Edgar Filing: INDEPENDENT BANK CORP /MI/

form10q.htm

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED September 30, 2012

Commission file number 0-7818

INDEPENDENT BANK CORPORATION

(Exact name of registrant as specified in its charter)

Michigan		38-2032782
State or jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification Number)

230 West Main Street, P.O. Box 491, Ionia, Michigan 48846

(Address of principal executive offices)

(616) 527-5820

(Registrant's telephone number, including area code)

NONE

Former name, address and fiscal year, if changed since last report.

Indicate by check mark whether the registrant (1) has filed all documents and reports required to be filed by Sections 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 x NO o

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 x NO o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, non-accelerated filer or smaller reporting company.

Large accelerated filer o

Accelerated filer o

Non-accelerated filer o

Smaller reporting company x

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES o NO x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Common stock, no par value		8,907,390
Class		Outstanding at November 9, 2012

INDEPENDENT BANK CORPORATION AND SUBSIDIARIES

INDEX

		Number(s)

PART I	Financial Information
Item 1.	Condensed Consolidated Statements of Financial Condition September 30, 2012 and December 31, 2011	3
	Condensed Consolidated Statements of Operations Three- and Nine-month periods ended September 30, 2012 and 2011	4
	Condensed Consolidated Statements of Comprehensive Income (Loss)Three- and Nine-month periods ended September 30, 2012 and 2011	5
	Condensed Consolidated Statements of Cash Flows Nine-month periods ended September 30, 2012 and 2011	6
	Condensed Consolidated Statements of Shareholders' Equity Nine-month periods ended September 30, 2012 and 2011	7
	Notes to Interim Condensed Consolidated Financial Statements	8-64
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	65-97
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	98
Item 4.	Controls and Procedures	98

PART II -	Other Information
Item 1A	Risk Factors	99
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	99-100
Item 3b.	Defaults Upon Senior Securities	100
Item 6.	Exhibits	100

Discussions and statements in this report that are not statements of historical fact, including, without limitation, statements that include terms such as “will,” “may,” “should,” “believe,” “expect,” “forecast,” “anticipate,” “estimate,” “project,” “intend,” “likely,” “optimistic” and “plan,” and statements about future or projected financial and operating results, plans, projections, objectives, expectations, and intentions and other statements that are not historical facts, are forward-looking statements. Forward-looking statements include, but are not limited to, descriptions of plans and objectives for future operations, products or services; projections of our future revenue, earnings or other measures of economic performance; forecasts of credit losses and other asset quality trends; predictions as to our Bank’s ability to maintain certain regulatory capital standards; our expectation that we will have sufficient cash on hand to meet expected obligations during 2012; and descriptions of steps we may take to improve our capital position. These forward-looking statements express our current expectations, forecasts of future events, or long-term goals and, by their nature, are subject to assumptions, risks, and uncertainties. Although we believe that the expectations, forecasts, and goals reflected in these forward-looking statements are reasonable, actual results could differ materially for a variety of reasons, including, among others:

our ability to successfully raise new equity capital, effect a conversion of our outstanding convertible preferred stock held by the U.S. Treasury into our common stock, and otherwise implement our capital restoration plan;

the failure of assumptions underlying the establishment of and provisions made to our allowance for loan losses;

the timing and pace of an economic recovery in Michigan and the United States in general, including regional and local real estate markets;

the ability of our Bank to remain well-capitalized;

the failure of assumptions underlying our estimate of probable incurred losses from vehicle service contract payment plan counterparty contingencies, including our assumptions regarding future cancellations of vehicle service contracts, the value to us of collateral that may be available to recover funds due from our counterparties, and our ability to enforce the contractual obligations of our counterparties to pay amounts owing to us;

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further adverse developments in the vehicle service contract industry;

potential limitations on our ability to access and rely on wholesale funding sources;

the risk that sales of our common stock could trigger a reduction in the amount of net operating loss carryforwards that we may be able to utilize for income tax purposes;

the continued services of our management team, particularly as we work through our asset quality issues and the implementation of our capital restoration plan;

implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act or other new legislation, which may have significant effects on us and the financial services industry, the exact nature and extent of which cannot be determined at this time; and

the risk that our common stock may be delisted from the Nasdaq Global Select Market.

This list provides examples of factors that could affect the results described by forward-looking statements contained in this report, but the list is not intended to be all inclusive. The risk factors disclosed in Part I – Item A of our Annual Report on Form 10-K for the year ended December 31, 2011, as updated by any new or modified risk factors disclosed in Part II – Item 1A of any subsequently filed Quarterly Report on Form 10-Q, include all known risks that our management believes could materially affect the results described by forward-looking statements in this report. However, those risks may not be the only risks we face. Our results of operations, cash flows, financial position, and prospects could also be materially and adversely affected by additional factors that are not presently known to us, that we currently consider to be immaterial, or that develop after the date of this report. We cannot assure you that our future results will meet expectations. While we believe the forward-looking statements in this report are reasonable, you should not place undue reliance on any forward-looking statement. In addition, these statements speak only as of the date made. We do not undertake, and expressly disclaim, any obligation to update or alter any statements, whether as a result of new information, future events, or otherwise, except as required by applicable law.

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Part I - Item 1.

INDEPENDENT BANK CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Financial Condition

	September 30,		December 31,
	2012		2011
	(unaudited)
Assets	(In thousands, except share amounts)
Cash and due from banks	$	56,911	$	62,777
Interest bearing deposits		403,633		278,331
Cash and Cash Equivalents		460,544		341,108
Trading securities		38		77
Securities available for sale		230,186		157,444
Federal Home Loan Bank and Federal Reserve Bank stock, at cost		20,494		20,828
Loans held for sale, carried at fair value		41,969		44,801
Loans held for sale, carried at lower of cost or fair value		52,280		-
Loans
Commercial		603,538		651,155
Mortgage		537,107		590,876
Installment		197,736		219,559
Payment plan receivables		93,608		115,018
Total Loans		1,431,989		1,576,608
Allowance for loan losses		(48,021)		(58,884	)
Net Loans		1,383,968		1,517,724
Other real estate and repossessed assets		30,347		34,042
Property and equipment, net		47,062		62,548
Bank-owned life insurance		50,493		49,271
Other intangibles		6,793		7,609
Capitalized mortgage loan servicing rights		10,205		11,229
Prepaid FDIC deposit insurance assessment		10,229		12,609
Vehicle service contract counterparty receivables, net		18,773		29,298
Property and equipment held for sale		10,148		-
Accrued income and other assets		27,303		18,818
Total Assets	$	2,400,832	$	2,307,406
Liabilities and Shareholders' Equity
Deposits
Non-interest bearing	$	485,109	$	497,718
Savings and interest-bearing checking		853,603		1,019,603
Retail time		377,085		526,525
Brokered time		48,859		42,279
Total Deposits		1,764,656		2,086,125
Deposits held for sale relating to branch sale		405,850		-
Other borrowings		17,720		33,387
Subordinated debentures		50,175		50,175
Vehicle service contract counterparty payables		8,414		6,633
Accrued expenses and other liabilities		32,489		28,459
Total Liabilities		2,279,304		2,204,779
Shareholders' Equity
Convertible preferred stock, no par value, 200,000 shares authorized; 74,426 shares issued and outstanding at September 30, 2012 and December 31, 2011; liquidation preference: $84,099 at September 30,2012 and $81,023 at December 31, 2011		83,097		79,857
Common stock, no par value, 500,000,000 shares authorized; issued and outstanding: 8,804,415 shares at September 30, 2012 and 8,491,526 shares at December 31, 2011		250,080		248,950
Accumulated deficit		(203,217)		(214,259	)
Accumulated other comprehensive loss		(8,432)		(11,921	)
Total Shareholders' Equity		121,528		102,627
Total Liabilities and Shareholders' Equity	$	2,400,832	$	2,307,406

See notes to interim condensed consolidated financial statements (unaudited)

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INDEPENDENT BANK CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011
	(unaudited)
Interest Income	(In thousands, except per share amounts)
Interest and fees on loans	$	23,385		$	27,222		$	71,427		$	84,808
Interest on securities
Taxable		655			297			2,246			1,108
Tax-exempt		261			301			801			931
Other investments		432			367			1,210			1,185
Total Interest Income		24,733			28,187			75,684			88,032
Interest Expense
Deposits		2,223			3,230			6,952			12,686
Other borrowings		1,059			1,183			3,351			3,738
Total Interest Expense		3,282			4,413			10,303			16,424
Net Interest Income		21,451			23,774			65,381			71,608
Provision for loan losses		251			6,171			6,438			21,029
Net Interest Income After Provision for Loan Losses		21,200			17,603			58,943			50,579
Non-interest Income
Service charges on deposit accounts		4,739			4,623			13,492			13,689
Interchange income		2,324			2,356			7,053			6,832
Net gains (losses) on assets
Mortgage loans		4,602			2,025			12,041			5,753
Securities		301			(57	)		1,154			271
Other than temporary impairment loss on securities
Total impairment loss		(70	)		(4	)		(332	)		(146	)
Loss recognized in other comprehensive loss		-			-			-			-
Net impairment loss recognized in earnings		(70	)		(4	)		(332	)		(146	)
Mortgage loan servicing		(364	)		(2,655	)		(716	)		(1,885	)
Title insurance fees		482			299			1,479			1,090
(Increase) decrease in fair value of U.S. Treasury warrant		(32	)		29			(211	)		1,025
Other		2,560			2,639			8,208			7,793
Total Non-interest Income		14,542			9,255			42,168			34,422
Non-interest Expense
Compensation and employee benefits		13,610			12,654			39,598			38,032
Loan and collection		2,832			2,658			8,129			10,105
Occupancy, net		2,482			2,651			7,688			8,415
Data processing		2,492			2,502			7,281			7,227
Furniture, fixtures and equipment		1,194			1,308			3,795			4,228
Legal and professional		952			751			3,117			2,330
FDIC deposit insurance		816			885			2,489			2,772
Communications		785			863			2,486			2,700
Net losses on other real estate and repossessed assets		291			1,931			1,911			4,114
Advertising		647			740			1,842			1,964
Credit card and bank service fees		433			869			1,708			2,929
Vehicle service contract counterparty contingencies		281			1,345			1,078			5,002
Write-down of property and equipment held for sale		860			-			860			-
Provision for loss reimbursement on sold loans		193			251			751			1,020
Costs (recoveries) related to unfunded lending commitments		(538	)		(172	)		(597	)		12
Other		1,966			2,226			4,692			6,385
Total Non-interest Expense		29,296			31,462			86,828			97,235
Income (Loss) Before Income Tax		6,446			(4,604	)		14,283			(12,234	)
Income tax benefit		-			(482	)		-			(748	)
Net Income (Loss)	$	6,446		$	(4,122	)	$	14,283		$	(11,486	)
Preferred stock dividends and discount accretion		1,093			1,043			3,241			3,102
Net Income (Loss) Applicable to Common Stock	$	5,353		$	(5,165	)	$	11,042		$	(14,588	)
Net Income (Loss) Per Common Share
Basic	$	.61		$	(.61	)	$	1.28		$	(1.78	)
Diluted		.16			(.61	)		.36			(1.78	)
Dividends Per Common Share
Declared	$	.00		$	.00		$	.00		$	.00
Paid		.00			.00			.00			.00

See notes to interim condensed consolidated financial statements (unaudited)

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INDEPENDENT BANK CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Comprehensive Income (Loss)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2012			2011			2012			2011
	(unaudited)						(unaudited)
	(In thousands)						(In thousands)
Net income (loss)	$	6,446		$	(4,122	)	$	14,283		$	(11,486	)
Other comprehensive income (loss), before tax
Available for sale securities
Unrealized gain arising during period		909			357			2,543			930
Change in unrealized losses for which a portion of other than temporary impairment has been recognized in earnings		770			(220	)		1,103			191
Reclassification adjustment for other than temporary impairment included in earnings		70			4			332			146
Reclassification adjustments for (gains) included in earnings		(350	)		-			(1,193	)		(204	)
Unrealized gains recognized in other comprehensive income on available for sale securities		1,399			141			2,785			1,063

Derivative instruments
Unrealized loss arising during period		(54	)		(215	)		(129	)		(478	)
Reclassification adjustment for expense recognized in earnings		92			200			397			603
Reclassification adjustment for accretion on settled derivatives		145			145			436			514
Unrealized gains recognized in other comprehensive income on derivative instruments		183			130			704			639
Other comprehensive income, before tax		1,582			271			3,489			1,702
Income tax expense related to components of other comprehensive income (loss)		-			95			-			596
Other comprehensive income		1,582			176			3,489			1,106
Comprehensive income (loss)	$	8,028		$	(3,946	)	$	17,772		$	(10,380	)

See notes to interim condensed consolidated financial statements (unaudited)

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INDEPENDENT BANK CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

	Nine months ended September 30,
	2012		2011
	(unaudited - In thousands)
Net Income (Loss)	$	14,283	$	(11,486	)
Adjustments to Reconcile Net Income (Loss) to Net Cash from Operating Activities
Proceeds from sales of loans held for sale		378,804		270,796
Disbursements for loans held for sale		(363,931)		(243,654	)
Net decrease in loans held for sale relating to branch sale		900		-
Net decrease in deposits held for sale relating to branch sale		(11,671)		-
Provision for loan losses		6,438		21,029
Deferred loan fees		(501)		(428	)
Depreciation, amortization of intangible assets and premiums and accretion of discounts on securities and loans		(3,532)		(9,303	)
Write-down of property and equipment held for sale		860		-
Net gains on mortgage loans		(12,041)		(5,753	)
Net gains on securities		(1,154)		(271	)
Securities impairment recognized in earnings		332		146
Net losses on other real estate and repossessed assets		1,911		4,114
Vehicle service contract counterparty contingencies		1,078		5,002
Share based compensation		572		762
Increase (decrease) in accrued income and other assets		(5,434)		6,714
Increase in accrued expenses and other liabilities		3,957		1,017
Total Adjustments		(3,412)		50,171
Net Cash from Operating Activities		10,871		38,685
Cash Flow from Investing Activities
Proceeds from the sale of securities available for sale		37,176		70,322
Proceeds from the maturity of securities available for sale		66,868		2,308
Principal payments received on securities available for sale		18,214		5,524
Purchases of securities available for sale		(192,382)		(104,052	)
Redemption of Federal Home Loan Bank stock		-		2,397
Redemption of Federal Reserve Bank stock		334		228
Net decrease in portfolio loans (loans originated, net of principal payments)		75,148		150,436
Proceeds from the collection of vehicle service contract counterparty receivables		7,413		1,438
Proceeds from the sale of other real estate and repossessed assets		14,062		14,241
Capital expenditures		(3,775)		(2,124	)
Net Cash from Investing Activities		23,058		140,718
Cash Flow from (used in) Financing Activities
Net increase (decrease) in total deposits		98,836		(173,197	)
Net increase (decrease) in other borrowings		3		(3	)
Proceeds from Federal Home Loan Bank advances		12,000		19,000
Payments of Federal Home Loan Bank advances		(27,670)		(54,303	)
Net increase (decrease) in vehicle service contract counterparty payables		1,781		(1,805	)
Proceeds from issuance of common stock		557		1,335
Net Cash from (used in) Financing Activities		85,507		(208,973	)
Net Increase (Decrease) in Cash and Cash Equivalents		119,436		(29,570	)
Cash and Cash Equivalents at Beginning of Period		341,108		385,374
Cash and Cash Equivalents at End of Period	$	460,544	$	355,804
Cash paid during the period for
Interest	$	8,647	$	15,475
Income taxes		198		26
Transfers to other real estate and repossessed assets		9,110		12,971
Transfer of payment plan receivables to vehicle service contract counterparty receivables		1,225		9,239
Transfers to loans held for sale		54,127		-
Transfers to deposits held for sale		420,261		-
Transfers to fixed assets held for sale		12,611		-

See notes to interim condensed consolidated financial statements (unaudited)

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INDEPENDENT BANK CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Shareholders' Equity

	Nine months ended
	September 30,
	2012		2011
	(unaudited)
	(In thousands)
Balance at beginning of period	$	102,627	$	119,085
Net income (loss)		14,283		(11,486	)
Issuance of common stock		557		1,335
Share based compensation		572		762
Net change in accumulated other comprehensive loss, net of related tax effect		3,489		1,106
Balance at end of period	$	121,528	$	110,802

See notes to interim condensed consolidated financial statements (unaudited)

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NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Preparation of Financial Statements

The interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to those rules and regulations, although we believe that the disclosures made are adequate to make the information not misleading. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes for the year ended December 31, 2011 included in our Annual Report on Form 10-K.

In our opinion, the accompanying unaudited condensed consolidated financial statements contain all the adjustments necessary to present fairly our consolidated financial condition as of September 30, 2012 and December 31, 2011, and the results of operations for the three and nine-month periods ended September 30, 2012 and 2011. The results of operations for the three and nine-month periods ended September 30, 2012, are not necessarily indicative of the results to be expected for the full year. Certain reclassifications have been made in the prior period financial statements to conform to the current period presentation. Our critical accounting policies include the assessment for other than temporary impairment (“OTTI”) on investment securities, the determination of the allowance for loan losses, the determination of vehicle service contract counterparty contingencies, the valuation of originated mortgage loan servicing rights and the valuation of deferred tax assets. Refer to our 2011 Annual Report on Form 10-K for a disclosure of our accounting policies.

