10-K 1 chfc201210-k.htm 10-K CHFC 2012 10-K

 
 
 
 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549 
FORM 10-K 

þ Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended December 31, 2012
or
¨ 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: 000-08185 
CHEMICAL FINANCIAL CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
Michigan
 
38-2022454
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
235 E. Main Street
Midland, Michigan
 
48640
(Address of Principal Executive Offices)
 
(Zip Code)
(989) 839-5350
(Registrant's Telephone Number, Including Area Code)
Securities Registered Pursuant to Section 12(b) of the Act:
Common Stock, $1 Par Value Per Share
 
The NASDAQ Stock Market
(Title of Class)
 
(Name of each exchange on which registered)
Securities Registered Pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No þ
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¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨
 
Accelerated filer þ
  
Non-accelerated filer ¨
 
Smaller reporting company ¨
 
 
 
 
(Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  þ
The aggregate market value of the registrant's outstanding voting common stock held by non-affiliates of the registrant as of June 30, 2012, determined using the closing price of the registrant's common stock on June 30, 2012 of $21.50 per share, as reported on The NASDAQ Stock Market®, was $550.1 million. The number of shares outstanding of the registrant's Common Stock, $1 par value per share, as of January 31, 2013, was 27,509,625 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive Proxy Statement of Chemical Financial Corporation for the April 15, 2013 annual shareholders' meeting are incorporated by reference into Part III of this Form 10-K.
 
 
 
 
 



CHEMICAL FINANCIAL CORPORATION
ANNUAL REPORT ON FORM 10-K
Table of Contents
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
Business
 
 
 
Risk Factors
 
 
 
Unresolved Staff Comments
 
 
 
Properties
 
 
 
Legal Proceedings
 
 
 
Mine Safety Disclosures
 
 
 
 
 
 
 
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
 
 
Selected Financial Data
 
 
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
 
 
 
Quantitative and Qualitative Disclosures About Market Risk
 
 
 
Financial Statements and Supplementary Data
 
 
 
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
 
 
Controls and Procedures
 
 
 
Other Information
 
 
 
 
 
 
 
Directors, Executive Officers and Corporate Governance
 
 
 
Executive Compensation
 
 
 
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
 
 
 
Certain Relationships and Related Transactions and Director Independence
 
 
 
Principal Accountant Fees and Services
 
 
 
 
 
 
 
Exhibits and Financial Statement Schedules
 
 
 



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 Chemical Financial Corporation (Corporation). Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "intends," "is likely," "judgment," "opinion," "plans," "predicts," "projects," "should," "trend," "will," and variations of such words and similar expressions are intended to identify such forward-looking statements. 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 future levels of loan charge-offs, future levels of provisions for loan losses, real estate valuation, future levels of nonperforming assets, the rate of asset dispositions, future capital levels, future dividends, future growth and funding sources, future liquidity levels, future profitability levels, future deposit insurance premiums, the effects on earnings of future changes in interest rates, the future level of other revenue sources, future economic trends and conditions, future initiatives to expand the Corporation's market share, expected cash flows from acquired loans, future effects of new or changed accounting standards, future opportunities for acquisitions, the impact of branch acquisition transactions on the Corporation's business, opportunities to increase top line revenues, the Corporation's ability to grow its core franchise, and future cost savings. All statements referencing future time periods are forward-looking. Management's determination of the provision and allowance for loan losses; the carrying value of acquired loans, goodwill and mortgage servicing rights; the fair value of investment securities (including whether any impairment on any investment security is temporary or other-than-temporary and the amount of any impairment); and management's assumptions concerning pension and other postretirement benefit plans involve judgments that are inherently forward-looking. There can be no assurance that future loan losses will be limited to the amounts estimated. All of the information concerning interest rate sensitivity is forward-looking. The future effect of changes in the financial and credit markets and the national and regional economies on the banking industry, generally, and on the Corporation, specifically, are also inherently uncertain. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions ("risk factors") that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forward-looking statements. The Corporation undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise.
Risk factors include, but are not limited to, the risk factors described in Item 1A of this report. These and other factors are representative of the risk factors that may emerge and could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.

1


PART I.
Item 1. Business.
General Business
Chemical Financial Corporation (Corporation), headquartered in Midland, Michigan, is a financial holding company registered under the Bank Holding Company Act of 1956 and incorporated in the State of Michigan. At December 31, 2012, the Corporation's consolidated total assets, loans, deposits and shareholders' equity were $5.92 billion, $4.17 billion, $4.92 billion and $596 million, respectively, and the Corporation employed approximately 1,800 full-time equivalent employees. For more information about the Corporation's financial condition and results of operations, see the consolidated financial statements and related notes included in Part II, Item 8 of this report.
The Corporation was incorporated in August 1973. On June 30, 1974, the Corporation acquired Chemical Bank and Trust Company (CBT) pursuant to a reorganization in which the former shareholders of CBT became shareholders of the Corporation. CBT's name was changed to Chemical Bank on December 31, 2005. In addition to the acquisition of CBT, the Corporation has acquired 20 community banks and 36 other branch bank offices through December 31, 2012, including the acquisition of 21 branch bank offices during 2012 and the acquisition of O.A.K. Financial Corporation (OAK) during 2010. The 2012 and 2010 transactions are discussed in more detail under the subheading, "Acquisitions" included in Management's Discussion and Analysis of Financial Condition and Results of Operations. The Corporation has consolidated its acquisitions into a single commercial subsidiary bank, Chemical Bank. Chemical Bank operated through an internal organizational structure of four regional banking units and 15 community banking units as of December 31, 2012.
Chemical Bank directly owns two operating non-bank subsidiaries: CFC Financial Services, Inc. and CFC Title Services, Inc. CFC Financial Services, Inc. is an insurance subsidiary that operates under the assumed name of "Chemical Financial Advisors" and provides mutual funds, annuity products and marketable securities to customers. CFC Title Services, Inc. is an issuer of title insurance to buyers and sellers of residential and commercial mortgage properties, including properties subject to loan refinancing.
The Corporation's business is concentrated in a single industry segment - commercial banking. Chemical Bank offers a full range of traditional banking and fiduciary products and services. These include business and personal checking accounts, savings and individual retirement accounts, time deposit instruments, electronically accessed banking products, residential and commercial real estate financing, commercial lending, consumer financing, debit cards, safe deposit box services, money transfer services, automated teller machines, access to insurance and investment products, corporate and personal wealth management services and other banking services.
The principal markets for the Corporation's products and services are the communities in Michigan where Chemical Bank's branches are located and the areas surrounding these communities. As of December 31, 2012, the Corporation and Chemical Bank served these markets through 162 banking offices located in 38 counties, all in the lower peninsula of Michigan. In addition to the banking offices, Chemical Bank operated two loan production offices and 173 automated teller machines, both on- and off-bank premises, as of December 31, 2012. The Corporation did not have banking offices or provide commercial banking services in the southeast portion of Michigan at December 31, 2012. The southeast portion of Michigan is not part of the Corporation's current or projected markets for the delivery of its products and services.
A summary of the composition of the Corporation's loan portfolio at December 31, 2012, 2011 and 2010 was as follows:
 
December 31,
 
2012
 
2011
 
2010
 
 
Amount
 
Percent of Total
 
Amount
 
Percent of Total
 
Amount
 
Percent of Total
 
 
(Dollars in millions)
Composition of Loans:
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
$
1,002.7

 
24
%
 
$
895.2

 
23
%
 
$
819.0

 
22
%
 
Commercial real estate
1,161.9

 
28

 
1,072.0

 
28

 
1,077.0

 
29

 
Real estate construction and land development
100.2

 
2

 
118.2

 
3

 
142.6

 
4

 
Residential mortgage
883.8

 
21

 
861.7

 
23

 
798.0

 
22

 
Consumer installment and home equity
1,019.1

 
25

 
884.2

 
23

 
845.0

 
23

 
Total composition of loans
$
4,167.7

 
100
%
 
$
3,831.3

 
100
%
 
$
3,681.6

 
100
%
 

2


The Corporation's loan portfolio totaled $4.17 billion at December 31, 2012, compared to $3.83 billion and $3.68 billion at December 31, 2011 and 2010, respectively. The Corporation's loan portfolio increased $336 million, or 8.8%, during 2012, with commercial loans increasing $107 million, or 12.0%, commercial real estate loans increasing $90 million, or 8.4%, residential mortgage loans increasing $22 million, or 2.6%, and consumer installment and home equity loans increasing $135 million, or 15.3%, while real estate construction and land development loans decreased $18 million, or 15.2%. The Corporation's loan portfolio increased $150 million, or 4.1%, during 2011. The growth in loans during 2012 and 2011 was primarily attributable to a combination of improving economic conditions in Michigan and the Corporation increasing its loan market share in its lending markets. The Corporation also acquired $44 million of loans in conjunction with its 2012 acquisition of 21 branch offices. The Corporation's loan portfolio is not concentrated in any one industry.
The principal source of revenue for the Corporation is interest income and fees on loans, which accounted for 74% of total revenue in 2012 and 76% of total revenue in both 2011 and 2010. Interest income on investment securities is also a significant source of revenue, accounting for 6% of total revenue in 2012, 2011 and 2010. The Corporation has no foreign loans, assets or activities. No material part of the business of the Corporation or Chemical Bank is dependent upon a single customer or very few customers.
The nature of the business of Chemical Bank is such that it holds title to numerous parcels of real property. These properties are primarily owned for branch offices. However, the Corporation and Chemical Bank may hold properties for other business purposes, as well as on a temporary basis for properties taken in, or in lieu of, foreclosure to satisfy loans in default. Under current state and federal laws, present and past owners of real property may be exposed to liability for the cost of clean up of contamination on or originating from those properties, even if they are wholly innocent of the actions that caused the contamination. These liabilities can be material and can exceed the value of the contaminated property.
The Corporation offers services through the Wealth Management department of Chemical Bank. These services include trust, investment management and custodial services; financial and estate planning; and retirement and employee benefit programs. The Wealth Management department had assets under custodial and management arrangements of $2.07 billion, $1.95 billion and $2.02 billion as of December 31, 2012, 2011 and 2010, respectively. The Wealth Management department earns revenue from fees based on the market value of those assets under management, which can fluctuate significantly as the market fluctuates.
Competition
The business of banking is highly competitive. The principal methods of competition for financial services are price (interest rates paid on deposits, interest rates charged on loans and fees charged for services) and service (convenience and quality of services rendered to customers). In addition to competition from other commercial banks, banks face significant competition from non-bank financial institutions, including savings and loan associations, credit unions, finance companies, insurance companies and investment firms. Credit unions and finance companies are particularly significant competitors in the consumer loan market. Banks also compete for deposits with a broad range of other types of investments, including mutual funds and annuities. In response to the competition for customers' bank deposits, Chemical Bank, through the Chemical Financial Advisors program, offers a broad array of mutual funds, annuity products, market securities and insurance products through an alliance with an independent, registered broker/dealer. In addition, the Wealth Management department of Chemical Bank offers customers a variety of investment products and services.
Supervision and Regulation
The Corporation and Chemical Bank are subject to extensive supervision and regulation under various federal and state laws. The supervisory and regulatory framework is intended primarily for the protection of depositors and the banking system as a whole, and not for the protection of shareholders and creditors.
Banks are subject to a number of federal and state laws and regulations that have a material impact on their business. These include, among others, minimum capital requirements, state usury laws, state laws relating to fiduciaries, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), the Truth in Lending Act, the Truth in Savings Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Expedited Funds Availability Act, the Community Reinvestment Act, the Real Estate Settlement Procedures Act, the USA Patriot Act, the Bank Secrecy Act, the Foreign Account Tax Compliance Act, Office of Foreign Assets Controls regulations, electronic funds transfer laws, redlining laws, predatory lending laws, antitrust laws, environmental laws, anti-money laundering laws and privacy laws. These laws and regulations can have a significant effect on the operating results of banks.
A summary of significant elements of some of the laws, regulations and regulatory policies applicable to the Corporation and Chemical Bank follows below. The descriptions are qualified in their entirety by reference to the full text of the statutes, regulations and policies that are described. These statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to the Corporation and Chemical Bank could have a material effect on the business of the Corporation and Chemical Bank.

3


Regulatory Agencies
The Corporation is a legal entity separate and distinct from Chemical Bank. The Corporation is regulated by the Federal Reserve Board (FRB) as a financial holding company and a bank holding company under the Bank Holding Company Act of 1956 (BHC Act). The BHC Act provides for general regulation of financial holding companies by the FRB and functional regulation of banking activities by banking regulators. The Corporation is also under the jurisdiction of the Securities and Exchange Commission (SEC) and is subject to the disclosure and regulatory requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934. The Corporation's common stock is traded on The NASDAQ Stock Market® (NASDAQ) under the symbol CHFC and is subject to the NASDAQ Listing Rules.
Chemical Bank is chartered by the State of Michigan and supervised, examined and regulated by the Michigan Office of Financial and Insurance Regulation (OFIR). Chemical Bank, as a member of the Federal Reserve System, is also supervised, examined and regulated by the FRB. Deposits of Chemical Bank are insured by the Federal Deposit Insurance Corporation (FDIC) to the maximum extent provided by law.
Bank Holding Company Activities
In general, the BHC Act limits the business of bank holding companies to banking, managing or controlling banks and other activities that the FRB has determined to be closely related to the business of banking. In addition, bank holding companies that qualify and elect to be financial holding companies, may engage in any activities that are financial in nature or complementary to a financial activity and do not pose a substantial risk to the safety and soundness of depository institutions or the financial system without prior approval of the FRB. Activities that are financial in nature include securities underwriting and dealing, insurance underwriting and making merchant banking investments.
In order for the Corporation to maintain financial holding company status, both the Corporation and Chemical Bank must be categorized as "well-capitalized" and "well-managed" under applicable regulatory guidelines. If the Corporation or Chemical Bank ceases to meet these requirements, the FRB may impose corrective capital and/or managerial requirements and place limitations on the Corporation's ability to conduct the broader financial activities permissible for financial holding companies. In addition, if the deficiencies persist, the FRB may require the Corporation to divest of Chemical Bank. At December 31, 2012, both the Corporation and Chemical Bank were categorized as "well-capitalized" and "well-managed".
The BHC Act requires prior approval of the FRB for any direct or indirect acquisition of more than 5% of the voting shares of a commercial bank or its parent holding company by the Corporation. In reviewing applications seeking approval of merger and acquisition transactions, the bank regulatory authorities will consider, among other things, the competitive effect and public benefits of the transactions, the capital position of the combined organization, the Corporation's performance record under the Community Reinvestment Act of 1977 (CRA), the Corporation's adherence to banking regulations, and fair lending laws and the effectiveness of the subject organizations in combating money laundering activities.
Interstate Banking and Branching
Bank holding companies may acquire banks located in any state in the United States without regard to geographic restrictions or reciprocity requirements imposed by state law. Banks may establish interstate branch networks through acquisitions of other banks. The establishment of de novo interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is allowed only if specifically authorized by state law.
Michigan permits both U.S. and non-U.S. banks to establish branch offices in Michigan. The Michigan Banking Code permits, in appropriate circumstances and with the approval of the OFIR, (1) acquisition of Michigan banks by FDIC-insured banks, savings banks or savings and loan associations located in other states, (2) sale by a Michigan bank of branches to an FDIC-insured bank, savings bank or savings and loan association located in a state in which a Michigan bank could purchase branches of the purchasing entity, (3) consolidation of Michigan banks and FDIC-insured banks, savings banks or savings and loan associations located in other states having laws permitting such consolidation, (4) establishment of branches in Michigan by FDIC-insured banks located in other states, the District of Columbia or U.S. territories or protectorates having laws permitting a Michigan bank to establish a branch in such jurisdiction, and (5) establishment by foreign banks of branches located in Michigan. A Michigan bank holding company may acquire a non-Michigan bank and a non-Michigan bank holding company may acquire a Michigan bank.
Dividends
The Corporation's primary source of funds is dividends paid to it by Chemical Bank. Federal and state banking laws and regulations limit both the extent to which Chemical Bank can lend or otherwise supply funds to the Corporation and also place certain restrictions on the amount of dividends Chemical Bank may pay to the Corporation.

