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CHFC > SEC Filings for CHFC > Form 10-Q on 31-Oct-2013All Recent SEC Filings

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Form 10-Q for CHEMICAL FINANCIAL CORP


31-Oct-2013

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 U.S. 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, 2012 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, 2012. 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 and Branch Closings
Acquisition of 21 Branches
On December 7, 2012, Chemical Bank acquired 21 branches from Independent Bank, a subsidiary of Independent Bank Corporation (branch acquisition transaction). In addition to the branch offices, which are located in the Northeast and Battle Creek regions of Michigan, the acquisition included $404 million in deposits and $44 million in loans. The purchase price of the branch offices, including equipment, was $8.1 million and the Corporation paid a premium on deposits of $11.5 million, or approximately 2.85% of total deposits acquired. The loans were purchased at a discount of 1.75%. In connection with the acquisition of the branches, the Corporation recorded $6.8 million of goodwill, which represented the excess of the purchase price over the fair value of identifiable net assets acquired, and $5.6 million of other intangible assets attributable to customer core deposits.
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. Branch Closings
During the first quarter of 2013, Chemical Bank closed six branch office locations. These six branch office locations had a combined net book value of $0.4 million. The Corporation recognized less than $0.1 million of expense as a result of closing these branch office locations because a majority of the employees of these six closed branch offices were transferred to other nearby Chemical Bank branch locations or other open positions within Chemical Bank.


Summary The Corporation's net income was $15.0 million, or $0.53 per diluted share, in the third quarter of 2013, compared to net income of $14.2 million, or $0.51 per diluted share, in the second quarter of 2013 and net income of $13.1 million, or $0.48 per diluted share, in the third quarter of 2012. The increase in net income and earnings per share in the third quarter of 2013, compared to the second quarter of 2013, was attributable to higher net interest income and lower operating expenses being partially offset by lower noninterest income. The increase in net income and earnings per share in the third quarter of 2013, compared to the third quarter of 2012, was attributable to a combination of higher net interest income, higher noninterest income and a lower provision for loan losses, all of which were partially offset by higher operating expenses. Return on average assets, on an annualized basis, was 1.00% in the third quarter of 2013, compared to 0.97% in the second quarter of 2013 and 0.96% in the third quarter of 2012. Return on average equity, on an annualized basis, was 9.6% in the third quarter of 2013, compared to 9.4% in the second quarter of 2013 and 8.8% in the third quarter of 2012.
The Corporation's net income was $42.4 million, or $1.53 per diluted share, for the nine months ended September 30, 2013, compared to net income of $39.3 million, or $1.43 per diluted share, for the nine months ended September 30, 2012. The increase in net income per diluted share of 7.0% for the nine months ended September 30, 2013 over the same period for 2012 was attributable to a combination of higher net interest income, higher noninterest income and a lower provision for loan losses, all of which were partially offset by higher operating expenses.

Financial Condition
Total Assets
Total assets were $6.26 billion at September 30, 2013, an increase of $452 million, or 7.8%, from total assets of $5.81 billion at June 30, 2013, an increase of $341 million, or 5.8%, from total assets of $5.92 billion at December 31, 2012, and an increase of $678 million, or 12.1%, from total assets of $5.58 billion at September 30, 2012.
Interest-earning assets were $5.90 billion at September 30, 2013, an increase of $452 million, or 8.3%, from interest-earning assets of $5.45 billion at June 30, 2013, an increase of $362 million, or 6.5%, from interest-earning assets of $5.54 billion at December 31, 2012, and an increase of $660 million, or 12.6%, from interest-earning assets of $5.24 billion at September 30, 2012. The increases in total assets and interest-earning assets during the three and nine months ended September 30, 2013 were largely attributable to seasonal increases in municipal customer deposits, while the increases in total assets and interest-earning assets during the twelve months ended September 30, 2013 were primarily attributable to the branch acquisition transaction. The Corporation acquired $339 million of cash and $44 million of loans in the branch acquisition transaction. The Corporation partially invested the cash acquired in the branch acquisition transaction in short-term investment securities and utilized the remainder to fund loan growth. The increases in total assets and interest-earning assets during the three-, nine- and twelve-month periods ended September 30, 2013 were also attributable to an increase in customer deposits, excluding those acquired in the branch acquisition transaction, that partially funded loan growth.
Investment Securities
The carrying value of investment securities totaled $988 million at September 30, 2013, a decrease of $21 million, or 2.1%, from investment securities of $1.01 billion at June 30, 2013, an increase of $171 million, or 21%, from investment securities of $817 million at December 31, 2012, and an increase of $120 million, or 14%, from investment securities of $868 million at September 30, 2012. The increases in investment securities during the nine- and twelve-month periods ended September 30, 2013 were primarily attributable to the Corporation deploying a portion of the cash acquired in the branch acquisition transaction into investment securities to obtain a higher yield than the 25 basis points it would have received by maintaining these excess funds at the Federal Reserve Bank (FRB), as the Corporation does not expect short-term interest rates to increase significantly in the near term. The decrease in investment securities during the three months ended September 30, 2013 was primarily attributable to the Corporation deploying maturing investment securities into higher yielding loans.
At September 30, 2013, the Corporation's investment securities portfolio consisted of: government sponsored agency (GSA) debt obligations, comprised primarily of variable-rate instruments backed by the Small Business Administration and Student Loan Marketing Corporation, totaling $85.9 million; state and political subdivisions debt obligations, comprised primarily of general debt obligations of issuers primarily located in the State of Michigan, totaling $317.7 million; 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), totaling $308.2 million; collaterized mortgage obligations (CMOs), comprised of approximately 70% fixed-rate and