2. New Accounting Standards

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-04, “Fair Value Measurement (Topic 820), Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs”. This ASU amended guidance that will result in common fair value measurement and disclosure requirements between U.S. GAAP and International Financial Reporting Standards (“IFRS”). Under the amended guidance, entities are required to expand disclosure for fair value instruments categorized within Level 3 of the fair value hierarchy to include (1) the valuation processes used; and (2) a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs for recurring fair value measurements and the interrelationships between those unobservable inputs, if any. They are also required to disclose the categorization by level of the fair value hierarchy for items that are not measured at fair value in the Consolidated Statement of Financial Condition but for which the fair value is required to be disclosed (e.g. portfolio loans). This amended guidance became effective for us at January 1, 2012. The effect of adopting this standard did not have a material impact on our consolidated operating results or financial condition, but the additional disclosures are included in Notes #12 and #13.

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NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220)”. This ASU amended guidance on the presentation requirements for comprehensive income. The amended guidance requires an entity to present total comprehensive income, the components of net income and the components of other comprehensive income on the face of the financial statements, either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The amended guidance did not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. This amended guidance became effective for us at January 1, 2012 and was applied retrospectively. The effect of adopting this standard did not have a material impact on our consolidated operating results or financial condition, but we have included separate Condensed Consolidated Statements of Comprehensive Income (Loss) immediately following our Condensed Consolidated Statements of Operations in our Condensed Consolidated Financial Statements.

3. Securities

Securities available for sale consist of the following:

	Amortized		Unrealized
	Cost		Gains		Losses		Fair Value
	(In thousands)
September 30, 2012
U.S. agency	$	45,615	$	77	$	55	$	45,637
U.S. agency residential mortgage-backed		131,427		1,204		11		132,620
Private label residential mortgage-backed		9,503		-		1,201		8,302
Obligations of states and political subdivisions		39,733		699		71		40,361
Trust preferred		4,702		-		1,436		3,266
Total	$	230,980	$	1,980	$	2,774	$	230,186

December 31, 2011
U.S. agency	$	24,980	$	58	$	21	$	25,017
U.S. agency residential mortgage-backed		93,415		1,007		216		94,206
Private label residential mortgage-backed		11,066		-		2,798		8,268
Obligations of states and political subdivisions		26,865		510		58		27,317
Trust preferred		4,697		-		2,061		2,636
Total	$	161,023	$	1,575	$	5,154	$	157,444

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NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Our investments’ gross unrealized losses and fair values aggregated by investment type and length of time that individual securities have been at a continuous unrealized loss position follows:

	Less Than Twelve Months				Twelve Months or More				Total
			Unrealized				Unrealized				Unrealized
	Fair Value		Losses		Fair Value		Losses		Fair Value		Losses
	(In thousands)

September 30, 2012
U.S. agency	$	13,065	$	55	$	-	$	-	$	13,065	$	55
U.S. agency residential mortgage-backed		2,653		1		10,264		10		12,917		11
Private label residential mortgage-backed						8,300		1,201		8,300		1,201
Obligations of states and political subdivisions		7,387		71						7,387		71
Trust preferred						3,266		1,436		3,266		1,436
Total	$	23,105	$	127	$	21,830	$	2,647	$	44,935	$	2,774

December 31, 2011
U.S. agency	$	9,974	$	21	$	-	$	-	$	9,974	$	21
U.S. agency residential mortgage-backed		42,500		216		-		-		42,500		216
Private label residential mortgage-backed		163		90		8,102		2,708		8,265		2,798
Obligations of states and political subdivisions		-		-		1,729		58		1,729		58
Trust preferred		591		1,218		2,045		843		2,636		2,061
Total	$	53,228	$	1,545	$	11,876	$	3,609	$	65,104	$	5,154

Our portfolio of available-for-sale securities is reviewed quarterly for impairment in value. In performing this review management considers (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) the impact of changes in market interest rates on the market value of the security and (4) an assessment of whether we intend to sell, or it is more likely than not that we will be required to sell a security in an unrealized loss position before recovery of its amortized cost basis. For securities that do not meet the aforementioned recovery criteria, the amount of impairment recognized in earnings is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income or loss.

U.S. agency and U.S. agency residential mortgage-backed securities — at September 30, 2012 we had three U.S. agency and three U.S. agency residential mortgage-backed securities whose fair market value is less than amortized cost. The U.S. Agency securities were purchased on September 28, 2012 and the impairment is primarily attributed to bid-offer spread. As management does not intend to liquidate these securities and it is more likely than not that we will not be required to sell these securities prior to recovery of these unrealized losses, no declines are deemed to be other than temporary.

Private label residential mortgage backed securities — at September 30, 2012 we had eight securities whose fair value is less than amortized cost. Two of the issues are rated by a major rating agency as investment grade while four are below investment grade and two are split rated. Four of these bonds have impairment in excess of 10% and all of these holdings have been impaired for more than 12 months.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

The unrealized losses are largely attributable to credit spread widening on these securities since their acquisition. Prices for these bonds did improve notably during the third quarter of 2012, due in part to the Federal Reserve Bank’s recent announcement of a third round of quantitative easing and improving fundamentals in the housing market. The underlying loans within these securities include Jumbo (74%) and Alt A (26%) at September 30, 2012.

	September 30, 2012					December 31, 2011
			Net					Net
	Fair		Unrealized			Fair		Unrealized
	Value		Gain (Loss)			Value		Gain (Loss)
	(In thousands)

Private label residential mortgage-backed
Jumbo	$	6,128	$	(879	)	$	6,454	$	(1,937	)
Alt-A		2,174		(322	)		1,814		(861	)

Seven of the private label residential mortgage-backed transactions have geographic concentrations in California, ranging from 22% to 58% of the collateral pool. Typical exposure levels to California (median exposure is 47%) are consistent with overall market collateral characteristics. Three transactions have modest exposure to Florida, ranging from 5% to 7% and one transaction has modest exposure to Nevada (5%). The underlying collateral pools do not have meaningful exposure to Arizona, Michigan or Ohio. None of the issues involve subprime mortgage collateral. Thus the impact of this market segment is only indirect, in that it has impacted liquidity and pricing in general for private label residential mortgage-backed securities. The majority of transactions are backed by fully amortizing loans. However, six transactions have concentrations in loans that pay interest only for a specified period of time and will fully amortize thereafter ranging from 31% to 94% (at origination date). The structure of the residential mortgage securities portfolio provides protection to credit losses. The portfolio primarily consists of senior securities as demonstrated by the following: super senior (22%), senior (43%), senior support (25%) and mezzanine (10%). The mezzanine class is from a seasoned transaction (97 months) with a significant level of subordination (8.69%). Except for the additional discussion below relating to other than temporary impairment, each private label residential mortgage-backed security has sufficient credit enhancement via subordination to reasonably assure full realization of book value. This assertion is based on a transaction level review of the portfolio.

Individual security reviews include: external credit ratings, forecasted weighted average life, recent prepayment speeds, underwriting characteristics of the underlying collateral, the structure of the securitization and the credit performance of the underlying collateral. The review of underwriting characteristics considers: average loan size, type of loan (fixed or ARM), vintage, rate, FICO, loan-to-value, scheduled amortization, occupancy, purpose, geographic mix and loan documentation. The review of the securitization structure focuses on the priority of cash flows to the bond, the priority of the bond relative to the realization of credit losses and the level of subordination available to absorb credit losses. The review of credit performance includes: current period as well as cumulative realized losses; the level of severe payment problems, which includes other real estate (ORE), foreclosures, bankruptcy and 90 day delinquencies; and the level of less severe payment problems, which consists of 30 and 60 day delinquencies.

All of these securities are receiving some principal and interest payments. Most of these transactions are passthrough structures, receiving pro rata principal and interest payments from a dedicated collateral pool for loans that are performing. The nonreceipt of interest cash flows is not expected and thus not presently considered in our discounted cash flow methodology discussed below.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

In addition to the review discussed above, all private label residential mortgage-backed securities are reviewed for OTTI utilizing a cash flow projection. The cash flow analysis forecasts cash flow from the underlying loans in each transaction and then applies these cash flows to the bonds in the securitization. The cash flows from the underlying loans considers contractual payment terms (scheduled amortization), prepayments, defaults and severity of loss given default. The analysis uses dynamic assumptions for prepayments, defaults and loss severity. Near term prepayment assumptions are based on recently observed prepayment rates. More weight is given to longer term historic performance (12 months). In some cases, recently observed prepayment rates are lower than historic norms due to the absence of new jumbo loan issuances. This loan market is heavily dependent upon securitization for funding, and new securitization transactions have been minimal. Our model projections anticipate that prepayment rates gradually revert to historical levels. For seasoned ARM transactions, normalized prepayment rates range from 12% to 18% CPR which is at the lower end of historically observed speeds for seasoned ARM collateral. For fixed rate collateral (one transaction), the prepayment speeds are projected to rise modestly.

Default assumptions are largely based on the volume of existing real-estate owned, pending foreclosures and severe delinquencies. Other considerations include the quality of loan underwriting, recent default experience, realized loss performance and the volume of less severe delinquencies. Default levels generally are projected to remain elevated or increase for a period of time sufficient to address the level of distressed loans in the transaction. Our projections expect defaults to then decline, generally beginning in year three. Current loss severity assumptions are based on recent observations when meaningful data is available. Loss severity is expected to remain elevated for the next three years. Severity is expected to decline beginning in year four as the back log of foreclosure and distressed sales clear the market. Except for three securities discussed in further detail below (all three are currently below investment grade), our cash flow analysis forecasts complete recovery of our cost basis for each reviewed security.

At September 30, 2012 three below investment grade private label residential mortgage-backed securities with fair values of $3.6 million, $1.9 million and $0.1 million, respectively and unrealized losses of $0.4 million, $0.1 million and $0.03 million, respectively (amortized cost of $4.0 million, $2.0 million and $0.1 million, respectively) had losses that were considered other than temporary.

The underlying loans in the first transaction are 30 year fixed rate jumbos with an average FICO of 744 and an average loan-to-value ratio of 72%. The loans backing this transaction were originated in 2007 and this is our only security backed by 2007 vintage loans. We believe that this vintage is a key differentiating factor between this security and the others in our portfolio that do not have unrealized losses that are considered OTTI. The bond is a senior security that is receiving principal and interest payments similar to principal reductions in the underlying collateral. The cash flow analysis described above calculated $0.715 million of cumulative credit related OTTI as of September 30, 2012 on this security. $0.070 million and $0.004 million of this credit related OTTI was recognized in our Condensed Consolidated Statements of Operations during the three months ended September 30, 2012 and 2011, respectively and $0.240 million and $0.056 million of this credit related OTTI was recognized during the nine months ended September 30, 2012 and 2011, respectively, with the balance being recognized in previous periods. The remaining non-credit related unrealized loss was attributed to other factors and is reflected in other comprehensive income (loss) during those same periods.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

The underlying loans in the second transaction are 30 year hybrid ARM Alt-A with an average FICO of 717 and an average loan-to-value ratio of 78%. The loans backing this transaction were originated in 2005. The bond is a super senior security that is receiving principal and interest payments similar to principal reductions in the underlying collateral. The cash flow analysis described above calculated $0.457 million of cumulative credit related OTTI as of September 30, 2012 on this security. There was no credit related OTTI recognized in our Condensed Consolidated Statements of Operations during the three months ended September 30, 2012 and 2011 while $0.032 million and zero of this credit related OTTI was recognized during the nine months ended September 30, 2012 and 2011, respectively, with the balance being recognized in previous periods. The remaining non-credit related unrealized loss was attributed to other factors and is reflected in other comprehensive income (loss) during those same periods.

The underlying loans in the third transaction are 30 year hybrid ARM jumbos with an average FICO of 738 and an average loan-to-value ratio of 57%. The loans backing this transaction were originated in 2005. The bond is a senior support security that is receiving principal and interest payments similar to principal reductions in the underlying collateral. The cash flow analysis described above calculated $0.380 million of cumulative credit related OTTI as of September 30, 2012 on this security. There was no credit related OTTI recognized in our Condensed Consolidated Statements of Operations during the three months ended September 30, 2012 and 2011, while $0.060 million and $0.090 million of this credit related OTTI was recognized during the nine months ended September 30, 2012 and 2011, respectively, with the balance being recognized in previous periods. The remaining non-credit related unrealized loss was attributed to other factors and is reflected in other comprehensive income (loss) during those same periods.

As management does not intend to liquidate these securities and it is more likely than not that we will not be required to sell these securities prior to recovery of these unrealized losses, no other declines discussed above are deemed to be other than temporary.

Obligations of states and political subdivisions — at September 30, 2012 we had seven municipal securities whose fair value is less than amortized cost. The unrealized losses are largely attributed to widening of market spreads. Six of the impaired securities are rated by a major rating agency as investment grade. The non rated security has a periodic internal credit review according to established procedures. As management does not intend to liquidate these securities and it is more likely than not that we will not be required to sell these securities prior to recovery of these unrealized losses, no declines are deemed to be other than temporary.

Trust preferred securities — at September 30, 2012 we had four securities whose fair value is less than amortized cost. All of our trust preferred securities are single issue securities issued by a trust subsidiary of a bank holding company. The pricing of trust preferred securities over the past several years has suffered from credit spread widening fueled by uncertainty regarding potential losses of financial companies and the absence of a liquid functioning secondary market.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

One of the four securities is rated by two major rating agencies as investment grade, while one is rated below investment grade by two major rating agencies and the other two are non-rated. The non-rated issues are relatively small banks and were never rated. The issuers of these non-rated trust preferred securities, which had a total amortized cost of $2.8 million and total fair value of $1.8 million as of September 30, 2012, continue to have satisfactory credit metrics and one continues to make interest payments. One non-rated issue began deferring dividend payments in the third quarter of 2011 apparently due to an increase in non-performing assets. Nevertheless, this issuer continues to have satisfactory capital measures and interim profitability.

The following table breaks out our trust preferred securities in further detail as of September 30, 2012 and December 31, 2011:

	September 30, 2012					December 31, 2011
			Net					Net
	Fair		Unrealized			Fair		Unrealized
	Value		Gain (Loss)			Value		Gain (Loss)
	(In thousands)

Trust preferred securities
Rated issues	$	1,474	$	(421	)	$	1,405	$	(484	)
Unrated issues - no OTTI		1,792		(1,015	)		1,231		(1,577	)

We recorded credit related OTTI charges in earnings on securities available for sale of $0.070 million and $0.004 during the three month periods ended September 30, 2012 and 2011, respectively and $0.332 million and $0.146 million during the nine month periods ended September 30, 2012 and 2011, respectively (see discussion above).

A roll forward of credit losses recognized in earnings on securities available for sale for the three and nine month periods ended September 30, follows:

	Three months ended				Nine months ended
	September 30,				September 30,
	2012		2011		2012		2011
	(In thousands)
Balance at beginning of period	$	1,732	$	852	$	1,470	$	710
Additions to credit losses on securities for which no previous OTTI was recognized		-		-		-		-
Increases to credit losses on securities for which OTTI was previously recognized		70		4		332		146
Balance at end of period	$	1,802	$	856	$	1,802	$	856

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

The amortized cost and fair value of securities available for sale at September 30, 2012, by contractual maturity, follow. The actual maturity may differ from the contractual maturity because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Amortized		Fair
	Cost		Value
	(In thousands)
Maturing within one year	$	1,620	$	1,633
Maturing after one year but within five years		6,604		6,818
Maturing after five years but within ten years		25,922		26,106
Maturing after ten years		55,904		54,707
		90,050		89,264
U.S. agency residential mortgage-backed		131,427		132,620
Private label residential mortgage-backed		9,503		8,302
Total	$	230,980	$	230,186

Gains and losses realized on the sale of securities available for sale are determined using the specific identification method and are recognized on a trade-date basis. A summary of proceeds from the sale of securities available for sale and gains and losses for the nine month periods ended September 30, follows:

			Realized
	Proceeds		Gains		Losses(1)
	(In thousands)
2012	$	37,176	$	1,193	$	-
2011		70,322		279		75

(1)	Losses in 2012 and 2011 exclude $0.332 million and $0.146 million, respectively of credit related OTTI recognized in earnings.

During 2012 and 2011 our trading securities consisted of various preferred stocks. During the first nine months of 2012 and 2011 we recognized gains (losses) on trading securities of ($0.039) million and $0.067 million, respectively, that are included in net gains (losses) on securities in the Condensed Consolidated Statements of Operations. Both of these amounts, relate to gains (losses) recognized on trading securities still held at each respective period end.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

4. Loans

Our assessment of the allowance for loan losses is based on an evaluation of the loan portfolio, recent loss experience, current economic conditions and other pertinent factors.

