it would have received by maintaining excess funds at the Federal Reserve Bank, as the Corporation does not expect short-term interest rates to increase significantly over the next 12 to 18 months. At September 30, 2012, the Corporation's investment securities portfolio consisted of $101.5 million in government sponsored agency (GSA) debt obligations comprised primarily of fixed-rate senior bonds issued by the twelve regional Federal Home Loan Banks that make up the Federal Home Loan Bank System (FHLBanks) and variable-rate instruments backed by the Federal Farm Credit Bank, Small Business Administration and Student Loan Marketing Corporation; $263.3 million in state and political subdivisions debt obligations comprised primarily of general debt obligations of issuers primarily located in the State of Michigan; $105.2 million in residential mortgage-backed securities (MBSs) comprised primarily of fixed rate instruments backed by a U.S. government agency (Government National Mortgage Association) or government sponsored enterprises (Federal Home Loan Mortgage Corporation and Federal National Mortgage Association); $299.1 million of collaterized mortgage obligations (CMOs) comprised primarily of variable-rate instruments backed by the same U.S. government agency and government sponsored enterprises as the residential MBSs with average maturities of less than three years; $82.1 million in corporate bonds comprised primarily of debt obligations of large national financial organizations; $6.4 million of preferred stock securities of two large regional/national banks and one Michigan bank holding company; and $10.5 million of trust preferred securities (TRUPs) comprised primarily of a 100% interest in a TRUP of a non-public bank holding company in Michigan.

The Corporation uses a third-party pricing service as its primary source for obtaining market value prices for its investment securities portfolio. On a quarterly basis, the Corporation validates the reasonableness of prices received from the third-party pricing service through independent price verification on a representative sample of investment securities in the portfolio, data integrity validation through comparison of current market prices to prior period market prices, and performing overall analytical expectations of movement in market prices based upon the changes in the related yield curves and other market factors. On a periodic basis, the Corporation reviews the pricing methodology of the third-party pricing vendor for pricing relevant investment securities and results of internal control assessments.


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The Corporation's investment securities portfolio with a carrying value of $868.1 million at September 30, 2012, had gross impairment of $8.2 million at that date. Management believed that the unrealized losses on investment securities were temporary in nature and due primarily to changes in interest rates on the investment securities and market illiquidity and not as a result of credit-related issues. Accordingly, at September 30, 2012, the Corporation believed the impairment in its investment securities portfolio was temporary in nature and, therefore, no impairment loss was realized in the Corporation's consolidated statement of income for the nine months ended September 30, 2012. However, other-than-temporary impairment (OTTI) may occur in the future as a result of material declines in the fair value of investment securities resulting from market, credit, economic or other conditions. A further discussion of the assessment of potential impairment and the Corporation's process that resulted in the conclusion that the impairment was temporary in nature follows.

At September 30, 2012, the Corporation's investment securities portfolio had gross impairment of $8.2 million comprised as follows: GSA securities, residential MBSs and CMOs, combined, with gross impairment of $0.6 million; state and political subdivisions securities with gross impairment of $1.7 million; corporate bonds with gross impairment of $0.6 million; and TRUPs with gross impairment of $5.3 million. The amortized costs and fair values of investment securities are disclosed in Note 3 to the consolidated financial statements.

GSA securities, residential MBSs and CMOs, included in the available-for-sale investment securities portfolio, with a combined amortized cost of $501.2 million had gross impairment of $0.6 million at September 30, 2012. Virtually all of the impaired investment securities in these categories are backed by the full faith and credit of the U.S. government or a guarantee of a U.S. government agency or government sponsored enterprise. The Corporation determined that the impairment on these investment securities was attributable to the slight reduction in market interest rates since these investment securities were purchased. The Corporation concluded that the impairment of its GSA securities, residential MBSs and CMOs was temporary in nature at September 30, 2012.

