Loans and ALLL

We grant commercial, agricultural, residential real estate, and consumer loans to customers situated primarily in Clare, Gratiot, Isabella, Mecosta, Midland, Montcalm, and Saginaw counties in Michigan. The ability of the borrowers to honor their repayment obligations is often dependent upon the real estate, agricultural, manufacturing, retail, gaming, tourism, higher education, and general economic conditions of this region. Substantially all of our consumer and residential real estate loans are secured by various items of property, while commercial loans are secured primarily by real estate, business assets, and personal guarantees. Some loans are unsecured.

Loans that we have the intent and ability to hold in our portfolio are reported at their outstanding principal balance adjusted for any charge-offs, the ALLL, and any deferred fees or costs. Interest income is accrued over the term of the loan based on the principal amount outstanding. Loan origination fees and certain direct loan origination costs are capitalized and recognized as a component of interest income over the term of the loan using the level yield method.

The accrual of interest on commercial, agricultural, and residential real estate loans is discontinued at the time the loan is 90 days or more past due unless the credit is well-secured and in the process of collection. Upon transferring the loans to nonaccrual status, we perform an evaluation to determine the net realizable value of the underlying collateral. This evaluation is used to help determine if any charge-offs are necessary. Consumer loans are typically charged-off no later than 180 days past due. Past due status is based on contractual terms of the loan. In all cases, loans are placed on nonaccrual status or charged-off at an earlier date if collection of principal or interest is considered doubtful.

For loans that are placed on nonaccrual status or charged-off, all interest accrued in the current calendar year, but not collected, is reversed against interest income while interest accrued in prior calendar years, but not collected, is charged against the ALLL. Loans may be returned to accrual status after six months of continuous performance and achievement of current payment status.

Commercial and agricultural loans include loans for commercial real estate, commercial operating loans, advances to mortgage brokers, farmland and agricultural production, and states and political subdivisions. Repayment of these loans is dependent upon the successful operation and management of a business. We minimize our risk by limiting the amount of direct credit exposure to any one borrower to $15,000. Borrowers with direct credit needs of more than $15,000 are serviced through the use of loan participations with other commercial banks. Commercial and agricultural real estate loans commonly require loan-to-value limits of 80% or less. Depending upon the type of loan, past credit history, and current operating results, we may require the borrower to pledge accounts receivable, inventory, and property and equipment. Personal guarantees are generally required from the owners of closely held corporations, partnerships, and sole proprietorships. In addition, we require annual financial statements, prepare cash flow analyses, and review credit reports.

We entered into a mortgage purchase program in 2016 with a financial institution where we participate in advances to mortgage brokers ("advances"). The mortgage brokers originate residential mortgage loans with the intent to sell them on the secondary market. We participate in the advance to the mortgage broker, which is secured by the underlying mortgage loan, until it is ultimately sold on the secondary market. As such, the average life of each participated advance is approximately 20-30 days. Funds from the sale of the loan are used to pay off our participation in the advance to the mortgage broker. We classify these advances as commercial loans and include the outstanding balance in commercial loans on our balance sheet. Under the participation agreement, we committed to a maximum outstanding aggregate amount of $30,000. The difference between our outstanding balances and the maximum outstanding aggregate amount is classified as “Unfunded commitments under lines of credit” in the “Contractual Obligations and Loan Commitments” section of the Management's Discussion and Analysis of Financial Condition and Results of Operations of this report.

We offer adjustable rate mortgages, construction loans, and fixed rate residential real estate loans which have amortization periods up to a maximum of 30 years. We consider the anticipated direction of interest rates, balance sheet duration, the sensitivity of our balance sheet to changes in interest rates, and overall loan demand to determine whether or not to sell fixed rate loans to Freddie Mac.

Our lending policies generally limit the maximum loan-to-value ratio on residential real estate loans to 100% of the lower of the appraised value of the property or the purchase price. Private mortgage insurance is typically required on loans with loan-to-value ratios in excess of 80% unless the loan qualifies for government guarantees.

Underwriting criteria for originated residential real estate loans generally include:


•	Evaluation of the borrower’s ability to make monthly payments.


•	Evaluation of the value of the property securing the loan.