4


Chemical Bank is required to obtain prior approval from the FRB for the declaration and payment of dividends to the Corporation if the total of all dividends declared in any calendar year will exceed the total of (i) Chemical Bank's net income (as defined by regulation) for that year plus (ii) the retained net income (as defined by regulation) for the preceding two years. At December 31, 2012, Chemical Bank could declare, without FRB approval, aggregate dividends of approximately $49.1 million from retained net income from the preceding two years. This amount is not necessarily indicative of amounts that may be paid or available to be paid in the future. Chemical Bank declared and paid dividends to the Corporation of $27.6 million and $22.0 million in 2012 and 2011, respectively.
The Corporation and Chemical Bank are subject to other regulatory policies and requirements relating to the payment of dividends, including requirements to maintain capital above regulatory minimums, which could prohibit the payment of dividends under circumstances where the payment could be deemed an unsafe and unsound banking practice. In addition, federal regulatory authorities have stated that, in the current financial and economic environment, banking organizations should generally pay dividends only out of current operating earnings. Further, the FRB has indicated that bank holding companies should carefully review their dividend policy and has discouraged payment ratios that are at maximum allowable levels unless both asset quality and capital are very strong.
Source of Strength
Under FRB policy, the Corporation is expected to act as a source of financial strength to Chemical Bank and to commit resources to support Chemical Bank. In addition, if the OFIR deems Chemical Bank's capital to be impaired, OFIR may require Chemical Bank to restore its capital by a special assessment on the Corporation as Chemical Bank's only shareholder. If the Corporation failed to pay any assessment, the Corporation's directors would be required, under Michigan law, to sell the shares of Chemical Bank's stock owned by the Corporation to the highest bidder at either a public or private auction and use the proceeds of the sale to restore Chemical Bank's capital.
Capital Requirements
The Corporation and Chemical Bank are subject to regulatory "risk-based" capital guidelines. Failure to meet these capital guidelines could subject the Corporation or Chemical Bank to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits, and other restrictions on its business. In addition, Chemical Bank would generally not receive regulatory approval of any application that requires the consideration of capital adequacy, such as a branch or merger application, unless it could demonstrate a reasonable plan to meet the capital requirement within a reasonable period of time.
The Federal Deposit Insurance Corporation Improvement Act (FDICIA) requires, among other things, federal banking agencies to take "prompt corrective action" in respect of depository institutions that do not meet minimum capital requirements. FDICIA sets forth the following five capital categories: "well-capitalized," "adequately-capitalized," "undercapitalized," "significantly-undercapitalized" and "critically-undercapitalized." A depository institution's capital category will depend upon how its capital levels compare with various relevant capital measures as established by regulation, which include Tier 1 and total risk-based capital ratio measures and a leverage capital ratio measure.
Federal banking regulators are required to take specified mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Subject to a narrow exception, the banking regulator must generally appoint a receiver or conservator for an institution that is critically undercapitalized. An institution in any of the undercapitalized categories is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. An undercapitalized institution is also generally prohibited from paying any dividends, increasing its average total assets, making acquisitions, establishing any branches, accepting or renewing any brokered deposits or engaging in any new line of business, except under an accepted capital restoration plan or with FDIC approval.
Regulations establishing the specific capital tiers provide that, for a depository institution to be well capitalized, it must have a total risk-based capital ratio of at least 10% and a Tier 1 risk-based capital ratio of at least 6%, a Tier 1 leverage ratio of at least 5% and not be subject to any specific capital order or directive. For an institution to be adequately capitalized, it must have a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% and a Tier 1 leverage ratio of at least 4% (and in some cases 3%). Under certain circumstances, the appropriate banking agency may treat a well capitalized, adequately capitalized or undercapitalized institution as if the institution were in the next lower capital category.
At December 31, 2012, the capital ratios of the Corporation and Chemical Bank exceeded the regulatory guidelines for institutions to be categorized as "well-capitalized." Additional information on the Corporation and Chemical Bank's capital ratios may be found under Note 20 to the consolidated financial statements under Item 8 of this report.

5


FDIC Insurance
The FDIC formed the Deposit Insurance Fund (DIF) in accordance with the Federal Deposit Insurance Reform Act of 2005 (Reform Act). The FDIC implemented the Reform Act to create a stronger and more stable insurance system. The FDIC maintains the insurance reserves of the DIF by assessing depository institutions an insurance premium. The DIF insures deposit accounts of Chemical Bank up to a maximum amount per separately insured depositor. Under the Dodd-Frank Act, the maximum amount of federal deposit insurance coverage permanently increased from $100,000 to $250,000 per depositor, per institution.
FDIC insured depository institutions are required to pay deposit insurance premiums based on the risk an institution poses to the DIF. As required by the Dodd-Frank Act, in February 2011, the FDIC finalized rules, effective for assessments occurring after April 1, 2011, which redefine an institution's assessment base as average consolidated total assets minus average tangible equity. The new rules also establish the general assessment rate for Risk Category 1 institutions, such as Chemical Bank, at 5 to 9 basis points (annualized). Prior to this, an institution's assessment base was average deposits and the assessment rate for Risk Category 1 institutions ranged from 12 to 16 basis points (annualized). The Corporation's FDIC DIF insurance premiums were $4.3 million in 2012, compared to $5.4 million in 2011 and $7.4 million in 2010.
In November 2009, the FDIC required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. Accordingly, on December 30, 2009, the Corporation prepaid $19.7 million in risk-based assessments. At December 31, 2012, the Corporation's remaining prepaid FDIC insurance assessments totaled $6.7 million and are available to offset its quarterly assessments through June 30, 2013. The amount remaining at June 30, 2013 is expected to be returned to the Corporation.
Safety and Soundness Standards
As required by FDICIA, the federal banking agencies' prompt corrective action powers impose progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. These actions can include: requiring an insured depository institution to adopt a capital restoration plan guaranteed by the institution's parent company; placing limits on asset growth and restrictions on activities, including restrictions on transactions with affiliates; restricting the interest rates the institution may pay on deposits; prohibiting the payment of principal or interest on subordinated debt; prohibiting the holding company from making capital distributions without prior regulatory approval; and, ultimately, appointing a receiver for the institution.
The federal banking agencies also have adopted guidelines prescribing safety and soundness standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation and benefits. The federal regulatory agencies may take action against a financial institution that does not meet such standards.
Depositor Preference
The FDIC provides that, in the event of the "liquidation or other resolution" of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC on behalf of insured depositors, and certain claims for administrative expenses of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including depositors whose deposits are payable only outside of the United States and the parent bank holding company, with respect to any extensions of credit they have made to such insured depository institution.
Community Reinvestment Act (CRA)
Banks are subject to the provisions of the CRA. Under the terms of the CRA, the appropriate federal bank regulatory agency is required, in connection with its examination of a bank, to assess such bank's record in meeting the credit needs of the community served by that bank, including low and moderate income neighborhoods, consistent with the safe and sound operation of the institution. Under the CRA, institutions are assigned a rating of "outstanding," "satisfactory," "needs to improve," or "substantial non-compliance". The regulatory agency's assessment of the bank's record is made available to the public. Further, such assessment is required of any bank that has applied to: (1) obtain deposit insurance coverage for a newly chartered institution, (2) establish a new branch office that will accept deposits, (3) relocate an office, or (4) merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. In the case of a bank holding company applying for approval to acquire a bank or another bank holding company, the FRB will assess the CRA compliance record of each subsidiary bank of the applicant bank holding company, and such compliance records may be the basis for denying the application.

6


Financial Privacy
Federal banking regulations limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. These regulations affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.
Anti-Money Laundering and the USA Patriot Act
A major focus of governmental policy on financial institutions has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (USA Patriot Act) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The United States Treasury Department has issued, and in some cases proposed, a number of regulations that apply various requirements of the USA Patriot Act to financial institutions. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers. Certain of those regulations impose specific due diligence requirements on financial institutions that maintain correspondent or private banking relationships with non-U.S. financial institutions or persons. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution.
Office of Foreign Assets Control Regulation
The United States Treasury Department Office of Foreign Assets Control (OFAC) has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. OFAC sanctions targeting countries take many different forms. Generally, however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions on "U.S. persons" engaging in financial transactions relating to making investments in, or providing investment-related advice or assistance to, a sanctioned country; and (ii) a blocking of assets in which the government or specially designated nationals of the sanctioned country have an interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons). Blocked assets (e.g., property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. Failure to comply with these sanctions could have serious legal and reputational consequences.
The Dodd-Frank Act
The Dodd-Frank Act was signed into law by President Obama on July 21, 2010. The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States, established the new federal Consumer Financial Protection Bureau (CFPB), and requires the CFPB and other federal agencies to implement many new and significant rules and regulations. The CFPB has issued significant new regulations that impact consumer mortgage lending and servicing. Those regulations will become effective in January 2014. In addition, the CFPB is drafting regulations that will change the disclosure requirements and forms used under the Truth in Lending Act and Real Estate Settlement and Procedures Act. Compliance with these new laws and regulations and other regulations under consideration by the CFPB will likely result in additional costs and changes in the products and/or services that are currently being offered, which could be significant and could adversely impact the Corporation's results of operations, financial condition or liquidity.
Incentive Compensation
The regulatory agencies have issued comprehensive guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization's incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization's ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management and (iii) be supported by strong corporate governance, including active and effective oversight by the organization's board of directors.
The FRB reviews, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Corporation, that are not "large, complex banking organizations." The findings will be included in reports of examination. Deficiencies will be incorporated into the organization's supervisory ratings, which can affect the organization's ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization's safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

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Mergers, Acquisitions, Consolidations and Divestitures
The Corporation's strategy for growth includes strengthening its presence in core markets, expanding into contiguous markets and broadening its product offerings, while taking into account the integration and other risks of growth. The Corporation evaluates strategic acquisition opportunities and conducts due diligence activities in connection with possible transactions. As a result, discussions, and in some cases, negotiations may take place and future acquisitions involving cash, debt or equity securities may occur. These generally involve payment of a premium over book value and current market price, and therefore, dilution of book value and net income per share may occur with any future transaction.
On December 7, 2012, Chemical Bank acquired 21 branches from Independent Bank, a subsidiary of Independent Bank Corporation (Ticker: IBCP). 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. The loans were purchased at a discount of 1.75%.
On April 30, 2010, the Corporation acquired all of the outstanding stock of O.A.K. Financial Corporation (OAK) for total consideration of $83.7 million. The total consideration consisted of the issuance of 3,529,772 shares of the Corporation's common stock with a total value of $83.7 million based upon a market price per share of $23.70 at the acquisition date, the exchange of 26,425 stock options for the outstanding vested stock options of OAK with a value of the exchange equal to approximately $41,000 at the acquisition date, and approximately $8,000 of cash in lieu of fractional shares.
There were no other business combinations, consolidations or divestitures completed by the Corporation during the three years ended December 31, 2012. However, during the three years ended December 31, 2012, the Corporation opened three branch offices and closed five branch offices. Each branch closure resulted in the transfer of customer accounts to a nearby branch of Chemical Bank.
Availability of Information
The Corporation files reports with the Securities and Exchange Commission (SEC). Those reports include the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy statements. The public may read and copy any materials the Corporation files with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov. The Corporation's annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy statements, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, but not including exhibits to those reports, may be obtained without charge upon written request to Lori A. Gwizdala, Chief Financial Officer of the Corporation, at P.O. Box 569, Midland, Michigan 48640-0569 and are accessible at no cost on the Corporation's website at www.chemicalbankmi.com in the "Investor Information" section, as soon as reasonably practicable after they are electronically filed with or furnished to the SEC. Copies of exhibits may be requested at the cost of 30 cents per page from the Corporation's corporate offices. In addition, interactive copies of the Corporation's 2012 Annual Report on Form 10-K and the 2013 Proxy Statement are available at www.edocumentview.com/chfc.
Item 1A. Risk Factors.
The Corporation's business model is subject to many risks and uncertainties. Although the Corporation seeks ways to manage these risks and develop programs to control those risks that management can, the Corporation ultimately cannot predict the future or control all of the risks to which it is subject. Actual results may differ materially from management's expectations. Some of these significant risks and uncertainties are discussed below. The risks and uncertainties described below are not the only ones that the Corporation faces. Additional risks and uncertainties of which the Corporation is unaware, or that it currently deems immaterial, also may become important factors that adversely affect the Corporation and its business. If any of these risks were to occur, the Corporation's business, financial condition or results of operations could be materially and adversely affected. If this were to happen, the market price of the Corporation's common stock per share could decline significantly.
Investments in the Corporation's common stock involve risk.
The market price of the Corporation's common stock may fluctuate significantly in response to a number of factors, including, among other things:
Variations in quarterly or annual results of operations
Changes in dividends paid per share
Deterioration in asset quality, including declining real estate values

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Changes in interest rates
Significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by, or involving, the Corporation or its competitors
Failure to integrate acquisitions or realize anticipated benefits from acquisitions
Regulatory actions, including changes to regulatory capital levels, the components of regulatory capital and how regulatory capital is calculated
New regulations that limit or significantly change the Corporation's ability to continue to offer existing banking products
Volatility of stock market prices and volumes
Issuance of additional shares of common stock or other debt or equity securities of the Corporation
Changes in market valuations of similar companies
Uncertainties and fluctuations in the financial markets
Changes in securities analysts' estimates of financial performance or recommendations
New litigation or contingencies or changes in existing litigation or contingencies
New technology used, or services offered, by competitors
Breaches in information security systems of the Corporation and/or its customers and competitors
Changes in accounting policies or procedures required by standard setting or other regulatory agencies
New developments in the financial services industry
News reports relating to trends, concerns and other issues in the financial services industry
Perceptions in the marketplace regarding the financial services industry, the Corporation and/or its competitors
Rumors or erroneous information
Geopolitical conditions such as acts or threats of terrorism or military conflicts
Disruptions in the credit and financial markets, either nationally or globally, including the impact of a downgrade of U.S. government obligations by one of the credit agencies and the adverse effects of the ongoing sovereign debt crisis in Europe
The Corporation is subject to lending risk.
A significant source of risk for the Corporation arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loan agreements. Most loans originated by the Corporation are secured, but some loans are unsecured depending on the nature of the loan. With respect to secured loans, the collateral securing repayment includes a wide variety of real and personal property that may be insufficient to cover the amounts owed. Collateral values are adversely affected by changes in prevailing economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government, terrorist activity, environmental contamination and other external events.
The Corporation maintains an allowance for loan losses, which is a reserve established through a provision for loan losses charged to net income that represents management's estimate of probable losses that have been incurred within the existing portfolio of loans. The level of the allowance for loan losses reflects management's continuing evaluation of specific credit risks, loan loss experience, current loan portfolio quality, the value of real estate, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires the Corporation to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Deterioration in economic conditions and declines in real estate values affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Corporation's control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review the Corporation's allowance for loan losses and may require an increase in the allowance for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. Any significant increase in the allowance for loan losses would likely result in a significant decrease in net income and may have a material adverse effect on the Corporation's financial condition and results of operations. See the sections captioned "Allowance for Loan Losses" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 4 - Loans in the notes to consolidated financial statements in Item 8. Financial Statements and Supplementary Data, located elsewhere in this report for further discussion related to the Corporation's process for determining the appropriate level of the allowance for loan losses.
Environmental liability associated with commercial lending could result in losses.
In the course of its business, the Corporation may acquire, through foreclosure, properties securing loans it has originated or purchased that are in default. Particularly in commercial real estate lending, there is a risk that hazardous substances could be discovered on these properties. In this event, the Corporation might be required to remove these substances from the affected properties at the Corporation's sole cost and expense. The cost of this removal could substantially exceed the value of affected properties. The Corporation may not have adequate remedies against the prior owner or other responsible parties and could find it difficult or impossible to sell the affected properties. These events could have an adverse effect on the Corporation's business, results of operations and financial condition.