State and political subdivisions securities, included in the available-for-sale and the held-to-maturity investment securities portfolios, with an amortized cost of $260.7 million had gross impairment of $1.7 million at September 30, 2012. The majority of these investment securities are from issuers primarily located in the State of Michigan and are general obligations of the issuer, meaning that repayment of these obligations is funded by general tax collections of the issuer. The gross impairment was attributable to impaired state and political subdivisions securities with an amortized cost of $73.1 million that generally mature beyond 2013. It was the Corporation's assessment that the impairment on these investment securities was attributable to the slight reduction in market interest rates since these investment securities were purchased and illiquidity in the market for these investment securities caused by the market's perception of the Michigan economy. The Corporation concluded that the impairment of its state and political subdivisions securities was temporary in nature at September 30, 2012.

Corporate bonds, included in the available-for-sale investment securities portfolio, with an amortized cost of $82.2 million had gross impairment of $0.6 million at September 30, 2012. All of the corporate bonds held at September 30, 2012 were of an investment grade. The investment grade ratings of all of the corporate bonds indicated that the obligors' capacities to meet their financial commitments was "strong." It was the Corporation's assessment that the impairment on the corporate bonds was attributable to the slight reduction in market interest rates since these investment securities were purchased and the recent negative market perception of the financial industry and not due to credit-related issues. The Corporation concluded that the impairment of its corporate bonds was temporary in nature at September 30, 2012.

At September 30, 2012, the Corporation held two TRUPs in the held-to-maturity investment securities portfolio, with a combined amortized cost of $10.5 million that had gross impairment of $5.3 million. One TRUP, with an amortized cost of $10.0 million, represents a 100% interest in a TRUP of a non-public bank holding company in Michigan that was purchased in the second quarter of 2008. At September 30, 2012, the Corporation determined that the fair value of this TRUP was $5.0 million. The second TRUP, with an amortized cost of $0.5 million, represents a 10% interest in the TRUP of another non-public bank holding company in Michigan. At September 30, 2012, the Corporation determined the fair value of this TRUP was $0.2 million. The fair value measurements of the two TRUP investments were developed based upon market pricing observations of much larger banking institutions in an illiquid market, adjusted by risk measurements. The fair values of the Corporation's TRUPs were based on calculations of discounted cash flows, and further based upon both observable inputs and appropriate risk adjustments that market participants would make for performance, liquidity and issuer specifics. See the additional discussion of the development of the fair values of the TRUPs in Note 3 to the consolidated financial statements. Management reviewed available financial information of the issuers of the TRUPs as of September 30, 2012.

The issuer of the $10.0 million TRUP reported net income in each of the first three quarters of 2012 and in each of the three years ended December 31, 2011 and was categorized as well-capitalized under applicable regulatory requirements during that time. Based on an analysis of financial information provided by the issuer, it was the Corporation's opinion that, as of September 30,


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2012, this issuer appeared to be a financially sound financial institution with sufficient liquidity to meet its financial obligations in 2012. There have been no material adverse changes in the issuer's financial performance since the TRUP was issued and purchased by the Corporation and no indication that any material adverse trends were developing that would suggest that the issuer would be unable to make all future principal and interest payments under the TRUP. Quarterly common stock cash dividends have consistently been paid by the issuer and the Corporation understands that the issuer's management anticipates cash dividends to continue to be paid in the future. All scheduled interest payments on this TRUP have been made on a timely basis. The principal of $10.0 million of this TRUP matures in 2038, with interest payments due quarterly. At September 30, 2012, the Corporation was not aware of any regulatory issues, memorandums of understanding or cease and desist orders that had been issued to the issuer or its subsidiaries. In reviewing all reasonably available information regarding the issuer, including past performance and its financial and liquidity position, it was the Corporation's opinion that the future cash flows of the issuer supported the carrying value of the TRUP at its original cost of $10.0 million at September 30, 2012. While the total fair value of the TRUP was $5.0 million below the Corporation's amortized cost at September 30, 2012, the Corporation concluded that, based on the overall financial condition of the issuer, the impairment was temporary in nature at September 30, 2012.