•	Ensuring the payment of principal, interest, taxes, and hazard insurance does not exceed 28% of a borrower’s gross income.


•	Ensuring all debt servicing does not exceed 40% of income.


•	Verification of acceptable credit reports.


•	Verification of employment, income, and financial information.

Appraisals are performed by independent appraisers and reviewed for appropriateness. All mortgage loan requests are reviewed by our mortgage loan committee or through a secondary market underwriting system; loans in excess of $500 require the approval of our Internal Loan Committee, the Executive Loan Committee, the Board of Directors’ Loan Committee, or the Board of Directors.

Consumer loans include secured and unsecured personal loans. Loans are amortized for a period of up to 15 years based on the age and value of the underlying collateral. The underwriting emphasis is on a borrower’s perceived intent and ability to pay rather than collateral value. No consumer loans are sold to the secondary market.

The ALLL is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the ALLL when we believe the uncollectability of the loan balance is confirmed. Subsequent recoveries, if any, are credited to the ALLL.

The appropriateness of the ALLL is evaluated on a quarterly basis and is based upon a periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The primary factors behind the determination of the level of the ALLL are specific allocations for impaired loans, historical loss percentages, as well as unallocated components. Specific allocations for impaired loans are primarily determined based on the difference between the loan’s outstanding balance and the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral, less cost to sell. Historical loss allocations are calculated at the loan class and segment levels based on a migration analysis of the loan portfolio, with the exception of advances to mortgage brokers, over the preceding five years. With no historical losses on advances to mortgage brokers, there is no allocation in the commercial segment displayed in the following tables based on historical loss factors. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A summary of changes in the ALLL and the recorded investment in loans by segments follows:



	Allowance for Loan Losses
	Three Months Ended March 31, 2018
	Commercial			Agricultural		Residential Real Estate			Consumer			Unallocated			Total
January 1, 2018	$	1,706		$	611	$	2,563		$	900		$	1,920		$	7,700
Charge-offs	(5		)	—		(10		)	(88		)	—			(103		)
Recoveries	103			—		56			60			—			219
Provision for loan losses	36			613		(127		)	(77		)	(61		)	384
March 31, 2018	$	1,840		$	1,224	$	2,482		$	795		$	1,859		$	8,200



	Allowance for Loan Losses and Recorded Investment in Loans
	March 31, 2018
	Commercial		Agricultural		Residential Real Estate		Consumer		Unallocated		Total
ALLL
Individually evaluated for impairment	$	842	$	141	$	1,520	$	—	$	—	$	2,503
Collectively evaluated for impairment	998		1,083		962		795		1,859		5,697
Total	$	1,840	$	1,224	$	2,482	$	795	$	1,859	$	8,200
Loans
Individually evaluated for impairment	$	11,675	$	11,468	$	7,940	$	12			$	31,095
Collectively evaluated for impairment	631,961		110,862		262,210		56,874				1,061,907
Total	$	643,636	$	122,330	$	270,150	$	56,886			$	1,093,002



	Allowance for Loan Losses
	Three Months Ended March 31, 2017
	Commercial			Agricultural			Residential Real Estate			Consumer			Unallocated		Total
January 1, 2017	$	1,814		$	884		$	2,664		$	624		$	1,414	$	7,400
Charge-offs	(27		)	—			(43		)	(74		)	—		(144		)
Recoveries	133			—			36			48			—		217
Provision for loan losses	(149		)	(357		)	441			73			19		27
March 31, 2017	$	1,771		$	527		$	3,098		$	671		$	1,433	$	7,500



	Allowance for Loan Losses and Recorded Investment in Loans
	December 31, 2017
	Commercial		Agricultural		Residential Real Estate		Consumer		Unallocated		Total
ALLL
Individually evaluated for impairment	$	650	$	—	$	1,480	$	—	$	—	$	2,130
Collectively evaluated for impairment	1,056		611		1,083		900		1,920		5,570
Total	$	1,706	$	611	$	2,563	$	900	$	1,920	$	7,700
Loans
Individually evaluated for impairment	$	8,099	$	10,598	$	7,939	$	17			$	26,653
Collectively evaluated for impairment	626,660		117,671		264,429		56,106				1,064,866
Total	$	634,759	$	128,269	$	272,368	$	56,123			$	1,091,519