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The Corporation is facing increased pressure from purchasers of its residential mortgage loans to repurchase those loans or reimburse purchasers for losses related to those loans.
The Corporation sells fixed rate long-term residential mortgage loans it originates in the secondary market. Purchasers of residential mortgage loans, such as government sponsored entities, are increasing their efforts to seek to require sellers of residential mortgage loans to either repurchase loans previously sold or reimburse purchasers for losses related to loans previously sold when losses are incurred on a loan previously sold due to actual or alleged failure to strictly conform to the purchaser's purchase criteria. As a result, the Corporation is facing increased pressure from purchasers of its residential mortgage loans to repurchase those loans or reimburse purchasers for losses related to those loans and it may face increasing expenses to defend against such claims. If the Corporation is required in the future to repurchase loans previously sold, reimburse purchasers for losses related to loans previously sold, or if it incurs increasing expenses to defend against such claims, the Corporation's financial condition and results of operations would be negatively affected.
The Corporation holds general obligation municipal bonds in its investment securities portfolio. If one or more issuers of these bonds were to become insolvent and default on its obligations under the bonds, it could have a negative effect on the financial condition and results of operations of the Corporation.
Municipal bonds held by the Corporation totaled $269 million at December 31, 2012, and were issued by many different municipalities with no significant concentration in any single municipality. There can be no assurance that the financial conditions of these municipalities will not be materially and adversely affected by future economic conditions. If one or more of the issuers of these bonds were to become insolvent and default on their obligations under the bonds, it could have a negative effect on the financial condition and results of operations of the Corporation.
The Corporation depends upon the accuracy and completeness of information about customers.
In deciding whether to extend credit to customers, the Corporation relies on information provided to it by its customers, including financial statements and other financial information. The Corporation may also rely on representations of customers as to the accuracy and completeness of that information and on reports of independent auditors on financial statements. The Corporation's financial condition and results of operations could be negatively impacted to the extent that the Corporation extends credit in reliance on financial statements that do not comply with generally accepted accounting principles or that are misleading or other information provided by customers that is false or misleading.
General economic conditions, and in particular conditions in the State of Michigan, effect the Corporation's business.
The Corporation is affected by general economic conditions in the United States, although most directly within Michigan. Business activity across a wide range of industries and regions continues to be hampered by stagnant economic conditions. Unemployment levels nationwide and in the State of Michigan remain elevated.
 The Corporation's success depends primarily on the general economic conditions in the State of Michigan and the specific local markets in which the Corporation operates. The local economic conditions in these local markets have a significant impact on the demand for the Corporation's products and services as well as the ability of the Corporation's customers to repay loans, the value of the collateral securing loans and the stability of the Corporation's deposit funding sources. Substantially all of the Corporation's loans are to individuals and businesses in Michigan. Consequently, any prolonged decline in Michigan's economy could have a materially adverse effect on the Corporation's financial condition and results of operations. A significant decline or a prolonged period of the lack of improvement in general economic conditions could impact these local economic conditions and, in turn, have a material adverse effect on the Corporation's financial condition and results of operations.
If the Corporation does not adjust to changes in the financial services industry, its financial performance may suffer.
The Corporation's ability to maintain its financial performance and return on investment to shareholders will depend largely on its ability to continue to grow its loan portfolio and also, in part, on its ability to maintain and grow its core deposit customer base and expand its financial services to its existing and/or new customers. In addition to other banks, competitors include savings and loan associations, credit unions, securities dealers, brokers, mortgage bankers, investment advisors and finance and insurance companies. The increasingly competitive environment is, in part, a result of changes in the economic environment within the State of Michigan, regulation, and changes in technology and product delivery systems. New competitors may emerge to increase the degree of competition for the Corporation's customers and services. Financial services and products are also constantly changing. The Corporation's financial performance will also depend, in part, upon customer demand for its products and services and its ability to develop and offer competitive financial products and services.

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Consumers may decide not to use banks to complete their financial transactions.
Technology and other changes are allowing customers to complete financial transactions without the involvement of banks. For example, consumers can now pay bills and transfer funds directly without banks. The process of eliminating banks as intermediaries in financial transactions, known as disintermediation, could result in the loss of fee income, the loss of customer deposits and income generated from those deposits and lending opportunities.
Changes in interest rates could reduce the Corporation's net income and cash flow.
The Corporation's net income and cash flow depends, to a great extent, on the difference between the interest earned on loans and securities and the interest paid on deposits and other borrowings. Market interest rates are beyond the Corporation's control, and they fluctuate in response to general economic conditions, the policies of various governmental and regulatory agencies and competition. Changes in monetary policy, including changes in interest rates and interest rate relationships, will influence the origination of loans, the purchase of investments, the generation of deposits, the interest received on loans and securities and the interest paid on deposits and other borrowings. Any significant adverse effects of changes in interest rates on the Corporation's results of operations, or any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on the Corporation's financial condition and results of operations. See the sections captioned "Net Interest Income" in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and "Market Risk" in Item 7A. Quantitative and Qualitative Disclosures About Market Risk, located elsewhere in this report, for further discussion related to the Corporation's management of interest rate risk.
The global market crisis has triggered a series of reductions in interest rates. During 2010, 2011 and 2012, the Federal Open Markets Committee (FOMC) kept the target federal funds rate between zero and 0.25%. The low interest rate environment has resulted in lower yields on interest-earning assets, which could have an adverse impact on the Corporation's revenue and results of operations.
The Corporation may be required to pay additional deposit insurance premiums to the FDIC, which could negatively impact earnings.
Depending upon the magnitude of future losses that the FDIC deposit insurance fund suffers, there can be no assurance that there will not be additional premium increases or assessments in order to replenish the fund. The FDIC may need to set a higher base rate schedule based on future financial institution failures and updated failure and loss projections. Potentially higher FDIC assessment rates than those currently projected or special assessments could have an adverse impact on the Corporation's financial condition and results of operations.
The Corporation is subject to liquidity risk in its operations, which could adversely affect its ability to fund various obligations.
Liquidity risk is the possibility of being unable to meet obligations as they come due or capitalize on growth opportunities as they arise because of an inability to liquidate assets or obtain adequate funding on a timely basis, at a reasonable cost and within acceptable risk tolerances. Liquidity is required to fund various obligations, including credit obligations to borrowers, loan originations, withdrawals by depositors, repayment of debt, dividends to shareholders, operating expenses and capital expenditures. Liquidity is derived primarily from retail deposit growth and earnings retention, principal and interest payments on loans and investment securities, net cash provided from operations and access to other funding. If the Corporation is unable to maintain adequate liquidity, then its business, financial condition and results of operations would be negatively effected.
The Corporation may issue debt and equity securities that are senior to the Corporation's common stock as to distributions and in liquidation, which could negatively affect the value of the Corporation's common stock.
In the future, the Corporation may increase its capital resources by entering into debt or debt-like financing or issuing debt or equity securities, which could include issuances of senior notes, subordinated notes, preferred stock or common stock. In the event of the Corporation's liquidation, its lenders and holders of its debt securities and preferred stock would receive a distribution of the Corporation's available assets before distributions to the holders of the Corporation's common stock. The Corporation's decision to incur debt and issue securities in future offerings may depend on market conditions and other factors beyond its control. The Corporation cannot predict or estimate the amount, timing or nature of its future offerings and debt financings. Future offerings could reduce the value of shares of the Corporation's common stock and dilute a shareholder's interest in the Corporation.
Evaluation of investment securities for other-than-temporary impairment involves subjective determinations and could materially impact the Corporation's financial condition and results of operations.
The evaluation of impairments is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions, the issuer's net income, projected net income and financial condition or future recovery prospects, the effects of changes in interest rates or credit spreads and the expected recovery period. Estimating future cash flows involves incorporating information received from third-party sources and making internal assumptions and

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judgments regarding the future performance of the underlying collateral and/or value of the underlying asset and also assessing the probability that an adverse change in future cash flows has occurred. The determination of the amount of other-than-temporary impairments is based upon the Corporation's quarterly evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available.
Additionally, the Corporation's management considers a wide range of factors about the security issuer and uses its best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for recovery. Inherent in management's evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations in the impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been less than cost or amortized cost; (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties; (iii) the potential for impairments in an entire industry sector or sub-sector; (iv) the potential for impairments in certain economically depressed geographic locations; (v) the potential for impairments of securities where the issuer, series of issuers or industry has suffered a catastrophic type of loss or has exhausted natural resources; (vi) the Corporation's intent and ability to retain the investment for a period of time sufficient to allow for the recovery of its value; (vii) unfavorable changes in forecasted cash flows on residential mortgage-backed and asset-backed securities; and (viii) other subjective factors, including concentrations and information obtained from regulators and rating agencies. Impairments to the carrying value of the Corporation's investment securities may need to be taken in the future, which could have a material adverse effect on the Corporation's financial condition and results of operations.
The Corporation may be required to recognize an impairment of goodwill or to establish a valuation allowance against deferred income tax assets, which could have a material adverse effect on the Corporation's financial condition and results of operations.
Goodwill represents the excess of the amounts paid to acquire subsidiaries over the fair value of their net assets at the date of acquisition. The Corporation tests goodwill at least annually for impairment. Impairment testing is performed based upon estimates of the fair value of the "reporting unit" to which the goodwill relates. Substantially all of the Corporation's goodwill at December 31, 2012 was recorded on the books of Chemical Bank. The fair value of Chemical Bank is impacted by the performance of its business and other factors. If it is determined that the goodwill has been impaired, the Corporation must write-down the goodwill by the amount of the impairment, with a corresponding charge to net income. Such write-downs could have a material adverse effect on the Corporation's financial condition and results of operations.
Deferred income tax represents the tax effect of the differences between the book and tax basis of assets and liabilities. Deferred tax assets are assessed periodically by management to determine if they are realizable. Factors in management's determination include the performance of the Corporation, including the ability to generate taxable net income. If, based on available information, it is more-likely-than-not that the deferred income tax asset will not be realized, then a valuation allowance must be established with a corresponding charge to net income. As of December 31, 2012, the Corporation did not carry a valuation allowance against its deferred tax assets. Future facts and circumstances may require a valuation allowance. Charges to establish a valuation allowance could have a material adverse effect on the Corporation's financial condition and results of operations.
If the Corporation is required to establish a valuation allowance with respect to its mortgage servicing rights asset, its financial condition and results of operations would be negatively affected.
At December 31, 2012, the Corporation's mortgage servicing rights asset had a book value of $3.5 million and a fair value of approximately $4.7 million. Because of the current interest rate environment and the increasing volume of mortgage refinancings, it is possible that the Corporation may have to establish a valuation allowance with respect to its mortgage servicing rights asset in the future. If the Corporation is required in the future to establish a valuation allowance with respect to its mortgage servicing rights asset, the Corporation's financial condition and results of operations could be negatively affected.
The Corporation may be a defendant in a variety of litigation and other actions, which may have a material adverse effect on the Corporation's financial condition and results of operations.
The Corporation and Chemical Bank are regularly involved in a variety of litigation arising out of the normal course of business. The Corporation's insurance may not cover all claims that may be asserted against it, and any claims asserted against it, regardless of merit or eventual outcome, may harm its reputation or cause the Corporation to incur unexpected expenses, which could be material in amount. Should the ultimate expenses, judgments or settlements in any litigation exceed the Corporation's insurance coverage, they could have a material adverse effect on the Corporation's financial condition and results of operations. In addition, the Corporation may not be able to obtain appropriate types or levels of insurance in the future, nor may it be able to obtain adequate replacement policies with acceptable terms, if at all.

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The Corporation operates in a highly competitive industry and market area.
The Corporation faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national and regional banks within the various markets where the Corporation operates, as well as internet banks. The Corporation also faces competition from many other types of financial institutions, including savings and loans associations, credit unions, finance companies, brokerage firms, insurance companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. The Corporation competes with these institutions both in attracting deposits and in making new loans. Technology has lowered barriers to entry into the market and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of the Corporation's competitors have fewer regulatory constraints and may have lower cost structures, such as credit unions that are not subject to federal income tax. Due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Corporation can.
The Corporation's ability to compete successfully depends on a number of factors, including, among other things:
The ability to develop, maintain and build long-term customer relationships based on top quality service, high ethical standards and safe, sound assets
The ability to expand the Corporation's market position
The ability to keep up-to-date with technological advancements in both delivering new products and maintaining existing products, while continuing to control operating costs
The scope, relevance and pricing of products and services offered to meet customer needs and demands
The rate at which the Corporation introduces new products and services relative to its competitors
Customer satisfaction with the Corporation's level of service
Industry and general economic trends
Failure to perform in any of these areas could significantly weaken the Corporation's competitive position, which could adversely affect the Corporation's growth and profitability and have a material adverse effect on the Corporation's financial condition and results of operations.
Legislative or regulatory changes or actions, or significant litigation, could adversely impact the Corporation or the businesses in which it is engaged.
The financial services industry is extensively regulated. The Corporation and Chemical Bank are subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of their operations. Laws and regulations may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance fund, and not to benefit the Corporation's shareholders. The impact of any changes to laws and regulations or other actions by regulatory agencies may negatively impact the Corporation or its ability to increase the value of its business. Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of an institution, the classification of assets by the institution and the adequacy of an institution's allowance for loan losses. Future regulatory changes or accounting pronouncements may increase the Corporation's regulatory capital requirements or adversely affect its regulatory capital levels. Additionally, actions by regulatory agencies or significant litigation against the Corporation or Chemical Bank could require the Corporation to devote significant time and resources to defending its business and may lead to penalties that materially affect the Corporation and its shareholders.
The soundness of other financial institutions could adversely affect the Corporation.
The Corporation's ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. The Corporation has exposure to many different industries and counterparties, and it routinely executes transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to losses or defaults by the Corporation or by other institutions. Many of these transactions expose the Corporation to credit risk in the event of default of the Corporation's counterparty or client. In addition, the Corporation's credit risk may be exacerbated when the collateral that it holds cannot be realized or is liquidated at prices insufficient to recover the full amount of the loan. The Corporation can give no assurance that any such losses would not materially and adversely affect its business, financial condition or results of operations.