An analysis of the allowance for loan losses by portfolio segment for the three months ended September 30, follows:

										Payment
										Plan
	Commercial			Mortgage			Installment			Receivables			Unallocated			Total
	(In thousands)
2012
Balance at beginning of period	$	15,476		$	21,271		$	4,981		$	195		$	9,423		$	51,346
Additions (deductions)
Provision for loan losses		18			1,839			(849	)		(17	)		(740	)		251
Recoveries credited to allowance		782			303			287			-			-			1,372
Loans charged against the allowance		(2,619	)		(1,720	)		(793	)		13			-			(5,119	)
Reclassification to loans held for sale		16			136			133			-			(114	)		171
Balance at end of period	$	13,673		$	21,829		$	3,759		$	191		$	8,569		$	48,021

2011
Balance at beginning of period	$	17,697		$	23,152		$	6,289		$	346		$	13,035		$	60,519
Additions (deductions)
Provision for loan losses		3,335			2,642			693			6			(505	)		6,171
Recoveries credited to allowance		229			247			421			1			-			898
Loans charged against the allowance		(4,330	)		(3,254	)		(1,131	)		(53	)		-			(8,768	)
Balance at end of period	$	16,931		$	22,787		$	6,272		$	300		$	12,530		$	58,820

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

An analysis of the allowance for loan losses by portfolio segment for the nine months ended September 30, follows:

										Payment
										Plan
	Commercial			Mortgage			Installment			Receivables			Unallocated			Total
	(In thousands)
2012
Balance at beginning of period	$	18,183		$	22,885		$	6,146		$	197		$	11,473		$	58,884
Additions (deductions)
Provision for loan losses		2,708			6,644			(331	)		6			(2,589	)		6,438
Recoveries credited to allowance		2,178			1,423			1,002			-			-			4,603
Loans charged against the allowance		(9,242	)		(9,067	)		(2,973	)		(12	)		-			(21,294	)
Reclassification to loans held for sale		(154	)		(56	)		(85	)		-			(315	)		(610	)
Balance at end of period	$	13,673		$	21,829		$	3,759		$	191		$	8,569		$	48,021

2011
Balance at beginning of period	$	23,836		$	22,642		$	6,769		$	389		$	14,279		$	67,915
Additions (deductions)
Provision for loan losses		9,378			10,975			2,374			51			(1,749	)		21,029
Recoveries credited to allowance		960			987			1,128			5			-			3,080
Loans charged against the allowance		(17,243	)		(11,817	)		(3,999	)		(145	)		-			(33,204	)
Balance at end of period	$	16,931		$	22,787		$	6,272		$	300		$	12,530		$	58,820

During the third quarter of 2012 we implemented a refinement in the calculation methodology for the historical loss component of our allowance for loan losses relating to homogenous mortgage and installment loan groups. This refinement now uses borrower credit scores and portfolio segment as well as a migration analysis to estimate a probability of default. For homogenous mortgage and installment loans a probability of default for each homogenous pool is calculated by way of credit score migration. Historical loss data for each homogenous pool coupled with the associated probability of default is utilized to calculate an expected loss allocation rate.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Allowance for loan losses and recorded investment in loans by portfolio segment follows:

							Payment
							Plan
	Commercial		Mortgage		Installment		Receivables		Unallocated		Total
	(In thousands)
September 30, 2012
Allowance for loan losses:
Individually evaluated for impairment	$	8,368	$	13,094	$	1,597	$	-	$	-	$	23,059
Collectively evaluated for impairment		5,305		8,735		2,162		191		8,569		24,962
Total ending allowance balance	$	13,673	$	21,829	$	3,759	$	191	$	8,569	$	48,021

Loans
Individually evaluated for impairment	$	63,711	$	90,580	$	7,505	$	-			$	161,796
Collectively evaluated for impairment		541,588		449,084		191,011		93,608				1,275,291
Total loans recorded investment		605,299		539,664		198,516		93,608				1,437,087
Accrued interest included in recorded investment		1,761		2,557		780		-				5,098
Total loans	$	603,538	$	537,107	$	197,736	$	93,608			$	1,431,989

December 31, 2011
Allowance for loan losses:
Individually evaluated for impairment	$	10,252	$	10,285	$	1,762	$	-	$	-	$	22,299
Collectively evaluated for impairment		7,931		12,600		4,384		197		11,473		36,585
Total ending allowance balance	$	18,183	$	22,885	$	6,146	$	197	$	11,473	$	58,884

Loans
Individually evaluated for impairment	$	58,674	$	93,702	$	7,554	$	-			$	159,930
Collectively evaluated for impairment		594,665		499,919		212,907		115,018				1,422,509
Total loans recorded investment		653,339		593,621		220,461		115,018				1,582,439
Accrued interest included in recorded investment		2,184		2,745		902		-				5,831
Total loans	$	651,155	$	590,876	$	219,559	$	115,018			$	1,576,608

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Loans on non-accrual status and past due more than 90 days (“Non-performing Loans”) follow:

	90+ and				Total Non-
	Still		Non-		Performing
	Accruing		Accrual		Loans
	(In thousands)
September 30, 2012
Commercial
Income producing - real estate	$	-	$	7,742	$	7,742
Land, land development and construction - real estate		-		4,598		4,598
Commercial and industrial		3		7,174		7,177
Mortgage
1-4 family		59		10,498		10,557
Resort lending		-		4,713		4,713
Home equity line of credit - 1st lien		-		607		607
Home equity line of credit - 2nd lien		-		709		709
Installment
Home equity installment - 1st lien		-		1,045		1,045
Home equity installment - 2nd lien		-		837		837
Loans not secured by real estate		-		648		648
Other		-		1		1
Payment plan receivables
Full refund		-		102		102
Partial refund		-		98		98
Other		-		13		13
Total recorded investment	$	62	$	38,785	$	38,847
Accrued interest included in recorded investment	$	-	$	-	$	-
December 31, 2011
Commercial
Income producing - real estate	$	490	$	13,788	$	14,278
Land, land development and construction - real estate		43		6,990		7,033
Commercial and industrial		-		7,984		7,984
Mortgage
1-4 family		54		15,929		15,983
Resort lending		-		8,819		8,819
Home equity line of credit - 1st lien		-		523		523
Home equity line of credit - 2nd lien		-		889		889
Installment
Home equity installment - 1st lien		-		1,542		1,542
Home equity installment - 2nd lien		-		1,023		1,023
Loans not secured by real estate		-		880		880
Other		-		4		4
Payment plan receivables
Full refund		-		491		491
Partial refund		-		424		424
Other		-		23		23
Total recorded investment	$	587	$	59,309	$	59,896
Accrued interest included in recorded investment	$	13	$	-	$	13

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

An aging analysis of loans by class follows:

	Loans Past Due								Loans not		Total
	30-59 days		60-89 days		90+ days		Total		Past Due		Loans
	(In thousands)
September 30, 2012
Commercial
Income producing - real estate	$	3,543	$	441	$	4,606	$	8,590	$	205,666	$	214,256
Land, land development and construction - real estate		301		1,871		1,090		3,262		40,310		43,572
Commercial and industrial		1,292		495		3,451		5,238		342,233		347,471
Mortgage
1-4 family		3,532		1,343		10,557		15,432		282,731		298,163
Resort lending		206		154		4,713		5,073		169,633		174,706
Home equity line of credit - 1st lien		271		-		607		878		18,811		19,689
Home equity line of credit - 2nd lien		602		90		709		1,401		45,705		47,106
Installment
Home equity installment - 1st lien		767		235		1,045		2,047		31,545		33,592
Home equity installment - 2nd lien		239		139		837		1,215		40,739		41,954
Loans not secured by real estate		862		204		648		1,714		118,514		120,228
Other		18		8		1		27		2,715		2,742
Payment plan receivables
Full refund		2,272		620		102		2,994		82,868		85,862
Partial refund		178		94		98		370		7,089		7,459
Other		12		7		13		32		255		287
Total recorded investment	$	14,095	$	5,701	$	28,477	$	48,273	$	1,388,814	$	1,437,087
Accrued interest included in recorded investment	$	117	$	48	$	-	$	165	$	4,933	$	5,098

December 31, 2011
Commercial
Income producing - real estate	$	1,701	$	937	$	6,408	$	9,046	$	264,620	$	273,666
Land, land development and construction - real estate		487		66		2,720		3,273		51,453		54,726
Commercial and industrial		1,861		1,132		3,516		6,509		318,438		324,947
Mortgage
1-4 family		3,507		1,418		15,983		20,908		294,771		315,679
Resort lending		2,129		932		8,819		11,880		184,943		196,823
Home equity line of credit - 1st lien		96		196		523		815		24,705		25,520
Home equity line of credit - 2nd lien		506		159		889		1,554		54,045		55,599
Installment
Home equity installment - 1st lien		757		264		1,542		2,563		41,239		43,802
Home equity installment - 2nd lien		676		365		1,023		2,064		51,224		53,288
Loans not secured by real estate		1,173		463		880		2,516		117,661		120,177
Other		36		10		4		50		3,144		3,194
Payment plan receivables
Full refund		2,943		951		491		4,385		99,284		103,669
Partial refund		380		200		424		1,004		9,918		10,922
Other		23		24		23		70		357		427
Total recorded investment	$	16,275	$	7,117	$	43,245	$	66,637	$	1,515,802	$	1,582,439
Accrued interest included in recorded investment	$	160	$	105	$	13	$	278	$	5,553	$	5,831

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Impaired loans are as follows :

	September 30,		December 31,
	2012		2011
Impaired loans with no allocated allowance	(In thousands)
TDR	$	26,094	$	26,945
Non - TDR		417		423
Impaired loans with an allocated allowance
TDR - allowance based on collateral		18,071		20,142
TDR - allowance based on present value cash flow		108,312		98,130
Non - TDR - allowance based on collateral		8,361		13,773
Non - TDR - allowance based on present value cash flow		-		-
Total impaired loans	$	161,255	$	159,413

Amount of allowance for loan losses allocated
TDR - allowance based on collateral	$	5,370	$	6,004
TDR - allowance based on present value cash flow		15,246		12,048
Non - TDR - allowance based on collateral		2,443		4,247
Non - TDR - allowance based on present value cash flow		-		-
Total amount of allowance for loan losses allocated	$	23,059	$	22,299

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Impaired loans by class are as follows (1):

	September 30, 2012						December 31, 2011
			Unpaid						Unpaid
	Recorded		Principal		Related		Recorded		Principal		Related
	Investment		Balance		Allowance		Investment		Balance		Allowance
With no related allowance recorded:	(In thousands)
Commercial
Income producing - real estate	$	1,806	$	2,672	$	-	$	4,626	$	6,386	$	-
Land, land development & construction-real estate		3,468		3,456		-		219		243		-
Commercial and industrial		3,634		4,144		-		3,593		3,677		-
Mortgage
1-4 family		6,891		9,079		-		6,975		9,242		-
Resort lending		5,933		6,386		-		7,156		7,680		-
Home equity line of credit - 1st lien		15		32		-		-		-		-
Home equity line of credit - 2nd lien		44		118		-		134		211		-
Installment
Home equity installment - 1st lien		2,026		2,201		-		2,100		2,196		-
Home equity installment - 2nd lien		2,226		2,225		-		1,987		1,987		-
Loans not secured by real estate		550		622		-		637		688		-
Other		22		21		-		24		24		-
		26,615		30,956		-		27,451		32,334		-
With an allowance recorded:
Commercial
Income producing - real estate		25,530		28,980		2,813		22,781		29,400		3,642
Land, land development & construction-real estate		9,367		11,847		2,279		12,362		14,055		3,633
Commercial and industrial		19,906		23,882		3,276		15,093		18,357		2,977
Mortgage
1-4 family		59,389		61,071		8,868		61,214		63,464		7,716
Resort lending		18,261		18,500		4,195		18,159		19,351		2,534
Home equity line of credit - 1st lien		47		46		31		64		73		35
Home equity line of credit - 2nd lien		-		-		-		-		-		-
Installment
Home equity installment - 1st lien		1,298		1,348		639		1,232		1,293		660
Home equity installment - 2nd lien		1,108		1,119		877		1,421		1,458		1,062
Loans not secured by real estate		275		284		81		153		156		40
Other		-		-		-		-		-		-
		135,181		147,077		23,059		132,479		147,607		22,299
Total
Commercial
Income producing - real estate		27,336		31,652		2,813		27,407		35,786		3,642
Land, land development & construction-real estate		12,835		15,303		2,279		12,581		14,298		3,633
Commercial and industrial		23,540		28,026		3,276		18,686		22,034		2,977
Mortgage
1-4 family		66,280		70,150		8,868		68,189		72,706		7,716
Resort lending		24,194		24,886		4,195		25,315		27,031		2,534
Home equity line of credit - 1st lien		62		78		31		64		73		35
Home equity line of credit - 2nd lien		44		118		-		134		211		-
Installment
Home equity installment - 1st lien		3,324		3,549		639		3,332		3,489		660
Home equity installment - 2nd lien		3,334		3,344		877		3,408		3,445		1,062
Loans not secured by real estate		825		906		81		790		844		40
Other		22		21		-		24		24		-
Total	$	161,796	$	178,033	$	23,059	$	159,930	$	179,941	$	22,299

Accrued interest included in recorded investment	$	541					$	517

(1)	There were no impaired payment plan receivables at September 30, 2012 or December 31, 2011.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Average recorded investment in and interest income earned on impaired loans by class for the three month periods ended September 30, follows:

	2012				2011
	Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized
With no related allowance recorded:	(In thousands)
Commercial
Income producing - real estate	$	1,827	$	15	$	2,214	$	65
Land, land development & construction-real estate		3,131		61		188		13
Commercial and industrial		3,483		58		1,711		83
Mortgage
1-4 family		7,271		80		9,042		82
Resort lending		5,923		52		8,877		99
Home equity line of credit - 1st lien		19		-		-		-
Home equity line of credit - 2nd lien		45		-		124		-
Installment
Home equity installment - 1st lien		2,063		20		2,053		24
Home equity installment - 2nd lien		2,233		29		2,133		24
Loans not secured by real estate		540		8		737		11
Other		22		1		26		-
		26,557		324		27,105		401
With an allowance recorded:
Commercial
Income producing - real estate		26,233		207		19,789		30
Land, land development & construction-real estate		9,785		31		7,356		(9	)
Commercial and industrial		20,749		136		10,445		(49	)
Mortgage
1-4 family		59,322		626		61,934		668
Resort lending		18,411		212		18,522		109
Home equity line of credit - 1st lien		47		1		47		-
Home equity line of credit - 2nd lien		-		-		10		-
Installment
Home equity installment - 1st lien		1,348		11		1,421		14
Home equity installment - 2nd lien		1,130		13		1,421		16
Loans not secured by real estate		277		2		131		2
Other		-		-		-		-
		137,302		1,239		121,076		781
Total
Commercial
Income producing - real estate		28,060		222		22,003		95
Land, land development & construction-real estate		12,916		92		7,544		4
Commercial and industrial		24,232		194		12,156		34
Mortgage
1-4 family		66,593		706		70,976		750
Resort lending		24,334		264		27,399		208
Home equity line of credit - 1st lien		66		1		47		-
Home equity line of credit - 2nd lien		45		-		134		-
Installment
Home equity installment - 1st lien		3,411		31		3,474		38
Home equity installment - 2nd lien		3,363		42		3,554		40
Loans not secured by real estate		817		10		868		13
Other		22		1		26		-
Total	$	163,859	$	1,563	$	148,181	$	1,182

(1)	There were no impaired payment plan receivables during the three month periods ended September 30, 2012 and 2011.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Average recorded investment in and interest income earned on impaired loans by class for the nine month periods ended September 30, follows:

	2012				2011
	Average		Interest		Average		Interest
	Recorded		Income		Recorded		Income
	Investment		Recognized		Investment		Recognized
With no related allowance recorded:	(In thousands)
Commercial
Income producing - real estate	$	2,713	$	45	$	2,806	$	95
Land, land development & construction-real estate		2,360		97		712		40
Commercial and industrial		3,755		104		2,694		100
Mortgage
1-4 family		7,274		229		8,964		296
Resort lending		6,339		178		7,900		322
Home equity line of credit - 1st lien		9		-		-		-
Home equity line of credit - 2nd lien		67		2		115		2
Installment
Home equity installment - 1st lien		1,945		72		1,919		72
Home equity installment - 2nd lien		2,047		80		2,021		73
Loans not secured by real estate		533		21		588		27
Other		23		2		13		1
		27,065		830		27,732		1,028
With an allowance recorded:
Commercial
Income producing - real estate		24,228		474		17,820		152
Land, land development & construction-real estate		10,680		136		9,195		60
Commercial and industrial		18,227		406		10,603		92
Mortgage
1-4 family		59,793		1,926		63,210		2,019
Resort lending		18,355		582		22,648		505
Home equity line of credit - 1st lien		57		2		24		1
Home equity line of credit - 2nd lien		24		-		11		-
Installment
Home equity installment - 1st lien		1,487		41		1,453		42
Home equity installment - 2nd lien		1,367		38		1,478		46
Loans not secured by real estate		227		7		172		3
Other		-		-		-		-
		134,445		3,612		126,614		2,920
Total
Commercial
Income producing - real estate		26,941		519		20,626		247
Land, land development & construction-real estate		13,040		233		9,907		100
Commercial and industrial		21,982		510		13,297		192
Mortgage
1-4 family		67,067		2,155		72,174		2,315
Resort lending		24,694		760		30,548		827
Home equity line of credit - 1st lien		66		2		24		1
Home equity line of credit - 2nd lien		91		2		126		2
Installment
Home equity installment - 1st lien		3,432		113		3,372		114
Home equity installment - 2nd lien		3,414		118		3,499		119
Loans not secured by real estate		760		28		760		30
Other		23		2		13		1
Total	$	161,510	$	4,442	$	154,346	$	3,948

(1)	There were no impaired payment plan receivables during the nine month periods ended September 30, 2012 and 2011.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Our average investment in impaired loans was approximately $163.9 million and $148.2 million for the three-month periods ended September 30, 2012 and 2011, respectively and $161.5 million and $154.3 million for the nine-month periods ended September 30, 2012 and 2011, respectively. Cash receipts on impaired loans on non-accrual status are generally applied to the principal balance. Interest income recognized on impaired loans during the three months ended September 30, 2012 and 2011 was approximately $1.6 million and $1.2 million, respectively and was approximately $4.4 million and $3.9 million during the nine months ended September 30, 2012 and 2011, respectively .