The following table displays the credit quality indicators for commercial and agricultural credit exposures based on internally assigned credit risk ratings as of:



	March 31, 2018
	Commercial								Agricultural
	Real Estate		Other		Advances to Mortgage Brokers		Total		Real Estate		Other		Total		Total
Rating
1 - Excellent	$	23	$	—	$	—	$	23	$	—	$	34	$	34	$	57
2 - High quality	5,417		14,939		—		20,356		2,783		814		3,597		23,953
3 - High satisfactory	117,378		44,538		17,974		179,890		20,474		6,094		26,568		206,458
4 - Low satisfactory	337,859		84,149		—		422,008		46,040		18,066		64,106		486,114
5 - Special mention	8,615		1,562		—		10,177		9,618		5,192		14,810		24,987
6 - Substandard	5,424		2,191		—		7,615		6,435		4,887		11,322		18,937
7 - Vulnerable	2,364		1,203		—		3,567		1,529		364		1,893		5,460
8 - Doubtful	—		—		—		—		—		—		—		—
Total	$	477,080	$	148,582	$	17,974	$	643,636	$	86,879	$	35,451	$	122,330	$	765,966



	December 31, 2017
	Commercial								Agricultural
	Real Estate		Other		Advances to Mortgage Brokers		Total		Real Estate		Other		Total		Total
Rating
1 - Excellent	$	24	$	316	$	—	$	340	$	—	$	34	$	34	$	374
2 - High quality	8,402		12,262		—		20,664		2,909		1,024		3,933		24,597
3 - High satisfactory	131,826		46,668		12,081		190,575		21,072		8,867		29,939		220,514
4 - Low satisfactory	326,166		75,591		—		401,757		47,835		18,467		66,302		468,059
5 - Special mention	8,986		3,889		—		12,875		10,493		8,546		19,039		31,914
6 - Substandard	5,521		2,298		—		7,819		4,325		2,747		7,072		14,891
7 - Vulnerable	729		—		—		729		1,531		419		1,950		2,679
8 - Doubtful	—		—		—		—		—		—		—		—
Total	$	481,654	$	141,024	$	12,081	$	634,759	$	88,165	$	40,104	$	128,269	$	763,028

Internally assigned credit risk ratings are reviewed, at a minimum, when loans are renewed or when management has knowledge of improvements or deterioration of the credit quality of individual credits. Descriptions of the internally assigned credit risk ratings for commercial and agricultural loans are as follows:

1. EXCELLENT – Substantially Risk Free

Credit has strong financial condition and solid earnings history, characterized by:


•	High liquidity, strong cash flow, low leverage.


•	Unquestioned ability to meet all obligations when due.


•	Experienced management, with management succession in place.


•	Secured by cash.

2. HIGH QUALITY – Limited Risk

Credit with sound financial condition and a positive trend in earnings supplemented by:


•	Favorable liquidity and leverage ratios.


•	Ability to meet all obligations when due.


•	Management with successful track record.


•	Steady and satisfactory earnings history.


•	If loan is secured, collateral is of high quality and readily marketable.


•	Access to alternative financing.


•	Well defined primary and secondary source of repayment.


•	If supported by guaranty, the financial strength and liquidity of the guarantor(s) are clearly evident.

3. HIGH SATISFACTORY – Reasonable Risk

Credit with satisfactory financial condition and further characterized by:


•	Working capital adequate to support operations.


•	Cash flow sufficient to pay debts as scheduled.


•	Management experience and depth appear favorable.


•	Loan performing according to terms.


•	If loan is secured, collateral is acceptable and loan is fully protected.

4. LOW SATISFACTORY – Acceptable Risk

Credit with bankable risks, although some signs of weaknesses are shown:


•	Would include most start-up businesses.


•	Occasional instances of trade slowness or repayment delinquency – may have been 10-30 days slow within the past year.


•	Management’s abilities are apparent, yet unproven.


•	Weakness in primary source of repayment with adequate secondary source of repayment.


•	Loan structure generally in accordance with policy.