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The Dodd-Frank Act may have a significant impact on the Corporation and results of its operations.
The Dodd-Frank Act was signed into law by President Obama on July 21, 2010. The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States, established the new federal Consumer Financial Protection Bureau (CFPB), and requires the CFPB and other federal agencies to implement many new and significant rules and regulations. The CFPB has issued significant new regulations that impact consumer mortgage lending and servicing. Those regulations will become effective in January 2014. In addition, the CFPB is drafting regulations that will change the disclosure requirements and forms used under the Truth in Lending Act and Real Estate Settlement and Procedures Act. Compliance with these new laws and regulations and other regulations under consideration by the CFPB will likely result in additional costs and changes in the products and/or services that are currently being offered, which could be significant and could adversely impact the Corporation's results of operations, financial condition or liquidity.
The Corporation's controls and procedures may fail or be circumvented.
Management regularly reviews and updates the Corporation's internal controls and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. A significant failure or circumvention of the Corporation's controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Corporation's business, results of operations and financial condition.
Potential acquisitions may disrupt the Corporation's business and dilute shareholder value.
The Corporation seeks merger or acquisition partners, including FDIC assisted acquisitions, that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale or expanded services. Acquiring other banks, businesses, or branches involves various risks commonly associated with acquisitions, including, among other things:
The recording of assets and liabilities of the target company at fair value may materially dilute shareholder value at the transaction date and could have a material adverse effect on the Corporation's financial condition and results of operations
The time and costs associated with identifying and evaluating potential acquisitions and merger targets
Potential exposure to unknown or contingent liabilities of the target company
The estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target institution may not be accurate
Exposure to potential asset quality issues of the target company
The time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion
The diversion of the Corporation's management's attention to the negotiation of a transaction, and the integration of the operations and personnel of the combining businesses
The introduction of new products and services into the Corporation's business
Potential disruption to the Corporation's business
The incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on the Corporation's results of operations
The possible loss of key employees and customers of the target company
Difficulty in estimating the value of the target company
Potential changes in banking or tax laws or regulations that may affect the target company
Difficulty or unanticipated expense associated with converting the communication and information systems of the target company to those of the Corporation
The transactions may be more expensive to complete and the anticipated benefits, including cost savings and strategic gains, may be significantly harder or take longer to achieve than expected or may not be achieved in their entirety as a result of unexpected factors or events, including the economic and financial conditions within the State of Michigan.
The Corporation regularly evaluates merger and acquisition opportunities and conducts due diligence activities related to possible transactions with other financial institutions and financial services companies. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur at any time. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, dilution of the Corporation's tangible book value, net income per common share and ownership interest may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on the Corporation's financial condition and results of operations.

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If the Corporation cannot raise additional capital when needed, its ability to further expand its operations through organic growth and acquisitions could be materially impaired.
The Corporation is required by federal and state regulatory authorities to maintain specified levels of capital to support its operations. The Corporation may need to raise additional capital to support its continued growth. The Corporation's ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside the Corporation's control, and on its financial performance. The Corporation cannot assure that it will be able to raise additional capital in the future on terms acceptable to the Corporation. If the Corporation cannot raise additional capital when needed, its ability to further expand its operations through organic growth and acquisitions could be materially limited.
The Corporation relies on dividends from Chemical Bank for most of its revenue.
The Corporation is a separate and distinct legal entity from Chemical Bank. It receives substantially all of its revenue from dividends from Chemical Bank. These dividends are the principal source of funds to pay cash dividends on the Corporation's common stock. Various federal and/or state laws and regulations limit the amount of dividends that Chemical Bank may pay to the Corporation. In the event Chemical Bank is unable to pay dividends to the Corporation, the Corporation may not be able to pay cash dividends on its common stock. The earnings of Chemical Bank have been the principal source of funds to pay cash dividends to shareholders. Over the long-term, cash dividends to shareholders are dependent upon earnings, as well as capital requirements, regulatory restraints and other factors affecting Chemical Bank. See the section captioned "Supervision and Regulation" in Item 1. Business and Note 20 - Regulatory Capital and Reserve Requirements in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which are located elsewhere in this report.
Unauthorized disclosure of sensitive or confidential client or customer information, whether through a breach of computer systems or otherwise, could severely harm the Corporation's business.
As part of its business, the Corporation collects, processes and retains sensitive and confidential client and customer information on behalf of itself and other third parties. Despite the security measures the Corporation has in place for its facilities and systems, and the security measures of its third party service providers, the Corporation may be vulnerable to security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming and/or human errors or other similar events. Any security breach involving the misappropriation, loss or other unauthorized disclosure of confidential customer information, whether by the Corporation or by its vendors, could severely damage the Corporation's reputation, expose it to the risks of litigation and liability, disrupt the Corporation's operations and have a material adverse effect on the Corporation's business.
The Corporation's information systems may experience an interruption or breach in security.
The Corporation relies heavily on communications and information systems to conduct its business and deliver its products. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Corporation's customer relationship management, general ledger, deposit, loan and other systems. While the Corporation has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches of the Corporation's information systems or its customers' information or computer systems would not damage the Corporation's reputation, result in a loss of customer business, subject the Corporation to additional regulatory scrutiny, or expose the Corporation to civil litigation and financial liability, any of which could have a material adverse effect on the Corporation's financial condition and results of operations.
Severe weather, natural disasters, acts of war or terrorism and other external events could significantly impact the Corporation's business.
Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on the Corporation's ability to conduct business. Such events could affect the stability of the Corporation's deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause the Corporation to incur additional expenses. Although management has established disaster recovery policies and procedures, the occurrence of any such event in the future could have a material adverse effect on the Corporation's business, financial condition and results of operations.
Item 1B. Unresolved Staff Comments.
None. 

15


Item 2. Properties.
The executive offices of the Corporation and Chemical Bank and certain operations' departments of Chemical Bank are located at 235 E. Main Street in downtown Midland, Michigan, in a three-story, approximately 35,000 square foot office building, owned by the Corporation free from mortgage. The main branch office and certain operations' departments of Chemical Bank are located in a three-story, approximately 74,000 square foot office building in downtown Midland, Michigan at 333 E. Main Street, owned by Chemical Bank free from mortgage. Chemical Bank also leases approximately 30,000 square feet of a building in Midland, Michigan for additional operations' departments under a ten-year lease agreement which extends through 2021.
Chemical Bank also conducted customer banking business from a total of 161 other banking offices and two loan production offices as of December 31, 2012. These offices are located in the lower peninsula of Michigan. Of these offices, 155 are owned by Chemical Bank free from mortgages and 8 are leased from independent parties. The leased property is considered insignificant.
The Corporation considers its properties to be suitable and adequate for its present needs.
Item 3. Legal Proceedings.
As of December 31, 2012, the Corporation was not a party to any material pending legal proceeding. As of December 31, 2012, Chemical Bank was a party, as plaintiff or defendant, to a number of legal proceedings, none of which were considered material, and all of which were considered ordinary routine litigation incidental to its business.
Item 4. Mine Safety Disclosures.
Not applicable.
PART II.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
The Corporation's common stock is traded on The NASDAQ Stock Market® under the symbol CHFC. As of December 31, 2012, there were approximately 27.5 million shares of the Corporation's common stock issued and outstanding, held by approximately 5,000 shareholders of record. The table below sets forth the range of high and low sales prices for transactions reported on The NASDAQ Stock Market® for the Corporation's common stock for the periods indicated.
 
2012
 
2011
 
High
 
Low
 
High
 
Low
First quarter
$
24.32

 
$
21.04

 
$
23.04

 
$
19.08

Second quarter
23.77

 
19.25

 
20.56

 
17.85

Third quarter
24.96

 
20.82

 
19.43

 
14.56

Fourth quarter
25.00

 
20.60

 
21.80

 
14.60

The earnings of Chemical Bank are the principal source of funds for the Corporation to pay cash dividends to its shareholders. Accordingly, cash dividends are dependent upon the earnings, capital needs, regulatory constraints, and other factors affecting Chemical Bank. See Note 20 to the consolidated financial statements in Item 8 of this report for a discussion of such limitations. The Corporation has paid regular cash dividends every quarter since it began operation as a bank holding company in 1973. Based on the financial condition of the Corporation at December 31, 2012, management expects the Corporation to pay quarterly cash dividends on its common shares in 2013. However, there can be no assurance as to future dividends because they are dependent on future earnings, capital requirements, regulatory approval and the Corporation's financial condition. On February 19, 2013, the Corporation announced that the board of directors declared a first quarter 2013 cash dividend of $0.21 per share, payable on March 15, 2013.

16


The following table summarizes the quarterly cash dividends paid to shareholders over the past five years.
 
Years Ended December 31,
 
2012
 
2011
 
2010
 
2009
 
2008
First quarter
$
0.200

 
$
0.200

 
$
0.200

 
$
0.295

 
$
0.295

Second quarter
0.200

 
0.200

 
0.200

 
0.295

 
0.295

Third quarter
0.210

 
0.200

 
0.200

 
0.295

 
0.295

Fourth quarter
0.210

 
0.200

 
0.200

 
0.295

 
0.295

Total
$
0.820

 
$
0.800

 
$
0.800

 
$
1.180

 
$
1.180

Shareholder Return
The following line graph compares Chemical Financial Corporation's cumulative total shareholder return on its common stock over the last five years, assuming the reinvestment of dividends, to the Standard and Poor's ("S&P") 500 Stock Index and the KBW Regional Banking Index (Ticker: KRXTR). Both of these indices are based upon total return (including reinvestment of dividends) and are market-capitalization-weighted indices. The S&P 500 Stock Index is a broad equity market index published by S&P. The KBW Regional Banking Index is published by Keefe, Bruyette & Woods, Inc. (KBW), an investment banking firm that specializes in the banking industry. The KBW Regional Banking Index is composed of 50 mid-cap regional bank holding companies. The line graph assumes $100 was invested on December 31, 2007.
The dollar values for total shareholder return plotted in the above graph are shown below:
 
 
December 31,
 
 
2007
 
2008
 
2009
 
2010
 
2011
 
2012
Chemical Financial Corporation
 
$
100.0

 
$
122.7

 
$
109.7

 
$
106.9

 
$
107.3

 
$
124.0

KBW Regional Banking Index
 
100.0

 
81.4

 
63.4

 
76.4

 
72.4

 
82.0

S&P 500 Stock Index
 
100.0

 
63.0

 
79.7

 
91.7

 
93.6

 
108.6


17


Equity Compensation Plans
Information about the Corporation's equity compensation plans as of December 31, 2012 is set forth in Part III, Item 12 of this report, and is here incorporated by reference.
The following schedule summarizes the Corporation's total monthly share repurchase activity for the year ended December 31, 2012:
 
 
Issuer Purchases of Equity Securities
Period Beginning on First Day of Month Ended
 
Total Number of Shares Purchased (1)
 
Average Price Paid Per Share
 
Total Number of Shares Purchased as Part of Publicly Announced
 Plans or Programs
 
Maximum Number of Shares that May Yet Be Purchased Under
Plans or Programs
 
January 31, 2012
 

 
$

 

 
500,000
 
February 29, 2012
 
10,570

 
23.45

 

 
500,000
 
March 31, 2012
 

 

 

 
500,000
 
April 30, 2012
 

 

 

 
500,000
 
May 31, 2012
 

 

 

 
500,000
 
June 30, 2012
 

 

 

 
500,000
 
July 31, 2012
 

 

 

 
500,000
 
August 31, 2012
 

 

 

 
500,000
 
September 30, 2012
 
351

 
24.46

 

 
500,000
 
October 31, 2012
 

 

 

 
500,000
 
November 30, 2012
 

 

 

 
500,000
 
December 31, 2012
 

 

 

 
500,000
 
    Total
 
10,921

 
$
23.48

 

 

 
(1)
Includes shares delivered or attested in satisfaction of the exercise price and/or tax withholding obligations by employees who received shares of the Corporation's common stock in 2012 upon conversion of vested restricted stock performance units and by holders of employee stock options who exercised options in 2012. The Corporation's share-based compensation plans permit employees to use stock to satisfy such obligations based on the market value of the stock on the date of vesting or date of exercise, as applicable.


18


Item 6. Selected Financial Data.
 
 
Years Ended December 31,
 
 
2012(a)
 
2011(a)
 
2010(a)
 
2009
 
2008
 
 
(Dollars in thousands, except per share data)
Earnings Summary
 
 
 
 
 
 
 
 
 
 
Net interest income
 
$
187,545

 
$
183,853

 
$
171,120

 
$
147,444

 
$
145,253

Provision for loan losses
 
18,500

 
26,000

 
45,600

 
59,000

 
49,200

Noninterest income
 
51,872

 
44,400

 
42,472

 
41,119

 
41,197

Operating expenses
 
149,109

 
142,003

 
136,802

 
117,610

 
109,108

Net income
 
51,008

 
43,050

 
23,090

 
10,003

 
19,842

Per Common Share Data
 
 
 
 
 
 
 
 
 
 
Net income — basic
 
$
1.86

 
$
1.57

 
$
0.88

 
$
0.42

 
$
0.83

Net income — diluted
 
1.85

 
1.57

 
0.88

 
0.42

 
0.83

Cash dividends declared and paid
 
0.82

 
0.80

 
0.80

 
1.18

 
1.18

Book value at end of period
 
21.69

 
20.82

 
20.41

 
19.85

 
20.58

Market value at end of period
 
23.76

 
21.32

 
22.15

 
23.58

 
27.88

Common shares outstanding at year end
 
27,499

 
27,457

 
27,440

 
23,891

 
23,881

Balance Sheet Data (Year End)
 
 
 
 
 
 
 
 
 
 
Total assets
 
$
5,917,252

 
$
5,339,453

 
$
5,246,209

 
$
4,250,712

 
$
3,874,313

Total loans
 
4,167,735

 
3,831,285

 
3,681,662

 
2,993,160

 
2,981,677

Total deposits
 
4,921,443

 
4,366,857

 
4,331,765

 
3,418,125

 
2,978,792

Short-term borrowings (customer repurchase agreements)
 
310,463

 
303,786

 
242,703

 
240,568

 
233,738

Federal Home Loan Bank advances
 
34,289

 
43,057

 
74,130

 
90,000

 
135,025

Total shareholders' equity
 
596,341

 
571,729

 
560,078

 
474,311

 
491,544

Balance Sheet Averages
 
 
 
 
 
 
 
 
 
 
Total assets
 
$
5,442,079

 
$
5,304,098

 
$
4,913,310

 
$
4,066,229

 
$
3,784,617

Total earning assets
 
5,116,127

 
4,971,704

 
4,618,012

 
3,847,006

 
3,550,611

Total loans
 
3,948,407

 
3,730,795

 
3,438,550

 
2,980,126

 
2,873,151

Total interest-bearing liabilities
 
3,868,108

 
3,874,811

 
3,685,186

 
3,002,050

 
2,711,413

Total deposits
 
4,464,062

 
4,349,873

 
4,017,230

 
3,195,411

 
2,924,361

Short-term borrowings (customer repurchase agreements)
 
312,729

 
287,176

 
249,731

 
232,185

 
196,413

Federal Home Loan Bank advances
 
39,301

 
64,257

 
87,051

 
116,050

 
120,171

Total shareholders' equity
 
587,451

 
569,521

 
530,819

 
483,034

 
509,100

Performance Ratios
 
 
 
 
 
 
 
 
 
 
Net interest margin
 
3.76
%
 
3.80
%
 
3.80
%
 
3.91
%
 
4.16
%
Return on average assets
 
0.94

 
0.81

 
0.47

 
0.25

 
0.52

Return on average shareholders' equity
 
8.7

 
7.6

 
4.3

 
2.1

 
3.9

Efficiency ratio
 
60.4

 
60.8

 
60.7

 
61.0

 
58.2

Dividend payout ratio
 
44.3

 
51.0

 
90.9

 
281.0

 
142.2

Consolidated Capital Ratios
 
 
 
 
 
 
 
 
 
 
Average shareholders' equity as a percentage of average assets
 
10.1
%
 
10.7
%
 
10.8
%
 
11.9
%
 
13.5
%
Year end ratios:
 
 
 
 
 
 
 
 
 
 
Leverage ratio
 
9.2

 
9.0

 
8.4

 
10.1

 
11.6

Tier 1 risk-based capital ratio
 
12.0

 
12.1

 
11.6

 
14.2

 
15.1

Total risk-based capital ratio
 
13.2

 
13.3

 
12.9

 
15.5

 
16.4

Asset Quality
 
 
 
 
 
 
 
 
 
 
Net loan charge-offs
 
$
22,342

 
$
27,197

 
$
36,911

 
$
35,215

 
$
31,566

Net loan charge-offs as a percentage of average loans
 
0.57
%
 
0.73
%
 
1.07
%
 
1.18
%
 
1.10
%
Year end balances:
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses — originated loans
 
$
83,991

 
$
86,733

 
$
89,530

 
$
80,841

 
$
57,056

Allowance for loan losses — acquired loans
 
500

 
1,600

 

 

 

Total nonperforming loans
 
90,854

 
106,269

 
147,729

 
135,755

 
93,328

Total nonperforming assets
 
109,323

 
131,753

 
175,239

 
153,295

 
113,251

Year end ratios:
 
 
 
 
 
 
 
 
 
 
Allowance for loan losses as a percentage of total originated loans
 
2.22
%
 
2.60
%
 
2.86
%
 
2.70
%
 
1.91
%
Allowance for loan losses as a percentage of nonperforming loans
 
92

 
82

 
61

 
60

 
61

Nonperforming loans as a percentage of total loans
 
2.18

 
2.77

 
4.01

 
4.54

 
3.13

Nonperforming assets as a percentage of total assets
 
1.85

 
2.47

 
3.34

 
3.61

 
2.92

 (a)
Includes the impact of the acquisition of O.A.K. Financial Corporation (OAK) on April 30, 2010. See Note 2 to the consolidated financial statements in Item 8 of this report for information on the acquisition of OAK.