Troubled debt restructurings follow:

	September 30, 2012
	Commercial		Retail			Total
	(In thousands)
Performing TDR's	$	44,061	$	88,441		$	132,502
Non-performing TDR's(1)		10,738		9,237	(2)		19,975
Total	$	54,799	$	97,678		$	152,477

	December 31, 2011
	Commercial		Retail			Total
	(In thousands)
Performing TDR's	$	29,799	$	86,770		$	116,569
Non-performing TDR's(1)		14,567		14,081	(2)		28,648
Total	$	44,366	$	100,851		$	145,217

(1)	Included in non-performing loans table shown previously.

(2)	Also includes loans on non-accrual at the time of modification until six payments are received on a timely basis.

The Company has allocated $20.6 million and $18.1 million of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of September 30, 2012 and December 31, 2011, respectively.

During the three and nine months ended September 30, 2012 and 2011, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans generally included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a permanent reduction of the recorded investment in the loan.

Modifications involving a reduction of the stated interest rate of the loan have generally been for periods ranging from 9 months to 60 months but have extended to as much as 480 months in certain circumstances. Modifications involving an extension of the maturity date have generally been for periods ranging from 1 month to 60 months but have extended to as much as 472 months in certain circumstances.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Loans that have been classified as troubled debt restructurings during the three-month periods ended September 30 follow:

			Pre-modification		Post-modification
	Number of		Recorded		Recorded
	Contracts		Balance		Balance
2012	(Dollars in thousands)
Commercial
Income producing - real estate		4	$	626	$	545
Land, land development & construction-real estate		2		460		523
Commercial and industrial		10		631		558
Mortgage
1-4 family		10		1,870		1,656
Resort lending		7		1,575		1,562
Home equity line of credit - 1st lien		-		-		-
Home equity line of credit - 2nd lien		-		-		-
Installment
Home equity installment - 1st lien		4		137		98
Home equity installment - 2nd lien		2		59		56
Loans not secured by real estate		2		22		21
Other		-		-		-
Total		41	$	5,380	$	5,019

2011
Commercial
Income producing - real estate		5	$	6,579	$	6,370
Land, land development & construction-real estate		1		1,900		1,804
Commercial and industrial		-		-		-
Mortgage
1-4 family		6		1,603		1,629
Resort lending		4		1,515		1,501
Home equity line of credit - 1st lien		-		-		-
Home equity line of credit - 2nd lien		-		-		-
Installment
Home equity installment - 1st lien		4		98		99
Home equity installment - 2nd lien		-		-		-
Loans not secured by real estate		5		67		68
Other		-		-		-
Total		25	$	11,762	$	11,471

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Loans that have been classified as troubled debt restructurings during the nine-month periods ended September 30 follow:

			Pre-modification		Post-modification
	Number of		Recorded		Recorded
	Contracts		Balance		Balance
2012	(Dollars in thousands)
Commercial
Income producing - real estate		18	$	8,894	$	8,736
Land, land development & construction-real estate		5		3,347		3,436
Commercial and industrial		43		8,827		8,453
Mortgage
1-4 family		58		7,738		7,330
Resort lending		29		7,529		7,356
Home equity line of credit - 1st lien		1		15		-
Home equity line of credit - 2nd lien		-		-		-
Installment
Home equity installment - 1st lien		14		561		521
Home equity installment - 2nd lien		16		604		590
Loans not secured by real estate		12		299		278
Other		-		-		-
Total		196	$	37,814	$	36,700

2011
Commercial
Income producing - real estate		16	$	14,793	$	13,928
Land, land development & construction-real estate		3		5,111		1,893
Commercial and industrial		10		1,129		1,111
Mortgage
1-4 family		59		7,663		7,540
Resort lending		27		7,474		7,393
Home equity line of credit - 1st lien		1		45		47
Home equity line of credit - 2nd lien		1		23		19
Installment
Home equity installment - 1st lien		18		475		470
Home equity installment - 2nd lien		14		464		450
Loans not secured by real estate		23		411		404
Other		-		-		-
Total		172	$	37,588	$	33,255

The troubled debt restructurings described above for 2012 increased the allowance for loan losses by $0.4 million and resulted in zero charge offs during the three months ended September 30, 2012, respectively and increased the allowance by $1.5 million and resulted in $0.4 million charge offs during the nine months ended September 30, 2012, respectively.

The troubled debt restructurings described above for 2011 increased the allowance for loan losses by $0.1 million and resulted in charge offs of $0.3 million during the three months ended September 30, 2011, respectively and increased the allowance by $0.7 million and resulted in charge offs of $3.8 million during the nine months ended September 30, 2011, respectively.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Loans that have been classified as troubled debt restructurings during the past twelve months and that have subsequently defaulted during the three-month periods ended September 30 follow:

	Number of		Recorded
	Contracts		Balance
2012	(Dollars in thousands)
Commercial
Income producing - real estate		2	$	827
Land, land development & construction-real estate		-		-
Commercial and industrial		-		-
Mortgage
1-4 family		-		-
Resort lending		2		468
Home equity line of credit - 1st lien		-		-
Home equity line of credit - 2nd lien		-		-
Installment
Home equity installment - 1st lien		-		-
Home equity installment - 2nd lien		-		-
Loans not secured by real estate		-		-
Other		-		-
		4	$	1,295

2011
Commercial
Income producing - real estate		1	$	136
Land, land development & construction-real estate		-		-
Commercial and industrial		-		-
Mortgage
1-4 family		4		607
Resort lending		1		340
Home equity line of credit - 1st lien		-		-
Home equity line of credit - 2nd lien		-		-
Installment
Home equity installment - 1st lien		-		-
Home equity installment - 2nd lien		1		46
Loans not secured by real estate		-		-
Other		-		-
		7	$	1,129

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Loans that have been classified as troubled debt restructurings during the past twelve months and that have subsequently defaulted during the nine-month periods ended September 30 follows:

	Number of		Recorded
	Contracts		Balance
2012	(Dollars in thousands)
Commercial
Income producing - real estate		2	$	827
Land, land development & construction-real estate		1		136
Commercial and industrial		7		520
Mortgage
1-4 family		2		148
Resort lending		3		584
Home equity line of credit - 1st lien		-		-
Home equity line of credit - 2nd lien		-		-
Installment
Home equity installment - 1st lien		1		26
Home equity installment - 2nd lien		1		20
Loans not secured by real estate		-		-
Other		-		-
		17	$	2,261

2011
Commercial
Income producing - real estate		3	$	1,042
Land, land development & construction-real estate		1		1,222
Commercial and industrial		-		-
Mortgage
1-4 family		8		1,024
Resort lending		5		1,128
Home equity line of credit - 1st lien		-		-
Home equity line of credit - 2nd lien		-		-
Installment
Home equity installment - 1st lien		1		19
Home equity installment - 2nd lien		4		264
Loans not secured by real estate		-		-
Other		-		-
		22	$	4,699

A loan is considered to be in payment default generally once it is 90 days contractually past due under the modified terms.

The troubled debt restructurings that subsequently defaulted described above for 2012 increased the allowance for loan losses by $0.7 million and resulted in zero charge offs during the three months ended September 30, 2012, respectively and increased the allowance for loan losses by $0.7 million and resulted in charge offs of $0.4 million during the nine months ended September 30, 2012, respectively.

The troubled debt restructurings that subsequently defaulted described above for 2011 increased the allowance for loan losses by $0.2 million and resulted in charge offs of $0.1 million during the three months ended September 30, 2011, respectively and decreased the allowance for loan losses by $0.4 million and resulted in charge offs of $1.5 million during the nine months ended September 30, 2011, respectively.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

The terms of certain other loans were modified during the three and nine months ended September 30, 2012 and 2011 that did not meet the definition of a troubled debt restructuring. The modification of these loans could have included modification of the terms of a loan to borrowers who were not experiencing financial difficulties or a delay in a payment that was considered to be insignificant.

In order to determine whether a borrower is experiencing financial difficulty, we perform an evaluation of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without the modification. This evaluation is performed under our internal underwriting policy.

Credit Quality Indicators – As part of our on on-going monitoring of the credit quality of our loan portfolios, we track certain credit quality indicators including (a) weighted-average risk grade of commercial loans, (b) the level of classified commercial loans (c) credit scores of mortgage and installment loan borrowers (d) investment grade of certain counterparties for payment plan receivables and (e) delinquency history and non-performing loans.

For commercial loans we use a loan rating system that is similar to those employed by state and federal banking regulators. Loans are graded on a scale of 1 to 12. A description of the general characteristics of the ratings follows:

Rating 1 through 6: These loans are generally referred to as our “non-watch” commercial credits that include very high or exceptional credit fundamentals through acceptable credit fundamentals.

Rating 7 and 8: These loans are generally referred to as our “watch” commercial credits. This rating includes loans to borrowers that exhibit potential credit weakness or downward trends. If not checked or cured these trends could weaken our asset or credit position. While potentially weak, no loss of principal or interest is envisioned with these ratings.

Rating 9: These loans are generally referred to as our “substandard accruing” commercial credits. This rating includes loans to borrowers that exhibit a well-defined weakness where payment default is probable and loss is possible if deficiencies are not corrected. Generally, loans with this rating are considered collectible as to both principal and interest primarily due to collateral coverage.

Rating 10 and 11: These loans are generally referred to as our “substandard - non-accrual” and “doubtful” commercial credits. This rating includes loans to borrowers with weaknesses that make collection of debt in full, on the basis of current facts, conditions and values at best questionable and at worst improbable. All of these loans are placed in non-accrual.

Rating 12: These loans are generally referred to as our “loss” commercial credits. This rating includes loans to borrowers that are deemed incapable of repayment and are charged-off.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

The following table summarizes loan ratings by loan class for our commercial loan segment:

	Commercial
					Substandard		Non-
	Non-watch		Watch		Accrual		Accrual
	1-6		7-8		9		10-11		Total
					(In thousands)
September 30, 2012
Income producing - real estate	$	166,740	$	37,261	$	2,513	$	7,742	$	214,256
Land, land development and construction - real estate		31,129		5,172		2,673		4,598		43,572
Commercial and industrial		294,232		30,032		16,033		7,174		347,471
Total	$	492,101	$	72,465	$	21,219	$	19,514	$	605,299
Accrued interest included in total	$	1,430	$	240	$	91	$	-	$	1,761

December 31, 2011
Income producing - real estate	$	201,655	$	52,438	$	5,785	$	13,788	$	273,666
Land, land development and construction - real estate		33,515		9,421		4,800		6,990		54,726
Commercial and industrial		275,245		27,783		13,935		7,984		324,947
Total	$	510,415	$	89,642	$	24,520	$	28,762	$	653,339
Accrued interest included in total	$	1,677	$	381	$	126	$	-	$	2,184

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

For each of our mortgage and consumer segment classes we generally monitor credit quality based on the credit scores of the borrowers. These credit scores are generally updated at least annually.

The following table summarizes credit scores by loan class for our mortgage and installment loan segments:

	Mortgage (1)
					Home		Home
			Resort		Equity		Equity
	1-4 Family		Lending		1st Lien		2nd Lien		Total
	(In thousands)
September 30, 2012
800 and above	$	23,203	$	19,052	$	2,586	$	5,282	$	50,123
750-799		58,758		64,803		5,871		13,757		143,189
700-749		57,904		46,530		3,476		9,033		116,943
650-699		59,330		23,087		2,347		8,432		93,196
600-649		34,130		10,136		2,578		4,507		51,351
550-599		27,993		6,786		1,326		2,941		39,046
500-549		22,506		2,888		885		2,308		28,587
Under 500		8,961		847		468		668		10,944
Unknown		5,378		577		152		178		6,285
Total	$	298,163	$	174,706	$	19,689	$	47,106	$	539,664
Accrued interest included in total	$	1,392	$	808	$	101	$	256	$	2,557

December 31, 2011
800 and above	$	26,509	$	17,345	$	4,062	$	6,317	$	54,233
750-799		63,746		76,381		8,058		16,892		165,077
700-749		55,047		53,210		4,280		12,131		124,668
650-699		54,579		21,579		2,854		7,909		86,921
600-649		40,977		12,750		2,485		5,066		61,278
550-599		29,732		10,698		1,547		3,466		45,443
500-549		28,573		3,716		1,615		2,758		36,662
Under 500		12,434		565		539		886		14,424
Unknown		4,082		579		80		174		4,915
Total	$	315,679	$	196,823	$	25,520	$	55,599	$	593,621
Accrued interest included in total	$	1,404	$	928	$	123	$	290	$	2,745

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

	Installment(1)
	Home		Home		Loans not
	Equity		Equity		Secured by
	1st Lien		2nd Lien		Real Estate		Other		Total
	(In thousands)
September 30, 2012
800 and above	$	3,900	$	3,741	$	19,738	$	46	$	27,425
750-799		8,350		11,554		46,222		551		66,677
700-749		5,507		9,231		23,674		711		39,123
650-699		5,813		7,541		14,369		592		28,315
600-649		3,791		4,666		6,685		497		15,639
550-599		3,309		2,489		3,269		170		9,237
500-549		2,164		1,786		2,802		125		6,877
Under 500		710		939		793		24		2,466
Unknown		48		7		2,676		26		2,757
Total	$	33,592	$	41,954	$	120,228	$	2,742	$	198,516
Accrued interest included in total	$	144	$	160	$	453	$	23	$	780

December 31, 2011
800 and above	$	5,466	$	5,047	$	18,245	$	70	$	28,828
750-799		11,651		16,475		41,501		572		70,199
700-749		6,899		10,693		23,174		883		41,649
650-699		7,144		8,407		15,646		673		31,870
600-649		4,943		5,412		7,599		434		18,388
550-599		3,435		3,221		4,573		270		11,499
500-549		3,021		3,145		3,011		183		9,360
Under 500		1,160		854		1,391		50		3,455
Unknown		83		34		5,037		59		5,213
Total	$	43,802	$	53,288	$	120,177	$	3,194	$	220,461
Accrued interest included in total	$	176	$	208	$	489	$	29	$	902

(1)	Credit scores have been updated within the last twelve months.

Mepco Finance Corporation (“Mepco”) is a wholly-owned subsidiary of our Bank that operates a vehicle service contract payment plan business throughout the United States. See Note #14 for more information about Mepco’s business. As of September 30, 2012, approximately 91.7% of Mepco’s outstanding payment plan receivables relate to programs in which a third party insurer or risk retention group is obligated to pay Mepco the full refund owing upon cancellation of the related service contract (including with respect to both the portion funded to the service contract seller and the portion funded to the administrator). These receivables are shown as “Full Refund” in the table below. Another approximately 8.0% of Mepco’s outstanding payment plan receivables as of September 30, 2012, relate to programs in which a third party insurer or risk retention group is obligated to pay Mepco the refund owing upon cancellation only with respect to the unearned portion previously funded by Mepco to the administrator (but not to the service contract seller). These receivables are shown as “Partial Refund” in the table below. The balance of Mepco’s outstanding payment plan receivables relate to programs in which there is no insurer or risk retention group that has any contractual liability to Mepco for any portion of the refund amount. These receivables are shown as “Other” in the table below. For each class of our payment plan receivables we monitor credit ratings of the counterparties as we evaluate the credit quality of this portfolio.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

The following table summarizes credit ratings of insurer or risk retention group counterparties by class of payment plan receivable:

	Payment Plan Receivables
	Full		Partial
	Refund		Refund		Other		Total
	(In thousands)
September 30, 2012
AM Best rating
A +	$	-	$	-	$	149	$	149
A		29,211		4,657		-		33,868
A-		18,001		2,802		-		20,803
B +		162		-		-		162
B		-		-		-		-
Not rated		38,488		-		138		38,626
Total	$	85,862	$	7,459	$	287	$	93,608

December 31, 2011
AM Best rating
A +	$	-	$	118	$	7	$	125
A		32,461		165		269		32,895
A-		27,056		10,639		-		37,695
B +		1,390		-		-		1,390
B		-		-		-		-
Not rated		42,762		-		151		42,913
Total	$	103,669	$	10,922	$	427	$	115,018

Although Mepco has contractual recourse against various counterparties for refunds owing upon cancellation of vehicle service contracts, please see Note #14 below regarding certain risks and difficulties associated with collecting these refunds.