•	If secured, loan collateral coverage is marginal.


•	Adequate cash flow to service debt, but coverage is low.

To be classified as less than satisfactory, only one of the following criteria must be met.

5. SPECIAL MENTION – Criticized

Credit constitutes an undue and unwarranted credit risk but not to the point of justifying a classification of substandard. The credit risk may be relatively minor yet constitute an unwarranted risk in light of the circumstances surrounding a specific loan:


•	Downward trend in sales, profit levels, and margins.


•	Impaired working capital position.


•	Cash flow is strained in order to meet debt repayment.


•	Loan delinquency (30-60 days) and overdrafts may occur.


•	Shrinking equity cushion.


•	Diminishing primary source of repayment and questionable secondary source.


•	Management abilities are questionable.


•	Weak industry conditions.


•	Litigation pending against the borrower.


•	Collateral or guaranty offers limited protection.


•	Negative debt service coverage, however the credit is well collateralized and payments are current.

6. SUBSTANDARD – Classified

Credit where the borrower’s current net worth, paying capacity, and value of the collateral pledged is inadequate. There is a distinct possibility that we will implement collection procedures if the loan deficiencies are not corrected. In addition, the following characteristics may apply:


•	Sustained losses have severely eroded the equity and cash flow.


•	Deteriorating liquidity.


•	Serious management problems or internal fraud.


•	Original repayment terms liberalized.


•	Likelihood of bankruptcy.


•	Inability to access other funding sources.


•	Reliance on secondary source of repayment.


•	Litigation filed against borrower.


•	Collateral provides little or no value.


•	Requires excessive attention of the loan officer.


•	Borrower is uncooperative with loan officer.

7. VULNERABLE – Classified

Credit is considered “Substandard” and warrants placing on nonaccrual status. Risk of loss is being evaluated and exit strategy options are under review. Other characteristics that may apply:


•	Insufficient cash flow to service debt.


•	Minimal or no payments being received.


•	Limited options available to avoid the collection process.


•	Transition status, expect action will take place to collect loan without immediate progress being made.

8. DOUBTFUL – Workout

Credit has all the weaknesses inherent in a “Substandard” loan with the added characteristic that collection and/or liquidation is pending. The possibility of a loss is extremely high, but its classification as a loss is deferred until liquidation procedures are completed, or reasonably estimable. Other characteristics that may apply:


•	Normal operations are severely diminished or have ceased.


•	Seriously impaired cash flow.


•	Original repayment terms materially altered.


•	Secondary source of repayment is inadequate.


•	Survivability as a “going concern” is impossible.


•	Collection process has begun.


•	Bankruptcy petition has been filed.


•	Judgments have been filed.


•	Portion of the loan balance has been charged-off.

Our primary credit quality indicator for residential real estate and consumer loans is the individual loan’s past due aging. The following tables summarize the past due and current loans as of:



	March 31, 2018
	Accruing Interest and Past Due:								Total Past Due and Nonaccrual
	30-59 Days		60-89 Days		90 Days or More		Nonaccrual				Current		Total
Commercial
Commercial real estate	$	95	$	30	$	51	$	2,364	$	2,540	$	474,540	$	477,080
Commercial other	1,331		49		—		1,203		2,583		145,999		148,582
Advances to mortgage brokers	—		—		—		—		—		17,974		17,974
Total commercial	1,426		79		51		3,567		5,123		638,513		643,636
Agricultural
Agricultural real estate	805		804		463		1,529		3,601		83,278		86,879
Agricultural other	250		42		18		364		674		34,777		35,451
Total agricultural	1,055		846		481		1,893		4,275		118,055		122,330
Residential real estate
Senior liens	3,020		300		22		754		4,096		225,033		229,129
Junior liens	23		—		10		23		56		6,422		6,478
Home equity lines of credit	189		173		100		—		462		34,081		34,543
Total residential real estate	3,232		473		132		777		4,614		265,536		270,150
Consumer
Secured	103		—		—		—		103		52,958		53,061
Unsecured	12		—		—		—		12		3,813		3,825
Total consumer	115		—		—		—		115		56,771		56,886
Total	$	5,828	$	1,398	$	664	$	6,237	$	14,127	$	1,078,875	$	1,093,002