30% 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, totaling $198.5 million; corporate bonds, comprised primarily of debt obligations of large U.S. global financial organizations, totaling $65.4 million; preferred stock securities, comprised of two large regional/national banks, totaling $1.6 million; and trust preferred securities (TRUPs), comprised primarily of a 100% interest in a variable-rate TRUP of a small non-public bank holding company in Michigan, totaling $10.5 million. Variable-rate instruments comprised 25% of the Corporation's investment securities portfolio at September 30, 2013.
The Corporation utilizes third-party pricing services to obtain 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 services through independent price verification on a sample of investment securities in the portfolio, data integrity validation based upon comparison of current market prices to prior period market prices and analysis of overall 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 vendors and the results of the vendors' internal control assessments to ensure the integrity of the process that the vendors use to develop market pricing for the Corporation's investment securities portfolio.
The Corporation's investment securities portfolio, with a carrying value of $987.7 million at September 30, 2013, had gross impairment of $19.0 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, the Corporation believed the impairment in its investment securities portfolio at September 30, 2013 was temporary in nature and, therefore, no impairment loss was recognized in the Corporation's consolidated statement of income for the three months ended September 30, 2013. 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, 2013, the Corporation's investment securities portfolio had gross impairment of $19.0 million comprised as follows: GSA securities, residential MBSs and CMOs, combined, with gross impairment of $6.1 million; state and political subdivisions securities with gross impairment of $8.4 million; corporate bonds with gross impairment of $0.2 million; and TRUPs with gross impairment of $4.3 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 $597.0 million, had gross impairment of $6.1 million at September 30, 2013. 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 current market interest rates being higher than the yields being earned on these investment securities. The Corporation concluded that the impairment of its GSA securities, residential MBSs and CMOs was temporary in nature at September 30, 2013. State and political subdivisions securities, included in the available-for-sale and the held-to-maturity investment securities portfolios, with an amortized cost of $316.3 million, had gross impairment of $8.4 million at September 30, 2013. Approximately 95% of the Corporation's state and political subdivisions 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 Corporation holds no general debt obligations issued by the City of Detroit, Michigan. The gross impairment was attributable to impaired state and political subdivisions securities with an amortized cost of $160 million that generally mature beyond 2014. It was the Corporation's assessment that the impairment on these investment securities was attributable to current market interest rates being slightly higher than the yield on these investment securities, illiquidity in the market for a portion of these investment securities caused by the market's perception of the Michigan economy, and illiquidity in the market due to the nature of a portion of these investment securities. The Corporation concluded that the impairment of its state and political subdivisions securities was temporary in nature at September 30, 2013.
Corporate bonds, included in the available-for-sale investment securities portfolio, with an amortized cost of $65.1 million, had gross impairment of $0.2 million at September 30, 2013. All of the corporate bonds held at September 30, 2013 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 current market interest rates being slightly higher than the yield on these investment securities and the market perception of the issuers, and not due to credit-related issues. The Corporation concluded that the impairment of its corporate bonds was temporary in nature at September 30, 2013.