5. Segments

Our reportable segments are based upon legal entities. We currently have two reportable segments: Independent Bank (“IB” or “Bank”) and Mepco. These business segments are also differentiated based on the products and services provided. We evaluate performance based principally on net income (loss) of the respective reportable segments.

In the normal course of business, our IB segment provides funding to our Mepco segment through an intercompany line of credit priced at the prime rate of interest as published in the Wall Street Journal. Our IB segment also provides certain administrative services to our Mepco segment which reimburses at an agreed upon rate. These intercompany transactions are eliminated upon consolidation. The only other material intersegment balances and transactions are investments in subsidiaries at the parent entities and cash balances on deposit at our IB segment.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

A summary of selected financial information for our reportable segments as of or for the three-month and nine-month periods ended September 30 follows:

As of or for the three months ended September 30,

	IB		Mepco			Other(1)			Elimination(2)			Total
	(In thousands)
2012
Total assets	$	2,252,476	$	145,690		$	178,098		$	(175,432	)	$	2,400,832
Interest income		21,057		3,676			-			-			24,733
Net interest income		19,380		2,806			(735	)		-			21,451
Provision for loan losses		270		(19	)		-			-			251
Income (loss) before income tax		6,988		405			(923	)		(24	)		6,446
Net income (loss)		7,125		268			(923	)		(24	)		6,446

2011
Total assets	$	2,116,134		$	202,034		$	168,422		$	(169,217	)	$	2,317,373
Interest income		22,913			5,274			-			-			28,187
Net interest income		20,474			3,982			(682	)		-			23,774
Provision for loan losses		6,165			6			-			-			6,171
Loss before income tax		(3,594	)		(150	)		(836	)		(24	)		(4,604	)
Net loss		(3,164	)		(96	)		(838	)		(24	)		(4,122	)

(1)	Includes amounts relating to our parent company and certain insignificant operations.

(2)	Includes parent company’s investment in subsidiaries and cash balances maintained at subsidiary.

As of or for the nine months ended September 30,

	IB		Mepco		Other(1)			Elimination(2)			Total
	(In thousands)
2012
Total assets	$	2,252,476	$	145,690	$	178,098		$	(175,432	)	$	2,400,832
Interest income		64,452		11,232		-			-			75,684
Net interest income		59,085		8,487		(2,191	)		-			65,381
Provision for loan losses		6,436		2		-			-			6,438
Income (loss) before income tax		14,945		2,298		(2,889	)		(71	)		14,283
Net income (loss)		15,726		1,517		(2,889	)		(71	)		14,283

2011
Total assets	$	2,116,134		$	202,034		$	168,422		$	(169,217	)	$	2,317,373
Interest income		71,226			16,806			-			-			88,032
Net interest income		61,078			12,556			(2,026			-			71,608
Provision for loan losses		20,986			43			-			-			21,029
Loss before income tax		(9,463	)		(1,062	)		(1,638	)		(71	)		(12,234	)
Net loss		(9,097	)		(678	)		(1,640	)		(71	)		(11,486	)

(1)Includes amounts relating to our parent company and certain insignificant operations.

(2)Includes parent company’s investment in subsidiaries and cash balances maintained at subsidiary.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

6. Earnings Per Common Share

		Three months ended					Nine months ended
		September 30,					September 30,
		2012		2011			2012		2011
		(In thousands, except per share amounts)
Net income (loss) applicable to common stock	$	5,353	$	(5,165	)	$	11,042	$	(14,588	)
Convertible preferred stock dividends		1,093		-			3,241		-
Net income (loss) applicable to common stock for calculation of diluted earnings per share(1) (2)	$	6,446	$	(5,165	)	$	14,283	$	(14,588	)

Weighted average shares outstanding		8,779		8,401			8,637		8,209
Effect of convertible preferred stock		30,523		42,452			30,523		42,452
Restricted stock units		221		140			167		116
Stock units for deferred compensation plan for non-employee directors		81		7			54		7
Effect of stock options		9		-			-		-
Weighted average shares outstanding for calculation of diluted earnings per share(1)		39,613		51,000			39,381		50,784
Net income (loss) per common share
Basic	$	.61	$	(.61	)	$	1.28	$	(1.78	)
Diluted(2)		.16		(.61	)		.36		(1.78	)

(1) For any period in which a loss is recorded, dividends on convertible preferred stock are not added back in the diluted per share calculation. For any period in which a loss is recorded, the assumed conversion of convertible preferred stock, assumed exercise of common stock warrants, assumed exercise of stock options, restricted stock units and stock units for a deferred compensation plan for non-employee directors would have an anti-dilutive impact on the loss per share and thus are ignored in the diluted per share calculation.

(2) Basic income (loss) per share includes weighted average common shares outstanding during the period and participating share awards.

Weighted average stock options outstanding that were not included in weighted average shares outstanding for calculation of diluted earnings per share because they were anti-dilutive totaled 0.1 million and 0.2 million for the three-month periods ended September 30, 2012 and 2011, respectively and totaled 0.2 million and 0.1 million for the nine-month periods ended September 30, 2012 and 2011, respectively. The warrant to purchase 346,154 shares of our common stock (see Note #15) was not included in weighted average shares outstanding for calculation of diluted earnings per share in all periods in 2012 and 2011 as it was anti-dilutive.

7. Derivative Financial Instruments

We are required to record derivatives on our Condensed Consolidated Statements of Financial Condition as assets and liabilities measured at their fair value. The accounting for increases and decreases in the value of derivatives depends upon the use of derivatives and whether the derivatives qualify for hedge accounting.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Our derivative financial instruments according to the type of hedge in which they are designated follows:

	September 30, 2012
			Average
	Notional		Maturity		Fair
	Amount		(years)		Value
	(Dollars in thousands)
Cash Flow Hedges - Pay fixed interest-rate swap agreements	$	10,000		2.3	$	(835	)

No hedge designation
Mandatory commitments to sell mortgage loans	$	62,883		0.1	$	2,787
Rate-lock mortgage loan commitments		101,482		0.1		(1,475	)
Amended Warrant		2,504		6.2		(385	)
Total	$	166,869		0.2	$	927

We have established management objectives and strategies that include interest-rate risk parameters for maximum fluctuations in net interest income and market value of portfolio equity. We monitor our interest rate risk position via simulation modeling reports. The goal of our asset/liability management efforts is to maintain profitable financial leverage within established risk parameters.

We use variable-rate and short-term fixed-rate (less than 12 months) debt obligations to fund a portion of our balance sheet, which exposes us to variability in interest rates. To meet our objectives, we may periodically enter into derivative financial instruments to mitigate exposure to fluctuations in cash flows resulting from changes in interest rates (“Cash Flow Hedges”). Cash Flow Hedges currently include certain pay-fixed interest-rate swaps. Pay-fixed interest-rate swaps convert the variable-rate cash flows on debt obligations to fixed-rates.

We record the fair value of Cash Flow Hedges in accrued income and other assets and accrued expenses and other liabilities. On an ongoing basis, we adjust our Condensed Consolidated Statements of Financial Condition to reflect the then current fair value of Cash Flow Hedges. The related gains or losses are reported in other comprehensive income or loss and are subsequently reclassified into earnings, as a yield adjustment in the same period in which the related interest on the hedged items (primarily variable-rate debt obligations) affect earnings. It is anticipated that approximately $0.4 million, of unrealized losses on Cash Flow Hedges at September 30, 2012 will be reclassified to earnings over the next twelve months. To the extent that the Cash Flow Hedges are not effective, the ineffective portion of the Cash Flow Hedges is immediately recognized as interest expense. The maximum term of any Cash Flow Hedge at September 30, 2012 is 2.3 years.

Certain financial derivative instruments have not been designated as hedges. The fair value of these derivative financial instruments has been recorded on our Condensed Consolidated Statements of Financial Condition and are adjusted on an ongoing basis to reflect their then current fair value. The changes in fair value of derivative financial instruments not designated as hedges are recognized in earnings.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

In the ordinary course of business, we enter into rate-lock mortgage loan commitments with customers (“Rate Lock Commitments”). These commitments expose us to interest rate risk. We also enter into mandatory commitments to sell mortgage loans (“Mandatory Commitments”) to reduce the impact of price fluctuations of mortgage loans held for sale and Rate Lock Commitments. Mandatory Commitments help protect our loan sale profit margin from fluctuations in interest rates. The changes in the fair value of Rate Lock Commitments and Mandatory Commitments are recognized currently as part of net gains on mortgage loans. We obtain market prices on Mandatory Commitments and Rate Lock Commitments. Net gains on mortgage loans, as well as net income (loss) may be more volatile as a result of these derivative instruments, which are not designated as hedges.

During 2010, we entered into an amended and restated warrant with the U.S. Department of the Treasury (“UST”) that would allow them to purchase our common stock at a fixed price (see Note #15). Because of certain anti-dilution features included in the Amended Warrant (as defined in Note #15), it is not considered to be indexed to our common stock and is therefore accounted for as a derivative instrument and recorded as a liability. Any change in value of the Amended Warrant is recorded in other income in our Condensed Consolidated Statements of Operations.

The following tables illustrate the impact that the derivative financial instruments discussed above have on individual line items in the Condensed Consolidated Statements of Financial Condition for the periods presented:

Fair Values of Derivative Instruments

	Asset Derivatives						Liability Derivatives
	September 30,			December 31,			September 30,			December 31,
	2012			2011			2012			2011
	Balance			Balance			Balance			Balance
	Sheet	Fair		Sheet	Fair		Sheet	Fair		Sheet	Fair
	Location	Value		Location	Value		Location	Value		Location	Value
	(In thousands)
Derivatives designated as hedging instruments
Pay-fixed interest rate swap agreements							Other liabilities	$	835	Other liabilities	$	1,103
Total									835			1,103

Derivatives not designated as hedging instruments
Rate-lock mortgage loan commitments	Other assets	$	2,787	Other assets	$	857
Mandatory commitments to sell mortgage loans	Other assets		-			-			1,475	Other liabilities		606

Amended Warrant			-			-	Other liabilities		385	Other liabilities		174
Total			2,787			857			1,860			780
Total derivatives		$	2,787		$	857		$	2,695		$	1,883

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

The effect of derivative financial instruments on the Condensed Consolidated Statements of Operations follows:

Three Month Periods Ended September 30,
							Location of
							Gain (Loss)
							Reclassified
							from
	Gain (Loss)						Accumulated	Gain (Loss)
	Recognized in						Other	Reclassified from
	Other						Comprehensive	Accumulated Other
	Comprehensive						Income into	Comprehensive						Location of	Gain (Loss)
	Income (Loss)						Income	Loss into Income						Gain (Loss)	Recognized
	(Effective Portion)						(Effective	(Effective Portion)						Recognized	in Income
	2012			2011			Portion)	2012			2011			in Income (1)	2012			2011
	(In thousands)
Cash Flow Hedges
Pay-fixed interest rate swap agreements	$	(54	)	$	(215	)	Interest expense	$	(237	)	$	(345	)		$	-		$	3
Interest-rate cap agreements		-			-		Interest expense		-			-				-			-
Total	$	(54	)	$	(215	)		$	(237	)	$	(345	)		$	-		$	3

No hedge designation
Rate-lock mortgage loan commitments														Net mortgage loan gains	$	804		$	369
Mandatory commitments to sell mortgage loans														Net mortgage loan gains		(779	)		(339	)
Amended warrant														(Increase) decrease in fair value of U.S. Treasury warrant		(32	)		29
Total															$	(7	)	$	59

(1)	For cash flow hedges, this location and amount refers to the ineffective portion.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Nine Month Periods Ended September 30,
							Location of
							Gain (Loss)
							Reclassified
							from
	Gain (Loss)						Accumulated	Gain (Loss)
	Recognized in						Other	Reclassified from
	Other						Comprehensive	Accumulated Other
	Comprehensive						Income into	Comprehensive						Location of	Gain (Loss)
	Income (Loss)						Income	Loss into Income						Gain (Loss)	Recognized
	(Effective Portion)						(Effective	(Effective Portion)						Recognized	in Income
	2012			2011			Portion)	2012			2011			in Income (1)	2012			2011
	(In thousands)
Cash Flow Hedges
Pay-fixed interest rate swap agreements	$	(129	)	$	(508	)	Interest expense	$	(833	)	$	(1,102	)		$	-		$	-
Interest-rate cap agreements		-			30		Interest expense		-			(15	)			-			-
Total	$	(129	)	$	(478	)		$	(833	)	$	(1,117	)		$	-		$	-

No hedge designation
Rate-lock mortgage loan commitments														Net mortgage loan gains	$	1,930		$	468
Mandatory commitments to sell mortgage loans														Net mortgage loan gains		(869	)		(1,635	)
Amended warrant														(Increase) decrease in fair value of U.S. Treasury warrant		(211	)		1,025
Total															$	850		$	(142	)

(1)	For cash flow hedges, this location and amount refers to the ineffective portion.

8. Intangible Assets

Other intangible assets, net of amortization, were comprised of the following at September 30, 2012 and December 31, 2011:

September 30, 2012

December 31, 2011

Gross

Carrying

Accumulated

Carrying

Accumulated

Amount

Amortization

Amount

Amortization

(In thousands)

Amortized other intangible assets - core deposits

31,326

24,533

31,326

23,717

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Amortization of other intangibles has been estimated through 2017 and thereafter in the following table.

	(In thousands)

Three months ended December 31, 2012	$	272
Year ending December 31:
2013		1,078
2014		801
2015		613
2016		613
2017 and thereafter		3,416
Total	$	6,793

9. Share Based Compensation

We maintain share based payment plans that include a non-employee director stock purchase plan and a long-term incentive plan that permits the issuance of share based compensation, including stock options and non-vested share awards. The long-term incentive plan, which is shareholder approved, permits the grant of additional share based awards for up to 0.2 million shares of common stock as of September 30, 2012. The non-employee director stock purchase plan permits the grant of additional share based payments for up to 0.3 million shares of common stock as of September 30, 2012. Share based awards and payments are measured at fair value at the date of grant and are expensed over the requisite service period. Common shares issued upon exercise of stock options come from currently authorized but unissued shares.

During the first quarter of 2012 our president’s annual salary was increased by $0.03 million, effective January 1, 2012. One half of this increase is currently being paid in the form of common stock (also referred to as “salary stock”). During the first quarter of 2011, pursuant to a management transition plan, our chief executive officer’s annual salary was increased by $0.2 million effective January 1, 2011. This increase is currently being paid entirely in the form of salary stock. These shares are issued each pay period and vest immediately.

During the third quarter of 2012, we issued 0.22 million restricted stock units to six of our executive officers. These restricted stock units do not vest for a minimum of three years and until we repay in full our obligations related to the Troubled Asset Relief Program (“TARP”). During the first quarter of 2011, we issued 0.14 million restricted stock units to five of our executive officers. These restricted stock units do not vest for a minimum of two years and until we repay in full our obligations related to the TARP.

During the third quarter of 2012, pursuant to our performance-based compensation plans we granted 0.1 million stock options to certain officers, none of whom is a named executive officer. The stock options have an exercise price equal to the market value on the date of grant, vest ratably over a three year period and expire 10 years from date of grant. We use the Black Scholes option pricing model to measure compensation cost for stock options. We also estimate expected forfeitures over the vesting period.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Beginning in the second quarter of 2011 our directors elected to receive their quarterly cash retainer fees in the form of common stock currently (or on a deferred basis pursuant to a deferred compensation and stock purchase plan). Shares equal in value to each director’s quarterly cash retainer are issued each quarter and vest immediately. We have issued 0.17 million shares and 0.08 million shares to directors during the first nine months of 2012 and 2011, respectively and expensed their value during those same periods.

Total compensation expense recognized for stock option grants, restricted stock grants, restricted stock unit grants and salary stock was $0.2 million and $0.3 million during the three and nine month periods ended September 30, 2012, and was $0.3 million and $0.7 million during the same periods in 2011. The corresponding tax benefit relating to this expense was zero for the three and nine month periods ended September 30, 2012 and 2011, respectively. Total expense recognized for non-employee director share based payments was $0.1 million in both three month periods ended September 30, 2012 and 2011 and $0.3 million and $0.2 million in the nine month periods ended September 30, 2012 and 2011, respectively.

At September 30, 2012, the total expected compensation cost related to non-vested stock options, restricted stock and restricted stock unit awards not yet recognized was $1.4 million. The weighted-average period over which this amount will be recognized is 2.8 years.