	December 31, 2017
	Accruing Interest and Past Due:								Total Past Due and Nonaccrual
	30-59 Days		60-89 Days		90 Days or More		Nonaccrual				Current		Total
Commercial
Commercial real estate	$	295	$	325	$	54	$	729	$	1,403	$	480,251	$	481,654
Commercial other	1,069		28		18		—		1,115		139,909		141,024
Advances to mortgage brokers	—		—		—		—		—		12,081		12,081
Total commercial	1,364		353		72		729		2,518		632,241		634,759
Agricultural
Agricultural real estate	84		190		—		1,531		1,805		86,360		88,165
Agricultural other	39		—		104		419		562		39,542		40,104
Total agricultural	123		190		104		1,950		2,367		125,902		128,269
Residential real estate
Senior liens	3,718		234		132		325		4,409		225,007		229,416
Junior liens	69		10		—		23		102		6,812		6,914
Home equity lines of credit	293		—		77		—		370		35,668		36,038
Total residential real estate	4,080		244		209		348		4,881		267,487		272,368
Consumer
Secured	37		10		10		—		57		52,005		52,062
Unsecured	13		—		—		—		13		4,048		4,061
Total consumer	50		10		10		—		70		56,053		56,123
Total	$	5,617	$	797	$	395	$	3,027	$	9,836	$	1,081,683	$	1,091,519

Impaired Loans

Loans may be classified as impaired if they meet one or more of the following criteria:


1.	There has been a charge-off of its principal balance (in whole or in part);


2.	The loan has been classified as a TDR; or


3.	The loan is in nonaccrual status.

Impairment is measured on a loan-by-loan basis for commercial and agricultural loans by comparing the loan’s outstanding balance to the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral, less cost to sell, if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Impairment is measured on a loan-by-loan basis for residential real estate and consumer loans by comparing the loan’s unpaid principal balance to the present value of expected future cash flows discounted at the loan’s effective interest rate.

We do not recognize interest income on impaired loans in nonaccrual status. For impaired loans not classified as nonaccrual, interest income is recognized daily, as earned, according to the terms of the loan agreement and the principal amount outstanding. The following is a summary of information pertaining to impaired loans as of:



	March 31, 2018						December 31, 2017
	Recorded Balance		Unpaid Principal Balance		Valuation Allowance		Recorded Balance		Unpaid Principal Balance		Valuation Allowance
Impaired loans with a valuation allowance
Commercial real estate	$	5,946	$	6,234	$	639	$	4,089	$	4,378	$	626
Commercial other	2,099		2,099		203		995		995		24
Agricultural real estate	881		881		141		—		—		—
Agricultural other	—		—		—		—		—		—
Residential real estate senior liens	7,831		8,459		1,514		7,816		8,459		1,473
Residential real estate junior liens	36		36		6		44		44		7
Total impaired loans with a valuation allowance	16,793		17,709		2,503		12,944		13,876		2,130
Impaired loans without a valuation allowance
Commercial real estate	2,466		2,540				1,791		1,865
Commercial other	1,164		1,164				1,224		1,224
Agricultural real estate	8,082		8,082				7,913		7,913
Agricultural other	2,505		2,505				2,685		2,685
Home equity lines of credit	73		373				79		379
Consumer secured	12		12				17		17
Total impaired loans without a valuation allowance	14,302		14,676				13,709		14,083
Impaired loans
Commercial	11,675		12,037		842		8,099		8,462		650
Agricultural	11,468		11,468		141		10,598		10,598		—
Residential real estate	7,940		8,868		1,520		7,939		8,882		1,480
Consumer	12		12		—		17		17		—
Total impaired loans	$	31,095	$	32,385	$	2,503	$	26,653	$	27,959	$	2,130

The following is a summary of information pertaining to impaired loans for the:



	Three Months Ended March 31
	2018				2017
	Average Recorded Balance		Interest Income Recognized		Average Recorded Balance		Interest Income Recognized
Impaired loans with a valuation allowance
Commercial real estate	$	5,018	$	91	$	5,015	$	73
Commercial other	1,547		24		1,275		24
Agricultural real estate	441		4		—		—
Agricultural other	—		—		67		—
Residential real estate senior liens	7,824		74		8,420		83
Residential real estate junior liens	40		—		75		—
Total impaired loans with a valuation allowance	14,870		193		14,852		180
Impaired loans without a valuation allowance
Commercial real estate	2,129		35		1,326		33
Commercial other	1,194		17		114		2
Agricultural real estate	7,998		40		4,042		62
Agricultural other	2,595		36		1,438		13
Home equity lines of credit	76		5		133		5
Consumer secured	15		—		25		—
Total impaired loans without a valuation allowance	14,007		133		7,078		115
Impaired loans
Commercial	9,888		167		7,730		132
Agricultural	11,034		80		5,547		75
Residential real estate	7,940		79		8,628		88
Consumer	15		—		25		—
Total impaired loans	$	28,877	$	326	$	21,930	$	295

We had committed to advance $637 and $472 in connection with impaired loans, which includes TDRs, as of March 31, 2018 and December 31, 2017, respectively.

Troubled Debt Restructurings

Loan modifications are considered to be TDRs when the modification includes terms outside of normal lending practices to a borrower who is experiencing financial difficulties.

Typical concessions granted include, but are not limited to:

•Agreeing to interest rates below prevailing market rates for debt with similar risk characteristics.

•Extending the amortization period beyond typical lending guidelines for loans with similar risk characteristics.

•Agreeing to an interest only payment structure and delaying principal payments.

•Forgiving principal.

•Forgiving accrued interest.

To determine if a borrower is experiencing financial difficulties, factors we consider include:


•	The borrower is currently in default on any of their debt.


•	The borrower would likely default on any of their debt if the concession was not granted.


•	The borrower’s cash flow was insufficient to service all of their debt if the concession was not granted.


•	The borrower has declared, or is in the process of declaring, bankruptcy.


•	The borrower is unlikely to continue as a going concern (if the entity is a business).

The following is a summary of information pertaining to TDRs granted for the:



	Three Months Ended March 31
	2018					2017
	Number of Loans	Pre-Modification Recorded Investment		Post-Modification Recorded Investment		Number of Loans	Pre-Modification Recorded Investment		Post-Modification Recorded Investment
Commercial other	3	$	1,255	$	1,255	2	$	227	$	227
Agricultural other	2	1,061		1,061		—	—		—
Residential real estate
Senior liens	2	167		167		—	—		—
Junior liens	—	—		—		1	8		8
Total residential real estate	2	167		167		1	8		8
Total	7	$	2,483	$	2,483	3	$	235	$	235

The following table summarizes concessions we granted to borrowers in financial difficulty for the:



	Three Months Ended March 31
	2018						2017
	Below Market Interest Rate			Below Market Interest Rate and Extension of Amortization Period			Below Market Interest Rate			Below Market Interest Rate and Extension of Amortization Period
	Number of Loans	Pre-Modification Recorded Investment		Number of Loans	Pre-Modification Recorded Investment		Number of Loans	Pre-Modification Recorded Investment		Number of Loans	Pre-Modification Recorded Investment
Commercial other	1	$	174	2	$	1,081	—	$	—	2	$	227
Agricultural other	1	98		1	963		—	—		—	—
Residential real estate
Senior liens	—	—		2	167		—	—		—	—
Junior liens	—	—		—	—		1	8		—	—
Total residential real estate	—	—		2	167		1	8		—	—
Total	2	$	272	5	$	2,211	1	$	8	2	$	227

We did not restructure any loans by forgiving principal or accrued interest in the three month periods ended March 31, 2018 or 2017.

Based on our historical loss experience, losses associated with TDRs are not significantly different than other impaired loans within the same loan segment. As such, TDRs, including TDRs that have been modified in the past 12 months that subsequently defaulted, are analyzed in the same manner as other impaired loans within their respective loan segment.

We had no loans that defaulted in the three month periods ended March 31, 2018 and March 31, 2017 which were modified within 12 months prior to the default date.

The following is a summary of TDR loan balances as of:



	March 31, 2018		December 31, 2017
TDRs	$	27,540	$	26,197