19


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
BUSINESS OF THE CORPORATION
Chemical Financial Corporation (Corporation) is a financial holding company headquartered in Midland, Michigan with its business concentrated in a single industry segment - commercial banking. The Corporation, through its wholly-owned subsidiary bank, Chemical Bank, offers a full range of traditional banking and fiduciary products and services. These products and services include business and personal checking accounts, savings and individual retirement accounts, time deposit instruments, electronically accessed banking products, residential and commercial real estate financing, commercial lending, consumer financing, debit cards, safe deposit box services, money transfer services, automated teller machines, access to insurance and investment products, corporate and personal wealth management services and other banking services.
The principal markets for the Corporation's products and services are communities in Michigan where the branches of Chemical Bank are located and the areas immediately surrounding those communities. As of December 31, 2012, Chemical Bank served these markets through 162 banking offices located in 38 counties across Michigan's lower peninsula. In addition to its banking offices, Chemical Bank operated two loan production offices and 173 automated teller machines, both on- and off-bank premises. Chemical Bank operates through an internal organizational structure of four regional banking units. Chemical Bank's regional banking units are collections of branch banking offices organized by geographical regions within the State of Michigan.
The principal source of revenue for the Corporation is interest and fees on loans, which accounted for 74% of total revenue in 2012 and 76% of total revenue in both 2011 and 2010. Interest on investment securities is also a significant source of revenue, accounting for 6% of total revenue in 2012, 2011 and 2010. Revenue is influenced by overall economic factors including market interest rates, business and consumer spending, consumer confidence and competitive conditions in the marketplace.
ACQUISITIONS
Acquisition of 21 Branches
On December 7, 2012, Chemical Bank acquired 21 branches from Independent Bank, a subsidiary of Independent Bank Corporation (Ticker: IBCP). 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. 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 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-related expenses associated with the acquisition of the branches totaled $2.9 million during 2012, which reduced net income per common share by $0.07 in 2012.
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.
In connection with the acquisition of OAK, the Corporation recorded $43.5 million of goodwill. Goodwill recorded was primarily attributable to the synergies and economies of scale expected from combining the operations of the Corporation and OAK. In addition, the Corporation recorded $9.8 million of other intangible assets in conjunction with the acquisition.
Acquisition-related expenses associated with the OAK acquisition totaled $4.3 million during 2010, which reduced net income per common share by $0.12 in 2010.

20


CRITICAL ACCOUNTING POLICIES
The Corporation's consolidated financial statements are prepared in accordance with United States 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 consolidated 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 consolidated 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. Estimates, assumptions and judgments are necessary when assets and liabilities are required to be recorded at fair value or when a decline in the value of an asset not carried at fair value on the financial statements warrants an impairment write-down or a valuation reserve to be established. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third-party sources, when available. When third-party sources are utilized, the Corporation's management remains responsible for complying with GAAP. To execute management's responsibilities, the Corporation has processes in place to develop an understanding of the third-party pricing methodologies and to design and implement specific internal controls over valuation. When third-party information is not available, valuation adjustments are estimated by management primarily through the use of internal discounted cash flow analyses, and to the extent available, observable market-based inputs.
The most significant accounting policies followed by the Corporation are presented in Note 1 to the consolidated financial statements included in Item 8 of this report. These policies, along with the disclosures presented in the other notes to the consolidated financial statements and in "Management's Discussion and Analysis of Financial Condition and Results of Operations," provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, estimates and assumptions underlying those amounts, 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, the evaluation of goodwill impairment and fair value measurements 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. Management reviews the following critical accounting policies with the Audit Committee of the board of directors at least annually.
Allowance for Loan Losses
The allowance for loan losses (allowance) is calculated with the objective of maintaining a reserve sufficient to absorb losses inherent in the loan portfolio. Loans represent the Corporation's largest asset type on the consolidated statements of financial position. The determination of the amount of the allowance is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected cash flows and collateral values on impaired loans, estimated losses on loans in the commercial loan portfolio (comprised of commercial, commercial real estate, real estate construction and land development loans) and on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The principal assumption used in deriving the allowance is the estimate of a loss percentage for each type of loan. In determining the allowance and the related provision for loan losses, the Corporation considers four principal elements: (i) specific impairment reserve allocations (valuation allowances) based upon probable losses identified during the review of impaired loans in the commercial loan portfolio, (ii) allocations established for adversely-rated loans in the commercial loan portfolio and nonaccrual residential mortgage, consumer installment and home equity loans, (iii) allocations on all other loans based principally on a five-year historical loan loss experience and loan loss trends, and (iv) an unallocated allowance based on the imprecision in the allowance methodology for loans collectively evaluated for impairment. It is extremely difficult to accurately measure the amount of losses that are inherent in the Corporation's loan portfolio. The Corporation uses a defined methodology to quantify the necessary allowance and related provision for loan losses, but there can be no assurance that the methodology will successfully identify and estimate all of the losses that are inherent in the loan portfolio. As a result, the Corporation could record future provisions for loan losses that may be significantly different than the levels that have been recorded in the three-year period ended December 31, 2012. Notes 1 and 4 to the consolidated financial statements further describe the methodology used to determine the allowance. In addition, a discussion of the factors driving changes in the amount of the allowance is included under the subheading "Allowance for Loan Losses" in "Management's Discussion and Analysis of Financial Condition and Results of Operations."
The Corporation has a loan review function that is independent of the loan origination function. At least annually, the loan review function reviews management's evaluation of the allowance and performs a detailed credit quality review of loans in the commercial loan portfolio, particularly focusing on larger balance loans and loans that have deteriorated below certain levels of credit risk.

21


Accounting for Loans Acquired in Business Combinations
Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (ASC 310-30), provides the GAAP guidance for accounting for loans acquired in a business combination that have experienced a deterioration in credit quality from origination to acquisition for which it is probable that the investor will be unable to collect all contractually required payments receivable, including both principal and interest.
Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered to be impaired. In the assessment of credit quality deterioration, the Corporation must make numerous assumptions, interpretations and judgments using internal and third-party credit quality information to determine whether or not it is probable that the Corporation will be able to collect all contractually required payments. This is a point in time assessment and inherently subjective due to the nature of the available information and judgment involved. Evidence of credit quality deterioration as of the acquisition date may include statistics such as past due and nonaccrual status, recent borrower credit scores and loan-to-value percentages. Those loans that qualify under ASC 310-30 are recorded at fair value at acquisition, which involves estimating the expected cash flows to be received. Accordingly, the associated allowance for loan losses related to these loans is not carried over at the acquisition date. ASC 310-30 also allows investors to aggregate acquired loans into loan pools that have common risk characteristics and use a composite interest rate and expectation of cash flows to be collected for the loan pools. The Corporation understands, as outlined in the American Institute of Certified Public Accountants' open letter to the Office of the Chief Accountant of the SEC dated December 18, 2009, and pending further standard setting, that for acquired loans that do not meet the scope criteria of ASC 310-30, a company may elect to account for such acquired loans pursuant to the provisions of either ASC Topic 310-20, Nonrefundable Fees and Other Costs, or ASC 310-30. The Corporation elected to apply ASC 310-30, by analogy, to loans acquired in the OAK acquisition that were determined not to have deteriorated credit quality, and therefore, did not meet the scope criteria of ASC 310-30. Accordingly, the Corporation follows the accounting and disclosure guidance of ASC 310-30 for these loans. Notes 1, 2 and 4 to the consolidated financial statements contain additional information related to loans acquired in the OAK acquisition.
The excess of cash flows of a loan, or pool of loans, expected to be collected over the estimated fair value is referred to as the "accretable yield" and is recognized into interest income over the estimated remaining life of the loan, or pool of loans, on a level-yield basis. The difference between the contractually required payments of a loan, or pool of loans, and the cash flows expected to be collected at acquisition, considering the impact of prepayments and estimates of future credit losses expected to be incurred over the life of the loan, or pool of loans, is referred to as the "nonaccretable difference."
The Corporation is required to quarterly evaluate its estimates of cash flows expected to be collected from acquired loans. These evaluations require the continued usage of key assumptions and estimates, similar to the initial estimate of fair value. Given the current economic environment, the Corporation must apply judgment to develop its estimates of cash flows for acquired loans given the impact of changes in property values, default rates, loss severities and prepayment speeds. Decreases in the estimates of expected cash flows will generally result in a charge to the provision for loan losses and a resulting increase to the allowance for loan losses. Increases in the estimates of expected cash flows will generally result in adjustments to the accretable yield which will increase amounts recognized in interest income in subsequent periods. Dispositions of acquired loans, which may include sales of loans to third parties, receipt of payments in full or in part by the borrower and foreclosure of the collateral, result in removal of the loan from the acquired loan portfolio at its carrying amount. As a result of the significant amount of judgment involved in estimating future cash flows expected to be collected for acquired loans, the adequacy of the allowance for loan losses could be significantly impacted by changes in expected cash flows resulting from changes in credit quality of acquired loans.
Acquired loans that were classified as nonperforming loans prior to being acquired and acquired loans that are not performing in accordance with contractual terms subsequent to acquisition are not classified as nonperforming loans subsequent to acquisition because the loans are recorded in pools at net realizable value based on the principal and interest the Corporation expects to collect on such loans. Judgment is required to estimate the timing and amount of cash flows expected to be collected when the loans are not performing in accordance with the original contractual terms.
Pension Plan Accounting
The Corporation has a defined benefit pension plan for certain salaried employees. Effective June 30, 2006, benefits under the defined benefit pension plan were frozen for approximately two-thirds of the Corporation's salaried employees as of that date. Pension benefits continued unchanged for the remaining salaried employees. At December 31, 2012, 214 employees, or 12% of total employees on a full-time equivalent basis, were earning pension benefits under the defined benefit pension plan. The Corporation's pension benefit obligations and related costs are calculated using actuarial concepts and measurements. Benefits under the plan are based on years of vested service, age and amount of compensation. Assumptions are made concerning future events that will determine the amount and timing of required benefit payments, funding requirements and pension expense.

22


The key actuarial assumptions used in the pension plan are the discount rate and long-term rate of return on plan assets. These assumptions have a significant effect on the amounts reported for net periodic pension expense, as well as the respective benefit obligation amounts. The Corporation evaluates these critical assumptions annually. At December 31, 2012, 2011 and 2010, the Corporation calculated a discount rate of 4.08%, 4.90% and 5.65%, respectively, for the pension plan using the results from a bond matching technique, which matched the future estimated annual benefit payments of the pension plan against a portfolio of bonds of Aa quality to determine the discount rate.
The assumed long-term rate of return on pension plan assets represents an estimate of long-term returns on an investment portfolio consisting primarily of equity and fixed income investments. When determining the expected long-term return on pension plan assets, the Corporation considers long-term rates of return on the asset classes in which the Corporation expects the pension funds to be invested. The expected long-term rate of return is based on both historical and forecasted returns of the overall stock and bond markets and the actual portfolio. The following rates of return by asset class were considered in setting the assumptions for long-term return on pension plan assets:
 
December 31,
 
2012
 
2011
 
2010
Equity securities
6% – 10%
 
6% – 10%
 
6% – 9%
Debt securities
2% – 5%
 
3% – 6%
 
3% – 7%
Other
2% – 3%
 
2% – 3%
 
2% – 3%
The assumed long-term return on pension plan assets is developed through an analysis of forecasted rates of return by asset class and forecasted asset allocations. It is used to compute the subsequent year's expected return on assets, using the "market-related value" of pension plan assets. The difference between the expected return and the actual return on pension plan assets during the year is either an asset gain or loss, which is deferred and amortized over future periods when determining net periodic pension expense. The Corporation's projection of the long-term return on pension plan assets was 7% in 2012, 2011 and 2010, while the actual return on pension plan assets was 8.6%, (0.9)% and 8.7% in 2012, 2011 and 2010, respectively.
Other assumptions made in the pension plan calculations involve employee demographic factors, such as retirement patterns, mortality, turnover and the rate of compensation increase.
The key actuarial assumptions that will be used to calculate pension expense in 2013 for the defined benefit pension plan are a discount rate of 4.08%, a long-term rate of return on pension plan assets of 7.0% and a rate of compensation increase of 3.5%. Pension expense in 2013 is estimated to be approximately $1.7 million, an increase of approximately $0.3 million, or 21%, from 2012. The increase in pension expense in 2013, as compared to 2012, is primarily attributable to the decrease in the discount rate, which has been largely mitigated by an additional contribution to the pension plan, as discussed further below. In 2013, a decrease in the discount rate of 50 basis points and 100 basis points is estimated to increase pension expense by $0.45 million and $0.9 million, respectively, while an increase of 50 basis points and 100 basis points is estimated to decrease pension expense by approximately the same amounts. The discount rate used to value the projected benefit obligation and estimated pension expense of the Corporation's defined benefit pension plan has averaged 6.38% over the last fifteen years. However, the discount rate used to estimate the projected benefit obligation and pension expense in 2012, 2011 and 2010 was significantly below this historical average due to the historically low interest rate environment. The Corporation was not required to make contributions to the pension plan during 2012, 2011 or 2010; however, in order to mitigate the increases in the projected benefit obligation and pension expense resulting from the lower discount rates, the Corporation made a $10 million contribution to the pension plan in 2010, a $12 million contribution to the pension plan in January 2012 related to the 2011 plan year, and a $15 million contribution in February 2013 related to the 2012 plan year.
There are uncertainties associated with the underlying key actuarial assumptions, and the potential exists for significant, and possibly material, impacts on either or both the results of operations and cash flows (e.g., additional pension expense and/or additional pension plan funding, whether expected or required) from changes in the key actuarial assumptions. If the Corporation were to determine that more conservative assumptions are necessary, pension expense would increase and have a negative impact on results of operations in the period in which the increase occurs.
The Corporation accounts for its defined benefit pension and other postretirement plans in accordance with ASC Topic 715, Compensation-Retirement Benefits, which requires companies to recognize the over- or under-funded status of a plan as an asset or liability as measured by the difference between the fair value of the plan assets and the projected benefit obligation and requires any unrecognized prior service costs and actuarial gains and losses to be recognized as a component of accumulated other comprehensive income (loss). The impact of pension plan accounting on the statements of financial position at December 31, 2012 and 2011 is further discussed in Note 16 to the consolidated financial statements.