A summary of outstanding stock option grants and transactions follows:

	Nine-months ended September 30, 2012
						Weighted- Average Remaining		Aggregated
	Number of Shares			Average Exercise Price		Contractual Term (years)		Intrinsic Value (in thousands)

Outstanding at January 1, 2012		180,862		$	7.98
Granted		113,400			2.70
Exercised		(1,401	)		1.92
Forfeited		(11,666	)		1.92
Expired		(5,495	)		90.66
Outstanding at September 30, 2012		275,700		$	4.45		8.67	$	100
Vested and expected to vest at September 30, 2012		253,972		$	4.62		8.60	$	94
Exercisable at September 30, 2012		77,881		$	9.73		7.04	$	32

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

A summary of non-vested restricted stock and stock units and transactions follows:

	2012
	Number of Shares			Weighted Average Grant Date Fair Value

Outstanding at January 1, 2012		165,045		$	17.90
Granted		221,147			2.78
Vested		(4,496	)		166.90
Forfeited		(522	)		93.14
Outstanding at September 30, 2012		381,174		$	7.27

A summary of the weighted-average assumptions used in the Black-Scholes option pricing model for grants of stock options during 2012 follows:

Expected dividend yield		0.74	%
Risk-free interest rate		0.88
Expected life (in years)		6.00
Expected volatility		100.00	%
Per share weighted-average fair value	$	2.02

The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. The expected life was obtained using a simplified method that, in general, averaged the vesting term and original contractual term of the stock option. This method was used as relevant historical data of actual exercise activity was not available. The expected volatility was based on historical volatility of our common stock.

The following summarizes certain information regarding options exercised during the three- and nine-month periods ended September 30:

	Three months ended				Nine months ended
	September 30,				September 30,
	2012		2011		2012		2011
	(In thousands)
Intrinsic value	$	1	$	-	$	1	$	-
Cash proceeds received	$	3	$	-	$	3	$	-
Tax benefit realized	$	-	$	-	$	-	$	-

10. Income Tax

At both September 30, 2012 and December 31, 2011, we had approximately $2.1 million of gross unrecognized tax benefits. We do not expect the total amount of unrecognized tax benefits to significantly increase or decrease during the balance of 2012.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

As a result of being in a net operating loss carryforward position, we have established a deferred tax asset valuation allowance of $69.2 million and $75.2 million as of September 30, 2012 and December 31, 2011, respectively against all of our net deferred tax assets. Accordingly, we are not recognizing much income tax expense (benefit) related to any income or loss before income tax. The income tax expense (benefit) was zero for the three and nine month periods ended September 30, 2012. Income tax (benefit) was $(0.48) million and $(0.75) million for the three and nine month periods ended September 30, 2011, respectively. The benefit recognized during these periods was primarily the result of current period adjustments to other comprehensive income (“OCI”), net of state income tax expense and adjustments to the deferred tax asset valuation allowance. In addition, the three- and nine-month periods in 2011 included the benefit of a favorable tax adjustment ($0.09 million) relating to an Internal Revenue Service review and interest ($0.13 million) relating to a refund.

Generally, the amount of income tax expense or benefit allocated to operations is determined without regard to the tax effects of other categories of income or loss, such as other comprehensive income (loss). However, an exception to the general rule is provided when, in the presence of a valuation allowance against deferred tax assets, there is a pretax loss from operations and pretax income from other categories in the current period. In such instances, income from other categories must offset the current loss from operations, the tax benefit of such offset being reflected in operations. For the three and nine month periods ended September 30, 2011 this resulted in an income tax (benefit) of $(0.23) million and $(0.49) million, respectively.

11. Regulatory Matters

Capital guidelines adopted by Federal and State regulatory agencies and restrictions imposed by law limit the amount of cash dividends our Bank can pay to us. Under these guidelines, the amount of dividends that may be paid in any calendar year is limited to the Bank’s current year’s net profits, combined with the retained net profits of the preceding two years. It is not our intent to have dividends paid in amounts which would reduce the capital of our Bank to levels below those which we consider prudent and in accordance with guidelines of regulatory authorities.

In December 2009, the Board of Directors of Independent Bank Corporation adopted resolutions (as subsequently amended) that impose the following restrictions:

●

We will not pay dividends on our outstanding common stock or the outstanding preferred stock held by the UST and we will not pay distributions on our outstanding trust preferred securities without, in each case, the prior written approval of the Federal Reserve Board (“FRB”) and the Michigan Office of Financial and Insurance Regulation (“OFIR”);

●

We will not incur or guarantee any additional indebtedness without the prior approval of the FRB;

●

We will not repurchase or redeem any of our common stock without the prior approval of the FRB; and

●

We will not rescind or materially modify any of these limitations without notice to the FRB and the OFIR.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

In December 2009, the Board of Directors of Independent Bank adopted resolutions (as subsequently amended) designed to enhance certain aspects of the Bank’s performance and, most importantly, to improve the Bank’s capital position. These resolutions require the following:

●

The adoption by the Bank of a capital restoration plan designed to help the Bank achieve the minimum capital ratios established by the Bank’s Board of Directors as described below;

●

The enhancement of the Bank’s documentation of the rationale for discounts applied to collateral valuations on impaired loans and improved support for the identification, tracking, and reporting of loans classified as TDR’s;

●

The adoption of certain changes and enhancements to our liquidity monitoring and contingency planning and our interest rate risk management practices;

●

Additional reporting to the Bank’s Board of Directors regarding initiatives and plans pursued by management to improve the Bank’s risk management practices;

●

Prior approval of the FRB and the OFIR for any dividends or distributions to be paid by the Bank to Independent Bank Corporation; and

●

Notice to the FRB and the OFIR of any rescission of or material modification to any of these resolutions.

The substance of all of the resolutions described above was developed in conjunction with discussions held with the FRB and the OFIR. Based on those discussions, we acted proactively to adopt the resolutions described above to address those areas of the Bank’s financial condition and operations that we believed most required our focus at that time.

On October 25, 2011, the respective Boards of Directors of the Company and the Bank entered into a Memorandum of Understanding (“MOU”) with the FRB and OFIR. The MOU largely duplicates certain of the provisions in the Board resolutions described above, but also has the following specific requirements:

●

Submission of a joint revised capital plan (the “Capital Plan”) by November 30, 2011 to maintain sufficient capital at the Company on a consolidated basis and at the Bank on a stand-alone basis;

●

Submission of quarterly progress reports regarding disposition plans for any assets in excess of $1.0 million that are in ORE, are 90 days or more past due, are on our “watch list”, or were adversely classified in our most recent examination;

●

Enhanced reporting and monitoring at Mepco regarding risk management and the internal classification of assets; and

●

Enhanced interest rate risk modeling practices.

We submitted our Capital Plan on a timely basis and believe that we are generally in compliance with the provisions of the MOU, however, we must still execute on certain strategies outlined in our Capital Plan.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

We are also subject to various regulatory capital requirements. The prompt corrective action regulations establish quantitative measures to ensure capital adequacy and require minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and Tier 1 capital to average assets. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly discretionary, actions by regulators that could have a material effect on our consolidated financial statements. Under capital adequacy guidelines, we must meet specific capital requirements that involve quantitative measures as well as qualitative judgments by the regulators. The most recent regulatory filings as of September 30, 2012 and December 31, 2011 categorized our Bank as well capitalized. Management is not aware of any conditions or events that would have changed the most recent Federal Deposit Insurance Corporation (“FDIC”) categorization.

Our actual capital amounts and ratios follow:

						Minimum for					Minimum for
						Adequately Capitalized					Well-Capitalized
	Actual					Institutions					Institutions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(Dollars in thousands)

September 30, 2012
Total capital to risk-weighted assets
Consolidated	$	189,627		12.98	%	$	116,898		8.00	%	NA		NA
Independent Bank		192,779		13.22			116,682		8.00		$	145,853		10.00	%

Tier 1 capital to risk-weighted assets
Consolidated	$	165,638		11.34	%	$	58,449		4.00	%	NA		NA
Independent Bank		174,171		11.94			58,341		4.00		$	87,512		6.00	%

Tier 1 capital to average assets
Consolidated	$	165,638		6.92	%	$	95,732		4.00	%	NA		NA
Independent Bank		174,171		7.29			95,626		4.00		$	119,533		5.00	%

December 31, 2011
Total capital to risk-weighted assets
Consolidated	$	174,547		11.31	%	$	123,470		8.00	%	NA		NA
Independent Bank		175,868		11.41			123,254		8.00		$	154,068		10.00	%

Tier 1 capital to risk-weighted assets
Consolidated	$	144,265		9.35	%	$	61,735		4.00	%	NA		NA
Independent Bank		156,104		10.13			61,627		4.00		$	92,441		6.00	%

Tier 1 capital to average assets
Consolidated	$	144,265		6.25	%	$	92,338		4.00	%	NA		NA
Independent Bank		156,104		6.77			92,268		4.00		$	115,335		5.00	%

NA - Not applicable

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

The components of our regulatory capital are as follows:

	Consolidated						Independent Bank
	September 30,			December 31,			September 30,			December 31,
	2012			2011			2012			2011
	(In thousands)
Total shareholders' equity	$	121,528		$	102,627		$	173,283		$	152,987
Add (deduct)
Qualifying trust preferred securities		43,320			38,183			-			-
Accumulated other comprehensive loss		8,432			11,921			8,530			11,583
Intangible assets		(6,793	)		(7,609	)		(6,793	)		(7,609	)
Disallowed capitalized mortgage loan servicing rights		(849	)		(857	)		(849	)		(857	)
Tier 1 capital		165,638			144,265			174,171			156,104
Qualifying trust preferred securities		5,348			10,485			-			-
Allowance for loan losses and allowance for unfunded lending commitments limited to 1.25% of total risk-weighted assets		18,641			19,797			18,608			19,764
Total risk-based capital	$	189,627		$	174,547		$	192,779		$	175,868

In November, 2011, our Board adopted the Capital Plan and submitted such Capital Plan to the FRB and the OFIR. The Capital Plan was updated in February, 2012. The FRB and OFIR have accepted such Capital Plan, assuming the execution of certain strategies and the attainment of the required Tier 1 Capital to Average Total Assets Ratio of 8%.

The primary objective of our Capital Plan is to achieve and thereafter maintain the minimum capital ratios required by the Board resolutions adopted in December 2009 (as subsequently amended). The minimum capital ratios established by our Board are higher than the ratios required in order to be considered “well-capitalized” under federal standards. The Board imposed these higher ratios in order to ensure that we have sufficient capital to withstand potential continuing losses based on our prevailing elevated level of non-performing assets and given certain other risks and uncertainties we face. As of September 30, 2012, our Bank continued to meet the requirements to be considered “well-capitalized” under federal regulatory standards and met one of the minimum capital ratio goals established by our Board.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Set forth below are the actual capital ratios of our Bank as of September 30, 2012, the minimum capital ratios imposed by the Board resolutions, and the minimum ratios necessary to be considered “well-capitalized” under federal regulatory standards:

	Independent						Minimum
	Bank			Minimum			Ratio
	Actual as of			Ratios			Required to
	September 30,			Established			be Well-
	2012			by our Board			Capitalized
Total Capital to Risk-Weighted Assets		13.22	%		11.00	%		10.00	%
Tier 1 Capital to Average Total Assets		7.29			8.00			5.00

If we are unable to achieve both minimum capital ratios set forth in our Capital Plan it may adversely affect our business and financial condition. An inability to improve our capital position could make it difficult for us to withstand future losses. In addition, we believe that if our financial condition and performance deteriorate, we may not be able to remain well-capitalized under federal regulatory standards. In that case, our primary bank regulators may impose additional regulatory restrictions and requirements on us. If we fail to remain well-capitalized under federal regulatory standards, we will be prohibited from accepting or renewing brokered certificates of deposit without the prior consent of the FDIC, which would likely have an adverse impact on our business and financial condition. If our regulators take more formal enforcement action against us, it would likely increase our expenses and could limit our business operations. There could be other expenses associated with a deterioration of our capital, such as increased deposit insurance premiums payable to the FDIC. At the present time, based on our current forecasts and expectations, we believe that our Bank can remain above “well-capitalized” for regulatory purposes for the foreseeable future, even without additional capital, due to our projected further decline in total assets (principally loans), our improved performance in 2012 and the impact of a pending branch sale (see Note #16).

12. Fair Value Disclosures

FASB ASC topic 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The standard describes three levels of inputs that may be used to measure fair value:

Level 1: Valuation is based upon quoted prices for identical instruments traded in active markets. Level 1 instruments include securities traded on active exchange markets, such as the New York Stock Exchange, as well as U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets.

Level 2: Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 2 instruments include securities traded in less active dealer or broker markets.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Level 3: Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

We used the following methods and significant assumptions to estimate fair value:

Securities: Where quoted market prices are available in an active market, securities (trading or available for sale) are classified as Level 1 of the valuation hierarchy. Level 1 securities include certain preferred stocks included in our trading portfolio for which there are quoted prices in active markets. If quoted market prices are not available for the specific security, then fair values are estimated by (1) using quoted market prices of securities with similar characteristics, (2) matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for specific securities but rather by relying on the securities’ relationship to other benchmark quoted prices, or (3) a discounted cash flow analysis whose significant fair value inputs can generally be verified and do not typically involve judgment by management. These securities are classified as Level 2 of the valuation hierarchy and include agency and private label residential mortgage-backed securities, municipal securities and trust preferred securities.

Loans held for sale: The fair value of mortgage loans held for sale is based on mortgage backed security pricing for comparable assets (recurring Level 2). The fair value of loans held for sale relating to branch sale is based on a discount provided for in the branch sale agreement (non-recurring Level 2).

Impaired loans with specific loss allocations based on collateral value: From time to time, certain loans are considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. We measure our investment in an impaired loan based on one of three methods: the loan’s observable market price, the fair value of the collateral or the present value of expected future cash flows discounted at the loan’s effective interest rate. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2012 and December 31, 2011, all of our total impaired loans were evaluated based on either the fair value of the collateral or the present value of expected future cash flows discounted at the loan’s effective interest rate. When the fair value of the collateral is based on an appraised value or when an appraised value is not available we record the impaired loan as nonrecurring Level 3. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments can be significant and thus will typically result in a Level 3 classification of the inputs for determining fair value.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Other real estate: At the time of acquisition, other real estate is recorded at fair value, less estimated costs to sell, which becomes the property’s new basis. Subsequent write-downs to reflect declines in value since the time of acquisition may occur from time to time and are recorded in other expense in the Condensed Consolidated Statements of Operations. The fair value of the property used at and subsequent to the time of acquisition is typically determined by a third party appraisal of the property. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments can be significant and typically result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by us. Once received, an independent third party (for commercial properties over $0.25 million) or a member of our special assets group (for commercial properties under $0.25 million and retail properties) reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with independent data sources such as recent market data or industry-wide statistics. On an annual basis, we compare the actual selling price of collateral that has been sold to the most recent appraised value to determine what additional adjustment, if any, should be made to the appraisal value to arrive at fair value. For commercial properties we typically do not discount an appraisal while for retail properties we generally discount the value by 5%. In addition, we will adjust the appraised values for expected liquidation costs including sales commissions and transfer taxes.

Capitalized mortgage loan servicing rights: The fair value of capitalized mortgage loan servicing rights is based on a valuation model used by an independent third party that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income. Since the secondary servicing market has not been active since the later part of 2009, model assumptions are generally unobservable and are based upon the best information available including data relating to our own servicing portfolio, reviews of mortgage servicing assumption and valuation surveys and input from various mortgage servicers and, therefore, are recorded as nonrecurring Level 3. At September 30, 2012 these assumptions included a weighted average (“WA”) discount rate of 11.0%, WA cost to service of $84, WA ancillary income of $44 and WA float rate of 0.76%. Management evaluates the third party valuation for reasonableness each quarter as part of our financial reporting control processes.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Derivatives: The fair value of interest rate swap agreements, in general, is determined using a discounted cash flow model whose significant fair value inputs can generally be verified and do not typically involve judgment by management (recurring Level 2). The fair value of the Amended Warrant at September 30, 2012 was estimated based on an internal update of an independent third party analysis that was performed at March 31, 2012 (the December 31, 2011 fair value was also based on an independent valuation performed at that date). Nearly all key variables remained consistent between March 31, 2012 (the last date a third party valuation was performed) and September 30, 2012. The internal update primarily focused on the change in our stock price during the second and third quarters of 2012, which was not significant. The third party valuation uses a simulation analysis which considers potential outcomes for a large number of independent scenarios regarding the future prices of our common stock. The simulation analysis relies on a binomial lattice model, a standard technique usually applied to the valuation of stock options. The binomial lattice maps out possible price paths of our common stock, the underlying asset of the Amended Warrant. The simulation is based on a 500-step lattice covering the term of the Amended Warrant. The binomial lattice requires specification of 14 variables, of which several are unobservable in the market including probability of a non-permitted capital raise (1.0% at September 30, 2012 and December 31, 2011), expected discount to stock price in an equity raise (10%), dollar amount of expected capital raise ($100 million) and expected time of equity raise (April, 2013 at September 30, 2012 and December 31, 2011). As a result of these unobservable inputs, the resulting fair value of the Amended Warrant is classified as Level 3 pricing. Changes in these variables would have an impact on the fair value of the Amended Warrant. If the probability of a non-permitted capital raise increased to 2.5%, 5.0% or 10.0%, the value of the Amended Warrant is estimated to increase to $0.43 million, $0.48 million and $0.61 million, respectively.

Property and equipment held for sale: The fair value of property and equipment held for sale relating to the branch sale was determined based upon a value agreed upon in the branch sale agreement (non-recurring Level 2) and property and equipment held for sale relating to our branch consolidation was based on recent offers (non-recurring Level 2) and appraisals (non-recurring Level 3).