At September 30, 2013, 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 $4.3 million. Management reviewed available financial information of the issuers of the TRUPs as of September 30, 2013. 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, 2013, the Corporation determined that the fair value of this TRUP was $6.0 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, 2013, 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.
The issuer of the $10.0 million TRUP reported net income in each of the first three quarters of 2013 and in each of the three years ended December 31, 2012 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, 2013, this issuer appeared to be a financially sound financial institution with sufficient liquidity to meet its financial obligations in 2013. There have been no material adverse changes in the issuer's financial performance since the TRUP was issued and purchased by the Corporation and there has been no indication that any material adverse trends are 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. The principal of $10.0 million of this TRUP matures in 2038, with interest payments of 360 basis points over the three-month London Interbank Offered Rate (LIBOR) due quarterly. All scheduled interest payments on this TRUP have been made on a timely basis. At September 30, 2013, 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, 2013. While the total fair value of the TRUP was $4.0 million below the Corporation's amortized cost at September 30, 2013, the Corporation concluded that, based on the overall financial condition of the issuer, the impairment was temporary in nature at September 30, 2013. The issuer of the $0.5 million TRUP reported a small amount of net income for the first half of 2013 as well as in 2011, compared to net losses in 2012 and 2010. At September 30, 2013, 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, 2013, 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, 2013. While the fair value of the TRUP was $0.3 million below the Corporation's amortized cost at September 30, 2013, the Corporation concluded that the impairment was temporary in nature at September 30, 2013.
At September 30, 2013, 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, 2013, 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, commercial real estate, real estate construction and land development loans, referred to as the Corporation's commercial loan portfolio, and residential mortgage, consumer installment and home equity loans, referred to as the Corporation's consumer loan portfolio. At September 30, 2013, the Corporation's loan portfolio was $4.52 billion and consisted of loans in the commercial loan portfolio totaling $2.45 billion, or 54% of total loans, and loans in the consumer loan portfolio totaling $2.08 billion, or 46% of total loans. Loans at fixed interest rates comprised 75% of the Corporation's total loan portfolio at September 30, 2013, compared to 73% at both June 30, 2013 and December 31, 2012 and 72% at September 30, 2012.
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 lower peninsula of Michigan, except for 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 $4.52 billion at September 30, 2013, an increase of $187 million, or 4.3%, from total loans of $4.34 billion at June 30, 2013, an increase of $355 million, or 8.5%, from total loans of $4.17 billion at December 31, 2012 and an increase of $504 million, or 12.5%, from total loans of $4.02 billion at September 30, 2012. The increases in total loans generally occurred across all major loan categories and were attributable to a combination of improving economic conditions and increased market share.
A summary of the composition of the Corporation's loan portfolio, by major loan category, follows:

                                        September 30,                         December 31,    September 30,
                                             2013          June 30, 2013          2012             2012
                                                                   (In thousands)
Commercial loan portfolio:
Commercial                              $  1,128,122     $     1,091,894     $  1,002,722     $    951,938
Commercial real estate                     1,215,631           1,172,347        1,161,861        1,117,073
Real estate construction                      78,361              73,448           62,689           56,071
Land development                              23,673              27,181           37,548           34,811
Subtotal                                   2,445,787           2,364,870        2,264,820        2,159,893
Consumer loan portfolio:
Residential mortgage                         942,777             898,816          883,835          880,295
Consumer installment                         622,040             577,241          546,036          538,412
Home equity                                  512,067             494,944          473,044          440,559
Subtotal                                   2,076,884           1,971,001        1,902,915        1,859,266
Total loans                             $  4,522,671     $     4,335,871     $  4,167,735     $  4,019,159

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, commercial real estate 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 $2.45 billion at September 30, 2013 included 80 loan relationships of $5.0 million or greater. These 80 loan relationships totaled $705 million, which represented 29% of the commercial loan portfolio at September 30, 2013, and included 26 loan relationships that had outstanding balances of $10 million or higher, totaling $334 million, or 14% of the commercial loan portfolio, at that date. Further, the Corporation had 11 loan relationships at September 30, 2013 with loan balances greater than $5.0 million and less than $10 million, totaling $88 million, that had unfunded credit commitments totaling $69 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 $1.13 billion at September 30, 2013, an increase of $36.2 million, or 3.3%, from commercial loans of $1.09 billion at June 30, 2013, an increase of $125.4 million, or 12.5%, from commercial loans of $1.00 billion at December 31, 2012 and an increase of $176.2 million, or 18.5%, from commercial loans of $951.9 million at September 30, 2012. The increases in commercial loans are the result of a combination of increased market share and improving economic conditions in the Corporation's lending markets. Commercial loans represented 25.0% of the Corporation's loan portfolio at September 30, 2013, compared to 25.2%, 24.1% and 23.7% at June 30, 2013, December 31, 2012 and September 30, 2012, respectively.
Commercial real estate 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. Commercial real estate loans were $1.22 . . .

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