23


Income and Other Taxes
The Corporation is subject to the income and other tax laws of the United States, the State of Michigan and other states where nexus has been created. These laws are complex and are subject to different interpretations by the taxpayer and the various taxing authorities. In determining the provisions for income and other taxes, management must make judgments and estimates about the application of these inherently complex laws, related regulations and case law. In the process of preparing the Corporation's tax returns, management attempts to make reasonable interpretations of applicable tax laws. These interpretations are subject to challenge by the taxing authorities upon audit or to reinterpretation based on management's ongoing assessment of facts and evolving regulations and case law.
The Corporation and its subsidiaries file a consolidated federal income tax return. The provision for federal income taxes is based on income and expenses, as reported in the consolidated financial statements, rather than amounts reported on the Corporation's federal income tax return. When income and expenses are recognized in different periods for tax purposes than for book purposes, applicable deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.
On a quarterly basis, management assesses the reasonableness of its effective federal income tax rate based upon its current best estimate of net income and the applicable taxes expected for the full year, including the impact of any discrete items that have occurred. Deferred tax assets and liabilities are reassessed on a quarterly basis, including the need for a valuation allowance for deferred tax assets. Reserves for uncertain tax positions are reviewed quarterly for adequacy based upon developments in tax law and the status of examinations or audits. As of December 31, 2012 and 2011, there were no federal income tax reserves recorded for uncertain tax positions.
Goodwill
At December 31, 2012, the Corporation had $120.2 million of goodwill, which was originated through the acquisition of various banks and bank branches, recorded on the consolidated statement of financial position. Goodwill is not amortized, but rather is tested by management annually for impairment, or more frequently if triggering events occur and indicate potential impairment, in accordance with ASC Topic 350-20, Goodwill (ASC 350-20). The Corporation's goodwill impairment assessment utilizes the methodology and guidelines established in GAAP, including assumptions regarding the valuation of Chemical Bank.
The Corporation performed its 2012 annual goodwill impairment assessment at October 31, 2012 utilizing the quantitative assessment approach to perform a Step 1 valuation of its goodwill as of that date. The fair value of Chemical Bank as of October 31, 2012 was measured utilizing the income and market approaches as prescribed in ASC Topic 820, Fair Value Measurements and Disclosures (ASC 820). GAAP identifies the cost approach as another acceptable method; however, the cost approach was not deemed an effective method to value a financial institution. The cost approach estimates a company's value by adjusting the reported values of assets and liabilities to their fair values. It is the Corporation's opinion that financial institutions cannot be liquidated in an efficient manner. Estimating the fair value of loans is a very difficult process and subject to a wide margin of error unless done on a loan by loan basis. Voluntary liquidations of financial institutions are not typical. More commonly, if a financial institution is liquidated, it is due to being taken over by the Federal Deposit Insurance Corporation (FDIC). The value of Chemical Bank was based as a going concern and not as a liquidation.
The income approach uses valuation techniques to convert future amounts (cash flows or earnings) to a single, discounted amount. The income approach includes present value techniques, option-pricing models, such as the Black-Scholes formula and lattice models, and the multi-period excess-earnings method. In the valuation of Chemical Bank, the income approach utilized the discounted cash flow method based upon a forecast of growth and earnings. Cash flows are measured by using projected earnings, projected dividends and dividend paying capacity over a five-year period. In addition to estimating periodic cash flows, an estimate of residual value is determined through the capitalization of earnings. The income approach assumed cost savings and earnings enhancements that a strategic acquiror would likely implement based upon typical participant assumptions of market transactions. The discount rate is critical to the discounted cash flow analysis. The discount rate reflects the risk of uncertainty associated with the cash flows and a rate of return that investors would require from similar investments with similar risks. At the valuation date of October 31, 2012, a discount rate of 14.25% was utilized in the income approach.
The market approach uses observable prices and other relevant information that are generated by market transactions involving identical or comparable assets or liabilities. The fair value measure is based on the value that those transactions indicate utilizing both financial and operating characteristics of the acquired companies. The most significant financial ratio analyzed in completed transactions involved the price to tangible book value. At the valuation date of October 31, 2012, the market approach utilized a price to tangible book value of 140%.

24


The fair value of Chemical Bank was determined to be slightly above the income approach and within the range of values in the market approach value range. The results of the valuation analysis concluded that the fair value of Chemical Bank was greater than its book value, including goodwill, and thus no goodwill impairment was evident at the valuation date of October 31, 2012. The weighted average of the fair values determined under the income and market approaches was a 2.0% premium over the market capitalization of the Corporation at the valuation date. The Corporation is publicly traded and, therefore, the price per share of its common stock as reported on The NASDAQ Stock Market® establishes the marketable minority value. It is management's opinion that the marketable minority value does not always represent the fair value of the reporting unit as a whole and that an adjustment to the marketable minority value for the acquiror's control is generally considered in the assessment of fair value. The market capitalization of the Corporation was $653 million on December 31, 2012, compared to $647 million on October 31, 2012. The Corporation determined that no triggering events occurred that indicated potential impairment of goodwill from the most recent valuation date through December 31, 2012. However, the Corporation could incur impairment charges related to goodwill in the future due to changes in financial results or other matters that could affect the valuation assumptions.
Fair Value Measurements
The Corporation determines the fair value of its assets and liabilities in accordance with ASC 820. ASC 820 establishes a standard framework for measuring and disclosing fair value under GAAP. A number of valuation techniques are used to determine the fair value of assets and liabilities in the Corporation's financial statements. The valuation techniques include quoted market prices for investment securities, appraisals of real estate from independent licensed appraisers and other valuation techniques. Fair value measurements for assets and liabilities where limited or no observable market data exists are based primarily upon estimates, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the valuation results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. Significant changes in the aggregate fair value of assets and liabilities required to be measured at fair value or for impairment are recognized in the income statement under the framework established by GAAP. See Note 13 to the Corporation's consolidated financial statements for more information on fair value measurements.
Accounting Standards Updates
See Note 1 to the consolidated financial statements included in this report for details of accounting pronouncements adopted by the Corporation during 2012 and recently issued accounting pronouncements and their impact on the Corporation's financial statements.
In December 2012, the FASB issued for public comment a draft proposal designed to improve financial reporting about expected credit losses on loans and other financial assets held by banks, financial institutions and other organizations. The proposed ASU, Financial Instruments - Credit Losses, proposes a new accounting model which would change the definition from inherent credit losses to expected credit losses, which could result in more timely recognition of credit losses, and also would provide additional transparency about credit risk. Stakeholders have been asked to review and provide comments to the FASB on the proposal by April 30, 2013.
FINANCIAL HIGHLIGHTS
The following discussion and analysis is intended to cover significant factors affecting the Corporation's consolidated statements of financial position and income included in this report. It is designed to provide a more comprehensive review of the consolidated operating results and financial position of the Corporation than could be obtained from an examination of the financial statements alone.
NET INCOME
Net income in 2012 was $51.0 million, or $1.85 per diluted share, compared to net income in 2011 of $43.1 million, or $1.57 per diluted share, and net income in 2010 of $23.1 million, or $0.88 per diluted share. Net income in 2012 represented an 18% increase from 2011 net income, with the increase primarily attributable to an increase in net interest income and noninterest income and a decrease in the provision for loan losses, which were partially offset by an increase in operating expenses. Net income in 2011 represented an 86% increase from 2010 net income, with the increase primarily attributable to an increase in net interest income and a decrease in the provision for loan losses.
The Corporation's return on average assets was 0.94% in 2012, 0.81% in 2011 and 0.47% in 2010. The Corporation's return on average shareholders' equity was 8.7% in 2012, 7.6% in 2011 and 4.3% in 2010.

25


ASSETS
Total assets were $5.92 billion at December 31, 2012, an increase of $578 million, or 11%, from total assets at December 31, 2011 of $5.34 billion. The increase in total assets during 2012 was primarily attributable to the acquisition of 21 branches on December 7, 2012. Excluding the acquisition of 21 branches, total assets increased $174 million, or 3.3%, during 2012, with the increase attributable to an increase in customer deposits that partially funded loan growth.
Average assets were $5.44 billion during 2012, an increase of $138 million, or 2.6%, from average assets during 2011 of $5.30 billion, while average assets during 2011 increased $391 million, or 8.0%, from average assets during 2010 of $4.91 billion. The increase in average assets during 2012, as compared to 2011, was primarily attributable to an increase in customer deposits that funded loan growth, while the increase in average assets during 2011, as compared to 2010, was attributable to an increase in customer deposits that partially funded loan growth, in addition to the acquisition of OAK.
INVESTMENT SECURITIES
Information about the Corporation's investment securities portfolio is summarized in Tables 1 and 2. The following table summarizes the maturities and yields of the carrying value of investment securities by investment category, and fair value by investment category, at December 31, 2012:
TABLE 1. MATURITIES AND YIELDS* OF INVESTMENT SECURITIES AT DECEMBER 31, 2012
 
Maturity**
 
 
 
 
 
 
 
Within
One Year
 
After One
but Within
Five Years
 
After Five
but Within
Ten Years
 
After
Ten Years
 
Total
Carrying
Value***
 
Total
Fair
Value
 
Amount
 
Yield
 
Amount
 
Yield
 
Amount
 
Yield
 
Amount
 
Yield
 
Amount
 
Yield
 
 
(Dollars in thousands)
Available-for-Sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Government sponsored agencies
$
68,632

 
0.74
%
 
$
11,703

 
0.91
%
 
$
11,379

 
0.89
%
 
$
5,843

 
0.85
%
 
$
97,557

 
0.79
%
 
$
97,557

State and political subdivisions
4,429

 
3.02

 
25,109

 
2.50

 
20,427

 
3.93

 

 

 
49,965

 
3.13

 
49,965

Residential mortgage-backed securities
51,036

 
2.40

 
37,395

 
2.18

 
9,878

 
2.34

 
1,102

 
5.61

 
99,411

 
2.35

 
99,411

Collateralized mortgage obligations
146,640

 
0.83

 
108,833

 
1.06

 
7,576

 
1.17

 
543

 
1.38

 
263,592

 
0.94

 
263,592

Corporate bonds

 

 
69,795

 
1.80

 

 

 

 

 
69,795

 
1.80

 
69,795

Preferred stock

 

 

 

 

 

 
6,489

 
5.49

 
6,489

 
5.49

 
6,489

Total investment securities available-for-sale
270,737

 
1.14

 
252,835

 
1.57

 
49,260

 
2.48

 
13,977

 
3.40

 
586,809

 
1.49

 
586,809

Held-to-Maturity:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
State and political subdivisions
38,311

 
2.88

 
92,915

 
4.15

 
64,915

 
4.77

 
23,336

 
5.99

 
219,477

 
4.31

 
224,197

Trust preferred securities

 

 

 

 

 

 
10,500

 
3.85

 
10,500

 
3.85

 
5,725

Total investment securities held-to-maturity
38,311

 
2.88

 
92,915

 
4.15

 
64,915

 
4.77

 
33,836

 
5.33

 
229,977

 
4.28

 
229,922

Total investment securities
$
309,048

 
1.35
%
 
$
345,750

 
2.26
%
 
$
114,175

 
3.78
%
 
$
47,813

 
4.76
%
 
$
816,786

 
2.28
%
 
$
816,731

*
Yields are weighted by amount and time to contractual maturity, are on a taxable equivalent basis using a 35% federal income tax rate and are based on carrying value. Yields disclosed are actual yields based on carrying value at December 31, 2012. Approximately 34% of the Corporation's investment securities at December 31, 2012 were variable-rate financial instruments.
**
Residential mortgage-backed securities, collateralized mortgage obligations and certain government sponsored agencies are based on scheduled principal maturity. All other investment securities are based on final contractual maturity.
***
The aggregate book value of securities issued by any single issuer, other than the U.S. government and government sponsored agencies, did not exceed 10% of the Corporation's shareholders' equity.
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 and the results of their internal control assessments to ensure the integrity of the process that the vendor uses to develop market pricing for the Corporation's investment portfolio.

26


The following table summarizes the carrying value of investment securities at December 31, 2012, 2011 and 2010:
TABLE 2. SUMMARY OF INVESTMENT SECURITIES
 
December 31,
 
2012
 
2011
 
2010
 
(In thousands)
Available-for-Sale:
 
 
 
 
 
Government sponsored agencies
$
97,557

 
$
70,679

 
$
117,521

State and political subdivisions
49,965

 
45,235

 
46,046

Residential mortgage-backed securities
99,411

 
120,780

 
136,935

Collateralized mortgage obligations
263,592

 
332,400

 
233,921

Corporate bonds
69,795

 
96,768

 
42,747

Preferred stock
6,489

 
1,414

 
1,440

Total investment securities available-for-sale
586,809

 
667,276

 
578,610

Held-to-Maturity:
 
 
 
 
 
State and political subdivisions
219,477

 
172,839

 
154,900

Trust preferred securities
10,500

 
10,500

 
10,500

Total investment securities held-to-maturity
229,977

 
183,339

 
165,400

Total investment securities
$
816,786

 
$
850,615

 
$
744,010

The carrying value of investment securities totaled $816.8 million at December 31, 2012, a decrease of $33.8 million, or 4.0%, from investment securities of $850.6 million at December 31, 2011. The decrease in investment securities during 2012 was attributable to the Corporation not reinvesting a portion of maturing investment securities in order to fund loan growth. At December 31, 2012, the Corporation's investment securities portfolio consisted of: $97.6 million in government sponsored agency (GSA) debt obligations comprised primarily of fixed-rate senior bonds that were 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; $269.4 million in state and political subdivisions debt obligations comprised primarily of general debt obligations of issuers primarily located in the State of Michigan; $99.4 million in residential mortgage-backed securities (MBSs) comprised of approximately 70% fixed-rate and 30% variable-rate instruments backed by a U.S. government agency (Government National Mortgage Association) or government sponsored enterprises (the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association); $263.6 million of 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; $69.8 million in corporate bonds comprised primarily of debt obligations of large U.S. based global financial organizations; $6.5 million of preferred stock comprised of preferred stock debt instruments of two large regional/national banks and fixed-rate cumulative preferred stock issued by a Michigan bank holding company under the U.S. Government's Troubled Asset Relief Program (TARP); and $10.5 million of variable-rate trust preferred securities (TRUPs) comprised primarily of a 100% interest in a TRUP of a small non-public bank holding company in Michigan.
The Corporation records all investment securities in accordance with ASC Topic 320, Investments-Debt and Equity Securities (ASC 320), under which the Corporation is required to assess equity and debt securities that have fair values below their amortized cost basis to determine whether the decline (impairment) is other-than-temporary. An assessment is performed quarterly by the Corporation to determine whether unrealized losses in its investment securities portfolio are temporary or other-than-temporary by considering all reasonably available information. The Corporation reviews factors such as financial statements, credit ratings, news releases and other pertinent information of the underlying issuer or company to make its determination. In assessing whether a decline is other-than-temporary, management considers, among other things (i) the length of time and the extent to which the fair value has been less than amortized cost, (ii) the financial condition and near-term prospects of the issuer, (iii) the potential for impairments in an entire industry or sub-sector and (iv) the potential for impairments in certain economically depressed geographical locations.