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Assets and liabilities measured at fair value, including financial assets for which we have elected the fair value option, were as follows:

			Fair Value Measurements Using
			Quoted
			Prices
			in Active
			Markets		Significant		Significant
			for		Other		Un-
	Fair Value		Identical		Observable		observable
	Measure-		Assets		Inputs		Inputs
	ments		(Level 1)		(Level 2)		(Level 3)
	(In thousands)
September 30, 2012:
Measured at Fair Value on a Recurring Basis:
Assets
Trading securities	$	38	$	38	$	-	$	-
Securities available for sale
U.S. agency		45,637		-		45,637		-
U.S. agency residential mortgage-backed		132,620		-		132,620		-
Private label residential mortgage-backed		8,302		-		8,302		-
Obligations of states and political subdivisions		40,361		-		40,361		-
Trust preferred		3,266		-		3,266		-
Loans held for sale		41,969		-		41,969		-
Derivatives (1)		2,787		-		2,787		-
Liabilities
Derivatives (2)		2,695		-		2,310		385

Measured at Fair Value on a Non-recurring basis:
Assets
Capitalized mortgage loan servicing rights (3)		8,855		-		-		8,855
Impaired loans (4)
Commercial
Income producing - real estate		4,862		-		-		4,862
Land, land development &construction-real estate		3,074		-		-		3,074
Commercial and industrial		7,622		-		-		7,622
Mortgage
1-4 Family		2,822		-		-		2,822
Resort Lending		239		-		-		239
Other real estate (5)
Commercial
Income producing - real estate		2,157		-		-		2,157
Land, land development &construction-real estate		5,193		-		-		5,193
Mortgage
1-4 Family		591		-		-		591
Resort Lending		4,636		-		-		4,636
Installment
Home equity installment - 1st lien		104		-		-		104
Loans held for sale relating to branch sale		52,280		-		52,280		-
Property and equipment held for sale		10,148		-		9,825		323

(1) Included in accrued income and other assets

(2) Included in accrued expenses and other liabilities

(3) Only includes servicing rights that are carried at fair value due to recognition of a valuation allowance.

(4) Only includes impaired loans with specific loss allocations based on collateral value.

(5) Only includes other real estate with subsequent write downs to fair value.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

			Fair Value Measurements Using
			Quoted
			Prices
			in Active
			Markets		Significant		Significant
			for		Other		Un-
	Fair Value		Identical		Observable		observable
	Measure-		Assets		Inputs		Inputs
	ments		(Level 1)		(Level 2)		(Level 3)
	(In thousands)
December 31, 2011:
Measured at Fair Value on a Recurring Basis:
Assets
Trading securities	$	77	$	77	$	-	$	-
Securities available for sale
U.S. agency		25,017		-		25,017		-
U.S. agency residential mortgage-backed		94,206		-		94,206		-
Private label residential mortgage-backed		8,268		-		8,268		-
Obligations of states and political subdivisions		27,317		-		27,317		-
Trust preferred		2,636		-		2,636		-
Loans held for sale		44,801		-		44,801		-
Derivatives (1)		857		-		857		-
Liabilities
Derivatives (2)		1,883		-		1,709		174

Measured at Fair Value on a Non-recurring basis:
Assets
Capitalized mortgage loan servicing rights (3)		11,004		-		-		11,004
Impaired loans (4)
Commercial
Income producing - real estate		8,022		-		-		8,022
Land, land development &construction-real estate		5,702		-		-		5,702
Commercial and industrial		5,613		-		-		5,613
Mortgage
1-4 Family		3,263		-		-		3,263
Resort Lending		1,064		-		-		1,064
Other real estate (5)
Commercial
Income producing - real estate		1,388		-		-		1,388
Land, land development &construction-real estate		7,512		-		-		7,512
Commercial and industrial		497		-		-		497
Mortgage
1-4 Family		2,079		-		-		2,079
Resort Lending		5,297		-		-		5,297
Home equity line of credit - 1st lien		53		-		-		53
Installment
Home equity installment - 1st lien		100		-		-		100

(1) Included in accrued income and other assets

(2) Included in accrued expenses and other liabilities

(3) Only includes servicing rights that are carried at fair value due to recognition of a valuation allowance.

(4) Only includes impaired loans with specific loss allocations based on collateral value.

(5) Only includes other real estate with subsequent write downs to fair value.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

There were no transfers between Level 1 and Level 2 during the nine months ended September 30, 2012 and 2011.

Changes in fair values for financial assets which we have elected the fair value option for the periods presented were as follows:

		Changes in Fair Values for the Nine-Month
		Periods Ended September 30 for Items Measured at
		Fair Value Pursuant to Election of the Fair Value Option
		2012								2011
							Total							Total
							Change							Change
							in Fair							in Fair
							Values							Values
							Included							Included
		Net Gains (Losses)					in Current			Net Gains (Losses)				in Current
		on Assets					Period			on Assets				Period
		Securities			Loans		Earnings			Securities		Loans		Earnings
		(In thousands)
Trading securities	$	(39	)	$	-	$	(39	)	$	67	$	-	$	67
Loans held for sale		-			587		587			-		807		807

For those items measured at fair value pursuant to our election of the fair value option, interest income is recorded within the Condensed Consolidated Statements of Operations based on the contractual amount of interest income earned on these financial assets and dividend income is recorded based on cash dividends.

The following represent impairment charges recognized during the three and nine month periods ended September 30, 2012 and 2011 relating to assets measured at fair value on a non-recurring basis:

Capitalized mortgage loan servicing rights, whose individual strata are measured at fair value, had a carrying amount of $8.9 million which is net of a valuation allowance of $7.2 million at September 30, 2012 and had a carrying amount of $11.0 million which is net of a valuation allowance of $6.5 million at December 31, 2011. A recovery (charge) of $(0.4) million and $(0.6) million was included in our results of operations for the three and nine month periods ended September 30, 2012, respectively and $(3.1) million and $(3.2) million during the same periods in 2011.

Loans which are measured for impairment using the fair value of collateral for collateral dependent loans, had a carrying amount of $26.4 million, with a valuation allowance of $7.8 million at September 30, 2012 and had a carrying amount of $33.9 million, with a valuation allowance of $10.3 million at December 31, 2011. An additional provision for loan losses relating to impaired loans of $0.3 million and $1.9 million was included in our results of operations for the three and nine month periods ended September 30, 2012, respectively and $2.7 million and $6.6 million during the same periods in 2011.

Other real estate, which is measured using the fair value of the property, had a carrying amount of $12.7 million which is net of a valuation allowance of $10.0 million at September 30, 2012 and a carrying amount of $16.9 million which is net of a valuation allowance of $14.7 million at December 31, 2011. An additional charge relating to ORE measured at fair value of $1.1 million and $1.5 million was included in our results of operations during the three and nine month periods ended September 30, 2012, respectively and $2.1 million and $4.1 million during the same periods in 2011.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Property and equipment held for sale, which is measured using the fair value of the assets, had a carrying amount of $10.1 million, which is net of a valuation allowance of $3.3 million at September 30, 2012. A charge relating to property and equipment measured at fair value of $0.9 million was included in our results of operations during the three and nine month periods ended September 30, 2012. There were no such balances at December 31, 2011 or charges during the three and nine month periods ended September 30, 2011.

A reconciliation for all liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three and nine months ended September 30 follows:

	(Liability)
	Amended Warrant
	Three months ended						Nine months ended
	September 30,						September 30,
	2012			2011			2012			2011

Beginning balance	$	(353	)	$	(315	)	$	(174	)	$	(1,311	)
Total gains (losses) realized and unrealized:
Included in results of operations		(32	)		29			(211	)		1,025
Included in other comprehensive income		-			-			-			-
Purchases, issuances, settlements, maturities and calls		-			-			-			-
Transfers in and/or out of Level 3		-			-			-			-
Ending balance	$	(385	)	$	(286	)	$	(385	)	$	(286	)

Amount of total gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to assets and liabilities still held at September 30	$	(32	)	$	29		$	(211	)	$	1,025

During 2010, we entered into an amended and restated warrant with the UST that would allow them to purchase our common stock at a fixed price (see Note #15). Because of certain anti-dilution features included in the Amended Warrant, it is not considered to be indexed to our common stock and is therefore accounted for as a derivative instrument (see Note #7). Any change in value of this warrant is recorded in other income in our Condensed Consolidated Statements of Operations.

The following table reflects the difference between the aggregate fair value and the aggregate remaining contractual principal balance outstanding for loans held for sale for which the fair value option has been elected for the periods presented.

	Aggregate Fair Value		Difference		Contractual Principal
	(In thousands)
Loans held for sale
September 30, 2012	$	41,969	$	1,990	$	39,979
December 31, 2011		44,801		1,403		43,398

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

13. Fair Values of Financial Instruments

Most of our assets and liabilities are considered financial instruments. Many of these financial instruments lack an available trading market and it is our general practice and intent to hold the majority of our financial instruments to maturity. Significant estimates and assumptions were used to determine the fair value of financial instruments. These estimates are subjective in nature, involving uncertainties and matters of judgment, and therefore, fair values cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Estimated fair values have been determined using available data and methodologies that are considered suitable for each category of financial instrument. For instruments with adjustable-interest rates which reprice frequently and without significant credit risk, it is presumed that estimated fair values approximate the recorded book balances.

Cash and due from banks and interest bearing deposits: The recorded book balance of cash and due from banks and interest bearing deposits approximate fair value and are classified as Level 1.

Securities: Financial instrument assets actively traded in a secondary market have been valued using quoted market prices. Trading securities are classified as Level 1 while securities available for sale are classified as Level 2 as described in Note #12.

Federal Home Loan Bank and Federal Reserve Bank Stock: It is not practicable to determine the fair value of FHLB and FRB Stock due to restrictions placed on transferability.

Net loans and loans held for sale: The fair value of loans is calculated by discounting estimated future cash flows using estimated market discount rates that reflect credit and interest-rate risk inherent in the loans resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described in Note #12. Loans held for sale are classified as Level 2 as described in Note #12.

Accrued interest receivable and payable: The recorded book balance of accrued interest receivable and payable approximate fair value and are classified at the same Level as the asset and liability they are associated with.

Derivative financial instruments: Interest rate swaps have principally been valued based on the discounted value of contractual cash flows using a discount rate approximating current market rates and are classified as Level 2 as described in Note #12 and the Amended Warrant has been valued based on a simulation analysis which considers potential outcomes for a large number of independent scenarios and is classified as Level 3 as described in Note #12.

Deposits: Deposits without a stated maturity, including demand deposits, savings, NOW and money market accounts, have a fair value equal to the amount payable on demand. Each of these instruments is classified as Level 1. Deposits with a stated maturity, such as certificates of deposit have been valued based on the discounted value of contractual cash flows using a discount rate approximating current market rates for liabilities with a similar maturity resulting in a Level 2 classification. Deposits include those held for sale relating to branch sale.

Other borrowings: Other borrowings have been valued based on the discounted value of contractual cash flows using a discount rate approximating current market rates for liabilities with a similar maturity resulting in a Level 2 classification.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Subordinated debentures: Subordinated debentures have generally been valued based on a quoted market price of the specific or similar instruments resulting in a Level 1 or Level 2 classification.

The estimated recorded book balances and fair values follows:

	September 30, 2012
					Fair Value Measurements Using
					Quoted
					Prices
					in Active
					Markets		Significant		Significant
					for		Other		Un-
	Recorded		Fair Value		Identical		Observable		observable
	Book		Measure-		Assets		Inputs		Inputs
	Balance		ments		(Level 1)		(Level 2)		(Level 3)
	(In thousands)
Assets
Cash and due from banks	$	56,911	$	56,911	$	56,911	$	-	$	-
Interest bearing deposits		403,633		403,633		403,633		-		-
Trading securities		38		38		38		-		-
Securities available for sale		230,186		230,186		-		230,186		-
Federal Home Loan Bank and Federal Reserve Bank Stock		20,494	NA		NA		NA		NA
Net loans and loans held for sale		1,478,217		1,437,327		-		94,249		1,343,078
Accrued interest receivable		6,557		6,557		151		954		5,452
Derivative financial instruments		2,787		2,787		-		2,787		-

Liabilities
Deposits with no stated maturity	$	1,630,166	$	1,630,166	$	1,630,166	$	-	$	-
Deposits with stated maturity		543,124		545,395		-		545,395		-
Other borrowings		17,720		21,805		-		21,805		-
Subordinated debentures		50,175		39,078		7,362		31,716		-
Accrued interest payable		6,761		6,761		2,735		4,026		-
Derivative financial instruments		2,695		2,695		-		2,310		385

	December 31, 2011
	Recorded
	Book		Estimated
	Balance		Fair Value
	(In thousands)
Assets
Cash and due from banks	$	62,777	$	62,777
Interest bearing deposits		278,331		278,331
Trading securities		77		77
Securities available for sale		157,444		157,444
Federal Home Loan Bank and Federal Reserve Bank Stock		20,828	NA
Net loans and loans held for sale		1,562,525		1,475,738
Accrued interest receivable		6,243		6,243
Derivative financial instruments		857		857

Liabilities
Deposits with no stated maturity	$	1,517,321	$	1,517,321
Deposits with stated maturity		568,804		571,552
Other borrowings		33,387		37,907
Subordinated debentures		50,175		16,138
Accrued interest payable		5,106		5,106
Derivative financial instruments		1,883		1,883

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

The fair values for commitments to extend credit and standby letters of credit are estimated to approximate their aggregate book balance, which is nominal and therefore are not disclosed.

Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale the entire holdings of a particular financial instrument.

Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business, the value of future earnings attributable to off-balance sheet activities and the value of assets and liabilities that are not considered financial instruments.

Fair value estimates for deposit accounts do not include the value of the core deposit intangible asset resulting from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.

14. Contingent Liabilities

Our Mepco segment conducts its payment plan business activities across the United States. Mepco acquires the payment plans from companies (which we refer to as Mepco’s “counterparties”) at a discount from the face amount of the payment plan. Each payment plan (which are classified as payment plan receivables in our Condensed Consolidated Statements of Financial Condition) permits a consumer to purchase a vehicle service contract by making installment payments, generally for a term of 12 to 24 months, to the sellers of those contracts (one of the “counterparties”). Mepco thereafter collects the payments from consumers. In acquiring the payment plan, Mepco generally funds a portion of the cost to the seller of the service contract and a portion of the cost to the administrator of the service contract. The administrator, in turn, pays the necessary contractual liability insurance policy (“CLIP”) premium to the insurer or risk retention group.

Consumers are allowed to voluntarily cancel the service contract at any time and are generally entitled to receive a refund from the administrator of the unearned portion of the service contract at the time of cancellation. As a result, while Mepco does not owe any refund to the consumer, it also does not have any recourse against the consumer for nonpayment of a payment plan and therefore does not evaluate the creditworthiness of the individual consumer. If a consumer stops making payments on a payment plan or exercises the right to voluntarily cancel the service contract, the service contract seller and administrator are each obligated to refund to Mepco the amount necessary to make Mepco whole as a result of its funding of the service contract. In addition, the insurer or risk retention group that issued the CLIP for the service contract often guarantees all or a portion of the refund to Mepco. See Note #4 above for a breakdown of Mepco’s payment plan receivables by the level of recourse Mepco has against various counterparties.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

Upon the cancellation of a service contract and the completion of the billing process to the counterparties for amounts due to Mepco, there is a decrease in the amount of “payment plan receivables” and an increase in the amount of “vehicle service contract counterparty receivables” until such time as the amount due from the counterparty is collected. These amounts represent funds actually due to Mepco from its counterparties for cancelled service contracts. At September 30, 2012, the aggregate amount of such obligations owing to Mepco by counterparties, net of write-downs and reserves made through the recognition of vehicle service contract counterparty contingencies expense, totaled $18.8 million. This compares to a balance of $29.3 million at December 31, 2011. Mepco is currently in the process of working to recover these receivables, including through liquidation of collateral and litigation against counterparties.

In some cases, Mepco requires collateral or guaranties by the principals of the counterparties to secure these refund obligations; however, this is generally only the case when no rated insurance company is involved to guarantee the repayment obligation of the seller and administrator counterparties. In most cases, there is no collateral to secure the counterparties’ refund obligations to Mepco, but Mepco has the contractual right to offset unpaid refund obligations against amounts Mepco would otherwise be obligated to fund to the counterparties. In addition, even when collateral is involved, the refund obligations of these counterparties are not fully secured. Mepco incurs losses when it is unable to fully recover funds owing to it by counterparties upon cancellation of the underlying service contracts. The sudden failure of one of Mepco’s major counterparties (an insurance company, administrator, or seller/dealer) could expose us to significant losses.

When counterparties do not honor their contractual obligations to Mepco to repay advanced funds, we recognize estimated losses. Mepco pursues collection (including commencing legal action if necessary) of funds due to it under its various contracts with counterparties. Charges related to estimated losses for vehicle service contract counterparty contingencies included in non-interest expenses were $0.3 million and $1.3 million for the three months ended September 30, 2012 and 2011, respectively and $1.1 million and $5.0 million for the nine months ended September 30, 2012 and 2011, respectively. These charges are being classified in non-interest expense because they are associated with a default or potential default of a contractual obligation under our counterparty contracts as opposed to loss on the administration of the payment plan itself.