The issuer of the $0.5 million TRUP reported a small amount of net income in 2011 and the first six months of 2012, compared to net losses reported in both 2010 and 2009. At September 30, 2012, the issuer was categorized as well-capitalized under applicable regulatory requirements. All scheduled interest payments on this TRUP have been made on a timely basis. The principal of $0.5 million of this TRUP matures in 2033, with interest payments due quarterly. At September 30, 2012, the Corporation was not aware of any regulatory issues, memorandums of understanding or cease and desist orders that had been issued to the issuer of this TRUP or any subsidiary. In reviewing all reasonably available financial information regarding the $0.5 million TRUP, it was the Corporation's opinion that the carrying value of this TRUP at its original cost of $0.5 million was supported by the issuer's financial position at September 30, 2012. While the fair value of the TRUP was $0.3 million below the Corporation's amortized cost at September 30, 2012, the Corporation concluded that the impairment was temporary in nature at September 30, 2012.

At September 30, 2012, the Corporation expected to fully recover the entire amortized cost basis of each impaired investment security in its investment securities portfolio at that date. Furthermore, at September 30, 2012, the Corporation did not have the intent to sell any of its impaired investment securities and believed that it was more-likely-than-not that the Corporation would not have to sell any of its impaired investment securities before a full recovery of amortized cost. However, there can be no assurance that OTTI losses will not be recognized on the TRUPs or on any other investment security in the future.

Loans

The Corporation's loan portfolio is comprised of commercial, real estate commercial, real estate construction and land development loans, referred to as the Corporation's commercial loan portfolio, and real estate residential, consumer installment and home equity loans, referred to as the Corporation's consumer loan portfolio. At September 30, 2012, the Corporation's loan portfolio was $4.02 billion and consisted of loans in the commercial loan portfolio totaling $2.16 billion, or 54% of total loans, and loans in the consumer loan portfolio totaling $1.86 billion, or 46% of total loans. Loans at fixed interest rates comprised 72% of the Corporation's total loan portfolio at both September 30, 2012 and June 30, 2012, compared to 71% at December 31, 2011 and 73% at September 30, 2011.

Chemical Bank is a full-service commercial bank and the acceptance and management of credit risk is an integral part of the Corporation's business. The Corporation maintains loan policies and credit underwriting standards as part of the process of managing credit risk. These standards include making loans generally only within the Corporation's market areas. The Corporation's lending markets generally consist of communities across the middle to southern and western sections of the lower peninsula of Michigan. The Corporation's lending market areas do not include the southeastern portion of Michigan. The Corporation has no foreign loans or any loans to finance highly leveraged transactions. The Corporation's lending philosophy is implemented through strong administrative and reporting controls. The Corporation maintains a centralized independent loan review function that monitors the approval process and ongoing asset quality of the loan portfolio.

Total loans were $4.02 billion at September 30, 2012, an increase of $57 million, or 1.4%, from total loans of $3.96 billion at June 30, 2012, an increase of $188 million, or 4.9%, from total loans of $3.83 billion at December 31, 2011 and an increase of $259 million, or 6.9%, from total loans of $3.76 billion at September 30, 2011. The increases in total loans were attributable to a combination of improving economic conditions and higher loan demand, as well as the Corporation increasing its market share.