27


The Corporation's investment securities portfolio with a carrying value of $816.8 million at December 31, 2012, had gross impairment of $9.1 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 December 31, 2012 was temporary in nature, and therefore, no impairment loss was recognized in the Corporation's consolidated statement of income for 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 December 31, 2012, the Corporation's investment securities portfolio had gross impairment of $9.1 million comprised as follows: GSA securities, residential MBSs and CMOs, combined, with gross impairment of $0.4 million, state and political subdivisions securities with gross impairment of $3.4 million, corporate bonds with gross impairment of $0.5 million and trust preferred securities with gross impairment of $4.8 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 $456.6 million, had gross impairment of $0.4 million at December 31, 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 current market interest rates being slightly 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 December 31, 2012.
State and political subdivisions securities included in both the available-for-sale and held-to-maturity investment securities portfolios, with an amortized cost of $267.1 million, had gross impairment of $3.4 million at December 31, 2012. The majority of these investment securities are from issuers 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 $62.6 million that generally mature beyond 2013. 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 earned 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 December 31, 2012.
Corporate bonds included in the available-for-sale investment securities portfolio, with an amortized cost of $69.8 million, had gross impairment of $0.5 million at December 31, 2012. All of the corporate bonds held at December 31, 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 were "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 being earned on these investment securities 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 December 31, 2012.
At December 31, 2012, the Corporation held two trust preferred securities (TRUPs) in the held-to-maturity investment securities portfolio with a combined amortized cost of $10.5 million that had gross impairment of $4.8 million. Management reviewed available information of the issuers of the TRUPs as of December 31, 2012. 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 December 31, 2012, the Corporation determined that the fair value of this TRUP was $5.5 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 December 31, 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.
The issuer of the $10.0 million TRUP reported net income 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 December 31, 2012, 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

28


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 December 31, 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 December 31, 2012. While the total fair value of the TRUP was $4.5 million below the Corporation's amortized cost at December 31, 2012, the Corporation concluded that, based on the overall financial condition of the issuer, the impairment was temporary in nature at December 31, 2012.
The Corporation expects the issuer of the $0.5 million TRUP to report a small net loss in 2012, compared to a reported small amount of net income in 2011 and a net loss in 2010. At December 31, 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 December 31, 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 December 31, 2012. While the fair value of the TRUP was $0.3 million below the Corporation's amortized cost at December 31, 2012, the Corporation concluded that the impairment was temporary in nature at December 31, 2012.
At December 31, 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 December 31, 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, 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 December 31, 2012, the Corporation's loan portfolio was $4.17 billion and consisted of loans in the commercial loan portfolio totaling $2.26 billion, or 54% of total loans, and loans in the consumer loan portfolio totaling $1.90 billion, or 46% of total loans. Loans at fixed interest rates comprised 73% of the Corporation's total loan portfolio at December 31, 2012, compared to 71% at December 31, 2011 and 72% at December 31, 2010.
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 $4.17 billion at December 31, 2012, an increase of $336 million, or 8.8%, from total loans of $3.83 billion at December 31, 2011. Total loans increased $150 million, or 4.1%, during 2011, from total loans of $3.68 billion at December 31, 2010. The increases in total loans during 2012 and 2011 were primarily attributable to a combination of improving economic conditions and higher loan demand, as well as the Corporation increasing its market share in both its commercial and consumer loan portfolios. In addition, the Corporation acquired $44 million of loans in conjunction with its acquisition of 21 branches from Independent Bank on December 7, 2012, including $3 million of commercial loans, $20 million of commercial real estate loans and $21 million of consumer installment and home equity loans.

29


Table 3 includes the composition of the Corporation's loan portfolio, by major loan category, as of December 31 for each of the past five years.
TABLE 3. SUMMARY OF LOANS
 
December 31,
 
2012
 
2011
 
2010
 
2009
 
2008
 
(In thousands)
Commercial loan portfolio:
 
 
 
 
 
 
 
 
 
Commercial
$
1,002,722

 
$
895,150

 
$
818,997

 
$
584,286

 
$
587,554

Commercial real estate
1,161,861

 
1,071,999

 
1,076,971

 
785,675

 
786,404

Real estate construction and land development
100,237

 
118,176

 
142,620

 
121,305

 
119,001

Subtotal — commercial loan portfolio
2,264,820

 
2,085,325

 
2,038,588

 
1,491,266

 
1,492,959

Consumer loan portfolio:
 
 
 
 
 
 
 
 
 
Residential mortgage
883,835

 
861,716

 
798,046

 
739,380

 
839,555

Consumer installment and home equity
1,019,080

 
884,244

 
845,028

 
762,514

 
649,163

Subtotal — consumer loan portfolio
1,902,915

 
1,745,960

 
1,643,074

 
1,501,894

 
1,488,718

Total loans
$
4,167,735

 
$
3,831,285

 
$
3,681,662

 
$
2,993,160

 
$
2,981,677

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 $2.26 billion at December 31, 2012 included 68 loan relationships of $5.0 million or greater. These 68 loan relationships totaled $584 million and represented 26% of the commercial loan portfolio at December 31, 2012 and included 19 loan relationships that had outstanding balances of $10 million or higher, totaling $235 million, or 10% of the commercial loan portfolio, at that date. The Corporation had 14 loan relationships at December 31, 2012 with loan balances greater than $5.0 million and less than $10 million, totaling $118 million, that had unfunded credit amounts that, if advanced, could result in a loan relationship of $10 million or more.
Table 4 presents the maturity distribution of the Corporation's $2.26 billion commercial loan portfolio at December 31, 2012. The percentage of these loans maturing within one year was 33% at December 31, 2012, while the percentage of these loans maturing beyond five years remained low at 12% at December 31, 2012. At December 31, 2012, loans in the commercial loan portfolio with maturities beyond one year totaled $1.51 billion, with 67% of these loans at fixed interest rates.
TABLE 4. COMPARISON OF LOAN MATURITIES AND INTEREST SENSITIVITY
 
 
December 31, 2012
 
 
Due In
 
 
1 Year
or Less
 
1 to 5
Years
 
Over 5
Years
 
Total
 
 
(Dollars in thousands)
Loan maturities:
 
 
 
 
 
 
 
 
Commercial
 
$
509,014

 
$
374,840

 
$
118,868

 
$
1,002,722

Commercial real estate
 
201,700

 
829,675

 
130,486

 
1,161,861

Real estate construction and land development
 
41,169

 
33,912

 
25,156

 
100,237

Total
 
$
751,883

 
$
1,238,427

 
$
274,510

 
$
2,264,820

Percent of total
 
33
%
 
55
%
 
12
%
 
100
%
Interest sensitivity of above loans:
 
 
 
 
 
 
 
 
Fixed interest rates
 
$
245,306

 
$
823,952

 
$
195,579

 
$
1,264,837

Variable interest rates
 
506,577

 
414,475

 
78,931

 
999,983

Total
 
$
751,883

 
$
1,238,427

 
$
274,510

 
$
2,264,820


30


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 $1.00 billion at December 31, 2012, an increase of $107.6 million, or 12.0%, from commercial loans of $895.2 million at December 31, 2011. Commercial loans increased $76.2 million, or 9.3%, during 2011 from commercial loans of $819.0 million at December 31, 2010. Commercial loans represented 24.0% of the Corporation's loan portfolio at December 31, 2012, compared to 23.3% and 22.2% at December 31, 2011 and 2010, 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 $1.16 billion at December 31, 2012, an increase of $89.9 million, or 8.4%, from commercial real estate loans of $1.07 billion at December 31, 2011. Loans secured by owner occupied properties, non-owner occupied properties and vacant land comprised 60%, 37% and 3%, respectively, of the Corporation's commercial real estate loans outstanding at December 31, 2012. Commercial real estate loans decreased $5.0 million, or 0.5%, during 2011 from commercial real estate loans of $1.08 billion at December 31, 2010. Commercial real estate loans represented 27.9% of the Corporation's loan portfolio at December 31, 2012, compared to 28.0% and 29.3% at December 31, 2011 and 2010, respectively.
Commercial and commercial real estate lending is generally considered to involve a higher degree of risk than residential mortgage, consumer installment and home equity lending as it 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 is 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.
The Corporation generally attempts to mitigate the risks associated with commercial and commercial real estate 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 2012, resulting in lower loan delinquencies compared to the previous three years. However, the economy in the State of Michigan continues to be strained by low levels of economic growth in many areas, resulting in commercial and residential real estate foreclosures continuing to remain higher than historical averages. Accordingly, management expects real estate foreclosures to remain elevated despite improvements in Michigan's economy. It is management's belief that the loan portfolio is generally well-secured, despite declining market values for all types of real estate in the State of Michigan and nationwide over the past four years.
Real estate construction and land development loans are primarily originated for construction of commercial properties and land development. Real estate construction and land development loans were $100.2 million at December 31, 2012, compared to $118.2 million and $142.6 million at December 31, 2011 and 2010, respectively. Real estate construction and land development loans represented 2.4% of the Corporation's loan portfolio at December 31, 2012, compared to 3.1% and 3.9% at December 31, 2011 and 2010, respectively.
Real estate construction loans often convert to a commercial real estate loan at the completion of the construction period. Real estate construction loans were $62.7 million at December 31, 2012, a decrease of $10.7 million, or 15%, from real estate construction loans of $73.4 million at December 31, 2011. Real estate construction loans decreased $15.8 million, or 18%, during 2011 from real estate construction loans of $89.2 million at December 31, 2010, with the decrease due primarily to one project to finance the construction of a private recreational facility paying off during 2011.
Land development loans include loans made to developers for the purpose of infrastructure improvements to vacant land to create finished marketable residential and commercial lots/land. Most land development loans are originated with the intention that the loans will be repaid through the sale of finished properties by the developers within twelve months of the completion date. Land development loans were $37.5 million at December 31, 2012, a decrease of $7.3 million, or 16%, from land development loans of $44.8 million at December 31, 2011. Land development loans decreased $8.6 million, or 16%, during 2011 from land development loans of $53.4 million at December 31, 2010. The Corporation's land development loans were primarily comprised of loans to develop residential real estate at December 31, 2012, 2011 and 2010.
Real estate construction and land development lending involves a higher degree of risk than commercial real estate lending and residential mortgage lending because of the uncertainties of construction, including the possibility of costs exceeding the initial estimates, the need to obtain a tenant or purchaser of the property if it will not be owner-occupied or the need to sell developed properties. The Corporation generally attempts to mitigate the risks associated with real estate construction and land development lending by, among other things, lending primarily in its market areas, using prudent underwriting guidelines and closely monitoring

31


the construction process. The Corporation's risk in this area has increased since early 2008 due to the weak economic environment within the State of Michigan. While the economy in Michigan began improving in 2011, the sale of lots and units in both residential and commercial development projects remains weak, as customer demand also remains low, resulting in the inventory of unsold lots and housing units remaining high across the State of Michigan and resulting in the inability of most developers to sell their finished developed lots and units within their original expected timeframes. Accordingly, the Corporation's land development borrowers have sold only a small percentage of their developed lots or units since early 2008 due to the unfavorable economic environment. At December 31, 2012, $11.1 million, or 30%, of the Corporation's $37.5 million of land development loans were impaired, whereby the Corporation determined it was probable that the full amount of principal and interest would not be collected on these loans in accordance with their original contractual terms.
Consumer Loan Portfolio
The Corporation's consumer loan portfolio is comprised of residential mortgage loans, consumer installment loans and home equity loans and lines of credit.
Residential mortgage loans consist primarily of one- to four-family residential loans with fixed interest rates of fifteen years or less. The loan-to-value ratio at the time of origination is generally 80% or less. Loans with more than an 80% loan-to-value ratio generally require private mortgage insurance. At December 31, 2012, approximately 75% of the Corporation's residential mortgage loans had an original loan-to-value ratio of 80% or less.
Residential mortgage loans were $883.8 million at December 31, 2012, an increase of $22.1 million, or 2.6%, from residential mortgage loans of $861.7 million at December 31, 2011. Residential mortgage loans increased $63.7 million, or 8.0%, during 2011 from residential mortgage loans of $798.0 million at December 31, 2010. Residential mortgage loans have historically involved the least amount of credit risk in the Corporation's loan portfolio, although the risk on these loans has increased with the increase in the unemployment rate and decrease in real estate property values in the State of Michigan over the last several years. Residential mortgage loans also include loans to consumers for the construction of single family residences that are secured by these properties. Residential mortgage construction loans were $25.5 million at December 31, 2012, compared to $21.6 million at December 31, 2011 and $15.3 million at December 31, 2010. Residential mortgage loans represented 21.2% of the Corporation's loan portfolio at December 31, 2012, compared to 22.5% and 21.7% at December 31, 2011 and 2010, respectively.
During 2012, the Corporation originated $523 million of residential mortgage loans. The Corporation retained $218 million of these originations in its loan portfolio, although residential mortgage loans increased only $22 million, as the majority of the residential mortgage loan originations in 2012 were attributable to the refinancing of existing loans. The demand for longer term fixed interest rate residential mortgage loans was high in both 2012 and 2011 due to the historically low level of long-term interest rates. The Corporation has historically sold fixed interest rate residential mortgage loans originated with maturities of fifteen years and over in the secondary market. However, due to a general low level of loan demand across its market areas, the Corporation retained $79 million and $99 million of fixed interest rate residential mortgage loans originated with terms of fifteen years in its loan portfolio during 2012 and 2011, respectively. At December 31, 2012, $290 million, or 33%, of the Corporation's residential mortgage loans had maturities beyond five years and were at fixed interest rates, compared to $268 million, or 31%, at December 31, 2011.
The Corporation's consumer installment and home equity loans (collectively referred to as consumer loans) consist of relatively small loan amounts to consumers to finance personal items, primarily automobiles, recreational vehicles, boats and home improvements. Consumer loans are spread across many individual borrowers, which minimizes the risk per loan transaction. In addition to loans originated directly through the Corporation's branch network, consumer installment loans also include indirect loans purchased from dealerships for automobiles, recreational vehicles and personal watercraft. These indirect consumer installment loans comprised 74% of the Corporation's consumer installment loans at December 31, 2012. Home equity loans, including home equity lines of credit, are comprised of loans to consumers who utilize equity in their personal residence, including junior lien mortgages, as collateral to secure the loan or line of credit. Collateral values on properties securing consumer loans are negatively impacted by many factors, including the physical condition of the collateral and property values, although losses on consumer loans are often more significantly impacted by the unemployment rate and other economic conditions.
Consumer loans were $1.02 billion at December 31, 2012, an increase of $134.8 million, or 15.2%, from consumer loans of $884.2 million at December 31, 2011. Consumer loans increased $39.2 million, or 4.6%, during 2011 from consumer loans of $845.0 million at December 31, 2010. The increases in consumer loans during 2012 and 2011 were primarily due to the Corporation's consumer loan promotion programs, combined with an increase in demand for consumer loans. At December 31, 2012, approximately 47% of consumer loans were secured by the borrowers' personal residences (of which approximately 45% were first lien mortgages and 55% were junior lien mortgages), 25% by automobiles, 19% by recreational vehicles and 8% by marine vehicles, while the remaining 1% was mostly unsecured. Consumer loans represented 24.5% of the Corporation's loan portfolio at December 31, 2012, compared to 23.1% and 22.9% at December 31, 2011 and 2010, respectively.