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A summary of the composition of the Corporation's loan portfolio, by major loan category, follows:

                                          September 30,       June 30,        December 31,       September 30,
                                              2012              2012              2011               2011
                                                                     (In thousands)
Commercial loan portfolio:
Commercial                              $       951,938     $   915,352     $      895,150     $       858,969
Real estate commercial                        1,117,073       1,119,655          1,071,999           1,056,092
Real estate construction and land
development                                      90,882          94,227            118,176             119,829
Subtotal                                      2,159,893       2,129,234          2,085,325           2,034,890
Consumer loan portfolio:
Real estate residential                         880,295         873,214            861,716             840,044
Consumer installment and home equity            978,971         959,894            884,244             885,492
Subtotal                                      1,859,266       1,833,108          1,745,960           1,725,536
Total loans                             $     4,019,159     $ 3,962,342     $    3,831,285     $     3,760,426

A discussion of the Corporation's loan portfolio by category follows. Commercial Loan Portfolio

The Corporation's commercial loan portfolio is comprised of commercial loans, real estate commercial loans, real estate construction loans and land development loans. The Corporation's commercial loan portfolio is well diversified across business lines and has no concentration in any one industry. The commercial loan portfolio of $2.16 billion at September 30, 2012 included 62 loan relationships of $5.0 million or greater. These 62 loan relationships totaled $499 million and represented 23% of the commercial loan portfolio at September 30, 2012 and included 12 loan relationships that had outstanding balances of $10 million or higher, totaling $150 million, or 7%, of the commercial loan portfolio at that date. Further, the Corporation had 11 loan relationships at September 30, 2012 with loan balances greater than $5.0 million and less than $10 million, totaling $89 million, that had unfunded credit commitments totaling $52 million that, if advanced, could result in a loan relationship of $10 million or more.

Commercial loans consist of loans and lines of credit to varying types of businesses, including municipalities, school districts and nonprofit organizations, for the purpose of supporting working capital and operational needs and term financing of equipment. Repayment of such loans is generally provided through operating cash flows of the customer. Commercial loans are generally secured with inventory, accounts receivable, equipment, personal guarantees of the owner or other sources of repayment, although the Corporation may also obtain real estate as collateral.

Commercial loans were $951.9 million at September 30, 2012, an increase of $36.6 million, or 4.0%, from commercial loans of $915.4 million at June 30, 2012, an increase of $56.8 million, or 6.3%, from commercial loans of $895.2 million at December 31, 2011 and an increase of $93.0 million, or 10.8%, from commercial loans of $859.0 million at September 30, 2011. Commercial loans represented 23.7% of the Corporation's loan portfolio at September 30, 2012, compared to 23.1%, 23.3% and 22.8% at June 30, 2012, December 31, 2011 and September 30, 2011, respectively.

Real estate commercial loans include loans that are secured by real estate occupied by the borrower for ongoing operations, non-owner occupied real estate leased to one or more tenants and vacant land that has been acquired for investment or future land development. Real estate commercial loans were $1.12 billion at September 30, 2012, a decrease of $2.6 million from real estate commercial loans at June 30, 2012, although an increase of $45.1 million, or 4.2%, from real estate commercial loans of $1.07 billion at December 31, 2011 and an increase of $61.0 million, or 5.8%, from real estate commercial loans of $1.06 billion at September 30, 2011. Loans secured by owner occupied properties, non-owner occupied properties and vacant land comprised 60%, 37% and 3%, respectively, of the Corporation's real estate commercial loans outstanding at September 30, 2012. Real estate commercial loans represented 27.8% of the Corporation's loan portfolio at September 30, 2012, compared to 28.3%, 28.0% and 28.1% at June 30, 2012, December 31, 2011 and September 30, 2011, respectively.

Real estate commercial lending is generally considered to involve a higher degree of risk than real estate residential, consumer installment and home equity lending, and typically involves larger loan balances concentrated in a single borrower. In addition, the payment experience on loans secured by income-producing properties and vacant land loans are typically dependent on the success of the operation of the related project and is typically affected by adverse conditions in the real estate market and in the economy.


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The Corporation generally attempts to mitigate the risks associated with commercial and real estate commercial lending by, among other things, lending primarily in its market areas, lending across industry lines, not developing a concentration in any one line of business and using prudent loan-to-value ratios in the underwriting process. Michigan's economy showed signs of improvement during 2011 and the first nine months of 2012, resulting in lower loan . . .

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