32


Consumer loans generally have shorter terms than residential mortgage loans, but generally involve more credit risk than residential mortgage lending because of the type and nature of the collateral. The Corporation originates consumer loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. Consumer lending collections are dependent on the borrowers' continuing financial stability and are more likely to be affected by adverse personal situations. The unemployment rate in the State of Michigan was 8.9% at December 31, 2012, down slightly from 9.3% at December 31, 2011, and down from 11.1% at December 31, 2010, although still higher than the national average of 7.8% at December 31, 2012.
The Corporation experienced decreases in losses on consumer loans during 2012, with net loan losses totaling 50 basis points of average consumer loans, compared to 59 basis points of average consumer loans during 2011, with the decrease primarily attributable to fewer losses on the Corporation's home equity loans and lines of credit. Net losses on the Corporation's home equity loans and lines of credit totaled 36 basis points during 2012, compared to 55 basis points during 2011, while net losses on the Corporation's remaining consumer loans (direct and indirect loans secured by personal property or unsecured) totaled 62 basis points during 2012, compared to 61 basis points during 2011. The credit risk on home equity loans and lines of credit has historically been low as property values of residential real estate had historically increased year over year. However, the credit risk on home equity loans and lines of credit secured by junior liens increased during the years 2008-2010 as property values declined throughout the State of Michigan. While Michigan's economy has shown signs of improvement, an increase in property values in Michigan has been slow to follow. The majority of the Corporation's home equity lines of credit are comprised of loans with payments of interest only until their maturity. Home equity lines of credit have original maturities up to ten years. Home equity lines of credit were $190 million and comprised 19% of the Corporation's consumer loans at December 31, 2012, compared to $189 million, or 21% of the Corporation's consumer loans, at December 31, 2011.
ASSET QUALITY
Nonperforming Assets
Nonperforming assets include nonperforming loans, which consist of originated loans for which the accrual of interest has been discontinued (nonaccrual loans), originated loans that are past due as to principal or interest by 90 days or more and still accruing interest and originated loans that have been modified under troubled debt restructurings (TDRs) where a concession has been granted to the borrower due to a decline in credit quality of the loan and the borrower has not satisfied the Corporation's payment policy (as described below) to be considered performing. Nonperforming assets also include assets obtained through foreclosures and repossessions, including foreclosed and repossessed assets acquired as a result of the OAK acquisition. The Corporation transfers an originated loan that is 90 days or more past due to nonaccrual status (except for loans that are secured by residential real estate, which are transferred at 120 days past due), unless it believes the loan is both well-secured and in the process of collection. TDRs continue to be reported as nonperforming loans until a six-month payment history of principal and interest payments is sustained in accordance with the terms of the loan modification, at which time the loan is no longer considered a nonperforming asset and the Corporation moves the loan to a performing TDR status.
Nonperforming assets were $109.3 million at December 31, 2012, a decrease of $22.5 million, or 17%, from $131.8 million at December 31, 2011. Nonperforming assets also decreased $43.4 million, or 25%, during 2011 from $175.2 million at December 31, 2010. Nonperforming assets comprised 1.9%, 2.5% and 3.3% of total assets at December 31, 2012, 2011 and 2010, respectively. The decreases in nonperforming assets in 2012 and 2011 were a sign of improvement in the credit quality of the Corporation's loan portfolio and the improving economic climate in Michigan that began in 2011. However, the Corporation's levels of nonperforming assets remained elevated, compared to historical levels, due to an unfavorable economic climate that has existed for more than four years in the State of Michigan, which resulted in cash flow difficulties being encountered by many business and consumer loan customers. The Corporation's nonperforming assets are not concentrated in any one industry or any one geographical area within Michigan, other than $9.4 million in nonperforming land development loans. At December 31, 2012, there was one commercial loan relationship exceeding $2.5 million, totaling $6.2 million, that was in nonperforming status. Based on declines in both residential and commercial real estate appraised values due to the weakness in the Michigan economy over the past several years, management continues to evaluate and, when appropriate, obtain new appraisals or discount appraised values of existing appraisals to compute estimated net realizable values of nonperforming real estate secured loans and other real estate properties. While the economic climate within Michigan has shown signs of improvement, it is management's belief that nonperforming assets will remain at elevated levels during 2013.


33


Table 5 provides a five-year history of nonperforming assets, including the composition of nonperforming loans by major loan category.
TABLE 5. NONPERFORMING ASSETS
 
December 31,
 
2012
 
2011
 
2010
 
2009
 
2008
 
(Dollars in thousands)
Nonaccrual loans(1):
 
 
 
 
 
 
 
 
 
Commercial
$
14,601

 
$
10,726

 
$
16,668

 
$
19,309

 
$
16,324

Commercial real estate
37,660

 
44,438

 
60,558

 
49,419

 
27,344

Real estate construction and land development
5,401

 
6,190

 
8,967

 
15,184

 
15,310

Residential mortgage
10,164

 
12,573

 
12,083

 
15,508

 
12,175

Consumer installment and home equity
3,472

 
4,467

 
4,686

 
7,169

 
5,313

Total nonaccrual loans
71,298

 
78,394

 
102,962

 
106,589

 
76,466

Accruing loans contractually past due 90 days or more as to interest or principal payments:
 
 
 
 
 
 
 
 
 
Commercial

 
1,381

 
530

 
1,371

 
1,652

Commercial real estate
87

 
374

 
1,350

 
3,971

 
9,995

Real estate construction and land development

 
287

 
1,220

 
1,990

 
759

Residential mortgage
1,503

 
752

 
3,253

 
3,614

 
3,369

Consumer installment and home equity
769

 
1,023

 
1,055

 
787

 
1,087

Total accruing loans contractually past due 90 days or more as to interest or principal payments
2,359

 
3,817

 
7,408

 
11,733

 
16,862

Nonperforming TDRs(2):
 
 
 
 
 
 
 
 
 
Commercial loan portfolio
13,876

 
14,675

 
15,057

 

 

Consumer loan portfolio
3,321

 
9,383

 
22,302

 
17,433

 

Total nonperforming TDRs
17,197

 
24,058

 
37,359

 
17,433

 

Total nonperforming loans
90,854

 
106,269

 
147,729

 
135,755

 
93,328

Other real estate and repossessed assets(3)
18,469

 
25,484

 
27,510

 
17,540

 
19,923

Total nonperforming assets
$
109,323

 
$
131,753

 
$
175,239

 
$
153,295

 
$
113,251

Nonperforming loans as a percent of total loans
2.18
%
 
2.77
%
 
4.01
%
 
4.54
%
 
3.13
%
Nonperforming assets as a percent of total assets
1.85
%
 
2.47
%
 
3.34
%
 
3.61
%
 
2.92
%
 (1)
There was no interest income recognized on nonaccrual loans in 2012 while they were in nonaccrual status. During 2012, the Corporation recognized $1.1 million of interest income on these loans while they were in an accruing status. Additional interest income of $4.5 million would have been recorded during 2012 on nonaccrual loans had they been current in accordance with their original terms.
(2)
Interest income of $2.9 million was recorded in 2012 on TDRs.
(3)
Includes property acquired through foreclosure and by acceptance of a deed in lieu of foreclosure and other property held for sale, including properties acquired as a result of the OAK transaction.
The following schedule summarizes changes in nonaccrual loans during 2012 and 2011:
 
Years Ended December 31,
 
2012
 
2011
 
(In thousands)
Balance at beginning of period
$
78,394

 
$
102,962

Additions during period
52,265

 
65,451

Principal balances charged off
(17,169
)
 
(26,751
)
Transfers to other real estate/repossessed assets
(12,830
)
 
(15,728
)
Return to accrual status
(10,956
)
 
(23,463
)
Payments received
(18,406
)
 
(24,077
)
Balance at end of period
$
71,298

 
$
78,394


34


Nonperforming Loans
The following schedule provides the composition of nonperforming loans, by major loan category, as of December 31, 2012 and 2011.
 
December 31,
 
2012
 
2011
 
 
Amount
 
Percent
of Total
 
Amount
 
Percent
of Total
 
 
(Dollars in thousands)
Commercial loan portfolio:
 
 
 
 
 
 
 
 
Commercial
$
19,763

 
22
%
 
$
15,684

 
15
%
 
Commercial real estate
42,472

 
47

 
55,791

 
53

 
Real estate construction and land development
9,390

 
10

 
6,596

 
6

 
Subtotal — commercial loan portfolio
71,625

 
79

 
78,071

 
74

 
Consumer loan portfolio:
 
 
 
 
 
 
 
 
Residential mortgage
14,988

 
16

 
22,708

 
21

 
Consumer installment and home equity
4,241

 
5

 
5,490

 
5

 
Subtotal — consumer loan portfolio
19,229

 
21

 
28,198

 
26

 
Total nonperforming loans
$
90,854

 
100
%
 
$
106,269

 
100
%
 
Total nonperforming loans were $90.9 million at December 31, 2012, a decrease of $15.4 million, or 15%, compared to $106.3 million at December 31, 2011. The Corporation's nonperforming loans in the commercial loan portfolio were $71.6 million at December 31, 2012, a decrease of $6.5 million, or 8.3%, from $78.1 million at December 31, 2011. Nonperforming loans in the commercial loan portfolio comprised 79% of total nonperforming loans at December 31, 2012, compared to 74% at December 31, 2011. The Corporation's nonperforming loans in the consumer loan portfolio were $19.2 million at December 31, 2012, a decrease of $9.0 million, or 32%, from $28.2 million at December 31, 2011.
Nonperforming Loans — Commercial Loan Portfolio
The following schedule presents information related to stratification of nonperforming loans in the commercial loan portfolio by dollar amount at December 31, 2012 and 2011.
 
December 31,
 
2012
 
2011
 
Number of
Borrowers
 
Amount
 
Number of
Borrowers
 
Amount
 
(Dollars in thousands)
$5,000,000 or more
1
 
$
6,157

 
1
 
$
6,906

$2,500,000 - $4,999,999
 

 
2
 
5,192

$1,000,000 - $2,499,999
16
 
27,408

 
14
 
23,516

$500,000 - $999,999
21
 
14,868

 
19
 
13,565

$250,000 - $499,999
28
 
9,521

 
39
 
13,738

Under $250,000
173
 
13,671

 
177
 
15,154

Total
239
 
$
71,625

 
252
 
$
78,071

Nonperforming commercial loans were $19.8 million at December 31, 2012, an increase of $4.1 million, or 26%, from $15.7 million at December 31, 2011. Nonperforming commercial loans comprised 2.0% of total commercial loans at December 31, 2012, compared to 1.8% at December 31, 2011. The nonperforming commercial loans at December 31, 2012 were not concentrated in any single industry.
Nonperforming commercial real estate loans were $42.5 million at December 31, 2012, a decrease of $13.3 million, or 24%, from $55.8 million at December 31, 2011. Nonperforming commercial real estate loans comprised 3.7% of total commercial real estate loans at December 31, 2012, compared to 5.2% at December 31, 2011. Nonperforming commercial real estate loans secured by owner occupied real estate, non-owner occupied real estate and vacant land totaled $24.7 million, $11.3 million and $6.5 million, respectively, at December 31, 2012, and comprised 4.1%, 3.5% and 22.9%, respectively, of total owner occupied real estate, non-

35


owner occupied real estate and vacant land loans included in the Corporation's originated commercial real estate loans at December 31, 2012. At December 31, 2012, the Corporation's nonperforming commercial real estate loans were comprised of a diverse mix of commercial lines of business and were also geographically disbursed throughout the Corporation's market areas. The largest concentration of the $42.5 million in nonperforming commercial real estate loans at December 31, 2012 was one customer relationship totaling $5.7 million that was secured by a combination of vacant land and non-owner occupied commercial real estate. This same customer relationship had another $0.5 million included in nonperforming real estate construction and land development loans and $0.4 million included in nonperforming residential mortgage loans. At December 31, 2012, $4.5 million of the nonperforming commercial real estate loans were in various stages of foreclosure with 25 borrowers. Challenges remain in the Michigan economy, despite some signs of improvement, thus creating a difficult business environment for many lines of business across the state.
Nonperforming real estate construction and land development loans were $9.4 million at December 31, 2012, an increase of $2.8 million, or 42%, from $6.6 million at December 31, 2011. The increase in nonperforming real estate construction and land development loans was due primarily to one land development loan relationship totaling $2.4 million moving to nonaccrual status during 2012. Nonperforming real estate construction and land development loans comprised 9.4% of total real estate construction and land development loans at December 31, 2012, compared to 5.6% at December 31, 2011. At December 31, 2012, $8.2 million of the nonperforming real estate construction and land development loans were land development loans secured primarily by residential real estate improved lots and housing units. The $8.2 million of nonperforming land development loans represented 22% of total land development loans in the originated loan portfolio at December 31, 2012. The economy in Michigan has adversely impacted housing demand throughout the state since 2008, and accordingly, a significant percentage of the Corporation's residential real estate development borrowers have experienced cash flow difficulties associated with a significant decline in sales of both lots and residential real estate.
Nonperforming Loans — Consumer Loan Portfolio
Nonperforming residential mortgage loans were $15.0 million at December 31, 2012, a decrease of $7.7 million, or 34%, from $22.7 million at December 31, 2011. The decrease in nonperforming residential mortgage loans during 2012 was primarily attributable to TDRs moving to performing status due to the borrowers' sustained payment histories. Nonperforming residential mortgage loans comprised 1.7% of total residential mortgage loans at December 31, 2012, compared to 2.6% at December 31, 2011. At December 31, 2012, nonperforming residential mortgage loans totaling $3.2 million were in various stages of foreclosure.
Nonperforming consumer installment and home equity loans were $4.2 million at December 31, 2012, a decrease of $1.3 million, or 24%, from $5.5 million at December 31, 2011. Nonperforming consumer installment and home equity loans comprised 0.4% of total consumer installment and home equity loans at December 31, 2012, compared to 0.6% at December 31, 2011.
Troubled Debt Restructurings (TDRs)
The unfavorable economic climate in Michigan has resulted in a large number of both business and consumer customers with cash flow difficulties and thus the inability to maintain their loan balances in a performing status. The Corporation determined that it was probable that certain customers who were past due on their loans, if provided a modification of their loan by reducing their monthly payment, would be able to bring their loan relationship to a performing status. The Corporation believed these modifications would potentially result in a lower level of loan losses and loan collection costs than if the Corporation currently proceeded through the foreclosure process with these borrowers. These modifications involve granting a concession to a borrower who is experiencing financial difficulty and, therefore, meet the criteria to be considered TDRs.
The Corporation's loans reported as TDRs continue to accrue interest at the loan's original interest rate as the Corporation expects to collect the remaining principal balance of the loan. The interest income recognized on residential mortgage TDRs may include accretion of an identified impairment at the time of modification which is attributable to a temporary reduction in the borrower's interest rate. A TDR is reported as a nonperforming loan (nonperforming TDR) until a six-month payment history of principal and interest payments is sustained in accordance with the loan modification, at which time the Corporation moves the loan to a performing status (performing TDR). If a performing TDR becomes contractually past due more than 30 days, it is transferred to a nonperforming status. Accordingly, all of the Corporation's performing TDRs at December 31, 2012 were current or less than 30 days past due. The Corporation's loans reported as TDRs do not include modified loans that are already reported in a nonaccrual status. The Corporation's nonaccrual loans at December 31, 2012 and 2011 included $47.5 million and $41.8 million, respectively, of these modified loans.

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The following summarizes the Corporation's reported TDRs at December 31, 2012 and 2011:
 
 
Performing
Status
 
Nonperforming Status
 
Total
 
 
Current
 
Past Due
31-90  Days
 
Sub-
Total
 
December 31, 2012
 
(In thousands)
Commercial loan portfolio
 
$
15,789

 
$
13,361

 
$
515

 
$
13,876

 
$
29,665

Consumer loan portfolio
 
15,580

 
2,688

 
633

 
3,321