The determination of losses related to vehicle service contract counterparty contingencies requires a significant amount of judgment because a number of factors can influence the amount of loss that we may ultimately incur. These factors include our estimate of future cancellations of vehicle service contracts, our evaluation of collateral that may be available to recover funds due from our counterparties, and the amount collected from counterparties in connection with their contractual obligations. Mepco is currently involved in litigation with certain of its counterparties in an attempt to collect amounts owing from those counterparties for cancelled service contracts.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

We apply a rigorous process, based upon observable contract activity and past experience, to estimate probable incurred losses and quantify the necessary reserves for our vehicle service contract counterparty contingencies, but there can be no assurance that our modeling process will successfully identify all such losses. As a result, we could record future losses associated with vehicle service contract counterparty contingencies that may be significantly different than the levels that we recorded during the first nine months of 2012 and 2011.

We believe our assumptions regarding the collection of vehicle service contract counterparty receivables are reasonable, and we based them on our good faith judgments using data currently available. We also believe the current amount of reserves we have established and the vehicle service contract counterparty contingencies expense that we have recorded are appropriate given our estimate of probable incurred losses at the applicable Condensed Consolidated Statement of Financial Condition date. However, because of the uncertainty surrounding the numerous and complex assumptions made, actual losses could exceed the charges we have taken to date.

We are also involved in various litigation matters in the ordinary course of business. At the present time, we do not believe any of these matters will have a significant impact on our Condensed Consolidated Financial Statements. The aggregate amount we have accrued for losses we consider probable as a result of these litigation matters is immaterial. However, because of the inherent uncertainty of outcomes from any litigation matter, we believe it is reasonably possible we may incur losses in addition to the amounts we have accrued. At this time, we estimate the maximum amount of additional losses that are reasonably possible is approximately $0.4 million. However, because of a number of factors, including the fact that certain of these litigation matters are still in their early stages and involve claims for which, at this point, we believe have little to no merit, this maximum amount may change in the future.

The litigation matters described in the preceding paragraph primarily include claims that have been brought against us for damages, but do not include litigation matters where we seek to collect amounts owed to us by third parties (such as litigation initiated to collect delinquent loans or vehicle service contract counterparty receivables). These excluded, collection-related matters may involve claims or counterclaims by the opposing party or parties, but we have excluded such matters from the disclosure contained in the preceding paragraph in all cases where we believe the possibility of us paying damages to any opposing party is remote. Risks associated with the likelihood that we will not collect the full amount owed to us, net of reserves, are disclosed elsewhere in this report.

15. Shareholders’ Equity

On April 2, 2010, we entered into an exchange agreement with the UST pursuant to which the UST agreed to exchange all 72,000 shares of our Series A Fixed Rate Cumulative Perpetual Preferred Stock, with an original liquidation preference of $1,000 per share (“Series A Preferred Stock”), beneficially owned and held by the UST, plus accrued and unpaid dividends on such Series A Preferred Stock, for shares of our Series B Fixed Rate Cumulative Mandatorily Convertible Preferred Stock, with an original liquidation preference of $1,000 per share (“Series B Preferred Stock”). As part of the terms of the exchange agreement, we also agreed to amend and restate the terms of the warrant, dated December 12, 2008, issued to the UST to purchase 346,154 shares of our common stock.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

On April 16, 2010, we closed the transactions described in the exchange agreement and we issued to the UST (1) 74,426 shares of our Series B Preferred Stock and (2) an Amended and Restated Warrant to purchase 346,154 shares of our common stock at an exercise price of $7.234 per share and expiring on December 12, 2018 (the “Amended Warrant”) for all of the 72,000 shares of Series A Preferred Stock and the original warrant that had been issued to the UST in December 2008 pursuant to the TARP Capital Purchase Program, plus approximately $2.4 million in accrued dividends on such Series A Preferred Stock.

With the exception of being convertible into shares of our common stock, the terms of the Series B Preferred Stock are substantially similar to the terms of the Series A Preferred Stock that was exchanged. The Series B Preferred Stock qualifies as Tier 1 regulatory capital and pays cumulative dividends quarterly at a rate of 5% per annum through February 14, 2014, and at a rate of 9% per annum thereafter. The Series B Preferred Stock is non-voting, other than class voting rights on certain matters that could adversely affect the Series B Preferred Stock. If dividends on the Series B Preferred Stock have not been paid for an aggregate of six quarterly dividend periods or more, whether consecutive or not, the holders of the Series B Preferred Stock, voting together with holders of any then outstanding voting parity stock, have the right to elect two additional directors at our next annual meeting of shareholders or at a special meeting of shareholders called for that purpose. These directors would be elected annually and serve until all accrued and unpaid dividends on the Series B Preferred Stock have been paid. Beginning in December of 2009, we suspended payment of quarterly dividends. The cash dividends payable to the UST amount to approximately $4.2 million per year until December of 2013, at which time they would increase to approximately $7.6 million per year. Because we have deferred dividends on the Series B Preferred Stock for at least six quarterly dividend periods, the UST currently has the right to elect two directors to our board. At this time, in lieu of electing such directors, the UST requested us to allow (and we have allowed) an observer to attend our Board of Directors meetings beginning in the third quarter of 2011. The UST continues to retain the right to elect two directors as described above.

Under the terms of the Series B Preferred Stock, UST (and any subsequent holder of the Series B Preferred Stock) has the right to convert the Series B Preferred Stock into our common stock at any time. In addition, we have the right to compel a conversion of the Series B Preferred Stock into common stock, subject to the following conditions:

(i) we shall have received all appropriate approvals from the Board of Governors of the Federal Reserve System;

(ii) we shall have issued our common stock in exchange for at least $40 million aggregate original liquidation amount of the trust preferred securities issued by the Company’s trust subsidiaries, IBC Capital Finance II, IBC Capital Finance III, IBC Capital Finance IV, and Midwest Guaranty Trust I;

(iii) we shall have closed one or more transactions (on terms reasonably acceptable to the UST, other than the price per share of common stock) in which investors, other than the UST, have collectively provided a minimum aggregate amount of $100 million in cash proceeds to us in exchange for our common stock; and

(iv) we shall have made the anti-dilution adjustments to the Series B Preferred Stock, if any, required by the terms of the Series B Preferred Stock.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

If converted by the holder or by us pursuant to either of the above-described conversion rights, each share of Series B Preferred Stock (liquidation amount of $1,000 per share) will convert into a number of shares of our common stock equal to a fraction, the numerator of which is $750 and the denominator of which is $7.234, which was the market price of our common stock at the time the exchange agreement was signed (as such market price was determined pursuant to the terms of the Series B Preferred Stock), referred to as the “conversion rate.” This conversion rate is subject to certain anti-dilution adjustments that may result in a greater number of shares being issued to the holder of the Series B Preferred Stock. If converted by the holder or by us pursuant to either of the above-described conversion rights, as of September 30, 2012, the Series B Preferred Stock and accrued and unpaid dividends would have been convertible into approximately 11.2 million shares of our common stock.

Unless earlier converted by the holder or by us as described above, the Series B Preferred Stock will convert into shares of our common stock on a mandatory basis on the seventh anniversary (April 16, 2017) of the issuance of the Series B Preferred Stock. In any such mandatory conversion, each share of Series B Preferred Stock (liquidation amount of $1,000 per share) will convert into a number of shares of our common stock equal to a fraction, the numerator of which is $1,000 and the denominator of which is the market price of our common stock at the time of such mandatory conversion (as such market price is determined pursuant to the terms of the Series B Preferred Stock).

At the time any Series B Preferred Stock are converted into our common stock, we will be required to pay all accrued and unpaid dividends on the Series B Preferred Stock being converted in cash or, at our option, in shares of our common stock, in which case the number of shares to be issued will be equal to the amount of accrued and unpaid dividends to be paid in common stock divided by the market value of our common stock at the time of conversion (as such market price is determined pursuant to the terms of the Series B Preferred Stock). Accrued and unpaid dividends on the Series B Preferred Stock totaled $9.7 million (approximately $130 per share of Series B Preferred Stock) and $6.6 million (approximately $89 per share of Series B Preferred Stock) at September 30, 2012 and December 31, 2011, respectively. These amounts are recorded in Convertible Preferred Stock on the Condensed Consolidated Statements of Financial Condition.

The maximum number of shares of our common stock that may be issued upon conversion of all shares of the Series B Preferred Stock and any accrued dividends on Series B Preferred Stock is 14.4 million, unless we receive shareholder approval to issue a greater number of shares.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

The Series B Preferred Stock may be redeemed by us, subject to the approval of the Board of Governors of the Federal Reserve System, at any time, in an amount up to the cash proceeds (minimum of approximately $18.6 million) from qualifying equity offerings of common stock (plus any net increase to our retained earnings after the original issue date). If the Series B Preferred Stock is redeemed the redemption price will be the greater of (a) the $1,000 liquidation amount per share plus any accrued and unpaid dividends and (b) the product of the applicable Conversion Rate (as described above) and the average of the market prices per share of our common stock (as such market price is determined pursuant to the terms of the Series B Preferred Stock) over a 20 trading day period beginning on the trading day immediately after we give notice of redemption to the holder (plus any accrued and unpaid dividends). In any redemption, we must redeem at least 25% of the number of Series B Preferred Stock shares originally issued to the UST, unless fewer of such shares are then outstanding (in which case all of the Series B Preferred Stock must be redeemed). In addition to the terms of the Series B Preferred Stock discussed above, the UST updated its Frequently Asked Questions regarding the Capital Purchase Program (“CPP”) as of March 1, 2012 to permit any CPP participant to repay its investment, in part, subject to a minimum repayment of the greater of (i) 5% of the aggregate liquidation amount of the preferred stock issued to the UST or (ii) $100,000. Under this updated guidance, we could repay a minimum of approximately $3.7 million, subject to the approval of the Board of Governors of the Federal Reserve System, in a partial redemption of the Series B Preferred Stock.

On July 7, 2010 we executed an Investment Agreement and Registration Rights Agreement with Dutchess Opportunity Fund, II, LP (“Dutchess”) for the sale of up to 1.50 million shares of our common stock. These agreements serve to establish an equity line facility as a contingent source of liquidity at the parent company level. Pursuant to the Investment Agreement, Dutchess committed to purchase up to $15.0 million of our common stock over a 36-month period ending November 1, 2013. We have the right, but no obligation, to draw on this equity line facility from time to time during such 36-month period by selling shares of our common stock to Dutchess. The sales price would be at a 5% discount to the market price of our common stock at the time of the draw; as such market price is determined pursuant to the terms of the Investment Agreement. Through September 30, 2012, 0.97 million shares of our common stock were sold to Dutchess pursuant to the Investment Agreement (0.02 million shares during the third quarter of 2012, 0.17 million shares during the second quarter of 2012, 0.43 million shares during 2011 and 0.35 million shares during the fourth quarter of 2010) for an aggregate purchase price of $2.4 million. In order to comply with Nasdaq rules, we needed shareholder approval to sell more than approximately 0.7 million more shares to Dutchess pursuant to the Investment Agreement. In April 2011, our shareholders approved a resolution at our Annual Meeting to authorize us to sell up to 2.5 million additional shares under this equity line, so we now have additional flexibility to take advantage of this contingent source of liquidity. Remaining shares approved to sell pursuant to the Investment Agreement totaled 3.0 million shares at September 30, 2012. Based on our closing stock price on September 30, 2012, additional funds available under the Investment Agreement totaled approximately $8.2 million at September 30, 2012.

16. Branch Sale

On May 23, 2012 we executed a definitive agreement to sell 21 branches to Chemical Bank, headquartered in Midland, Michigan (the “Branch Sale”). The branches to be sold include 6 branch locations in the Battle Creek, Michigan market area and 15 branch locations in Northeast Michigan.

Index

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

(unaudited)

We expect that the Branch Sale will result in the transfer of approximately $408.6 million of deposits to Chemical Bank in exchange for the payment of a deposit premium of approximately $11.8 million. This represents a deposit premium of approximately 3.0% on identified core deposits. Certain non-core deposits will be transferred at no premium. Chemical Bank will also have the right to purchase certain loans associated with the branches being sold, at a discount of 1.75%. Currently, we estimate that approximately $53.2 million of loans will be sold to Chemical Bank. These loans are classified as held for sale in the September 30, 2012 Condensed Consolidated Statement of Financial Condition and are carried at the lower of cost or fair value. Certain fixed assets with a fair value at September 30, 2012 of approximately $8.4 million (cost, net of accumulated depreciation of approximately $10.9 million) are expected to be sold and are also classified as held for sale in the September 30, 2012 Condensed Consolidated Statement of Financial Condition. In addition, approximately $2.6 million of remaining unamortized intangible assets at September 30, 2012 relate to customers and deposits associated with the pending Branch Sale. The Branch Sale is expected to be completed by the end of the fourth quarter of 2012, subject to the satisfaction of terms and conditions of sale. Based on the deposit premium outlined above, we expect to record a net gain on the Branch Sale of approximately $5.8 million. This estimated gain is net of an allocation of $2.6 million of existing core deposit intangibles, a $2.5 million loss on the sale of fixed assets, a $0.3 million loss on the sale of loans and $0.6 million in transaction related costs.

The following summarizes estimated loans and deposits related to the Branch Sale:

	September 30,
	2012
	(In thousands)
Loans:
Commercial	$	31,060
Mortgage		8,569
Installment		13,582
Total loans		53,211
Allowance for loan losses		(610	)
Adjustment to lower of cost or fair value		(321	)
Net loans	$	52,280

Deposits
Non-interest bearing	$	66,392
Savings and interest bearing-checking		225,062
Retail time		117,180
Total deposits		408,634
Net adjustments		(2,784	)
Net deposits	$	405,850

Index

ITEM 2.

Management’s Discussion and Analysis

of Financial Condition and Results of Operations

The following section presents additional information that may be necessary to assess our financial condition and results of operations. This section should be read in conjunction with our condensed consolidated financial statements contained elsewhere in this report as well as our 2011 Annual Report on Form 10-K. The Form 10-K includes a list of risk factors that you should consider in connection with any decision to buy or sell our securities.

Introduction. Our success depends to a great extent upon the economic conditions in Michigan’s Lower Peninsula. We have in general experienced a difficult economy in Michigan since 2001, although economic conditions in the state began to show signs of improvement during 2010 and generally these improvements have continued into 2012, albeit at a slower pace.

We provide banking services to customers located primarily in Michigan’s Lower Peninsula. Our loan portfolio, the ability of the borrowers to repay these loans and the value of the collateral securing these loans has been and will be impacted by local economic conditions. The weaker economic conditions faced in Michigan have had and may continue to have adverse consequences as described below in “Portfolio Loans and asset quality.” However, since early- to mid-2009, we have generally seen a decline in non-performing loans and a declining level of provision for loan losses.

In response to these difficult market conditions and the significant losses that we incurred from 2008 through 2011 that reduced our capital, we have taken steps or initiated actions designed to increase our capital ratios, improve our operations and augment our liquidity as described in more detail below.

Index

At the present time, based on our current forecasts and expectations, we believe that our Bank can remain above “well-capitalized” for regulatory purposes for the foreseeable future, even without additional capital, primarily because of our reduction in total assets and our return to profitability during 2012. Our forecast for future profitability reflects an expectation for reduced credit costs (in particular the provision for loan losses, net losses on other real estate [“ORE”] and repossessed assets and loan and collection costs) that is anticipated to be partially offset by a decline in net interest income (due primarily to a change in asset mix as higher yielding loans are expected to continue to decline and lower yielding investment securities are expected to increase as well as due to the impact of the Branch Sale). This forecast is susceptible to significant variations, particularly if the Michigan economy were to deteriorate and credit costs were to be higher than anticipated or if we incur any significant future losses at Mepco Finance Corporation (“Mepco”) related to the collection of vehicle service contract counterparty receivables (see “Non-interest expense”). Because of such uncertainties, it is possible that our Bank may not be able to remain well-capitalized as we work through asset quality issues and seek to return to consistent profitability. As described in more detail under “Liquidity and capital resources” below, we believe failing to remain well-capitalized would have a material adverse effect on our business and financial condition as it would, among other consequences, likely lead to further regulatory enforcement actions (see “Regulatory development”), a potential loss of our mortgage servicing rights with Fannie Mae and/or Freddie Mac, and limits on our access to certain wholesale funding sources. In addition, any significant deterioration in our ability to improve our capital position would make it very difficult for us to withstand future losses that we may incur and that may be increased or made more likely as a result of economic difficulties and other factors.

In July 2010, Congress passed and the President signed into law the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the “Dodd-Frank Act”). The Dodd-Frank Act includes the creation of the new Consumer Financial Protection Bureau with power to promulgate and enforce consumer protection laws; the creation of the Financial Stability Oversight Council chaired by the Secretary of the Treasury with authority to identify institutions and practices that might pose a systemic risk; provisions affecting corporate governance and executive compensation of all companies whose securities are registered with the SEC; a provision that broadened the base for Federal Deposit Insurance Corporation (“FDIC”) insurance assessments; a provision under which interchange fees for debit cards are set by the Federal Reserve Bank (“FRB”) under a restrictive “reasonable and proportional cost” per transaction standard; a provision that requires bank regulators to set minimum capital levels for bank holding companies that are as strong as those required for their insured depository subsidiaries, subject to a grandfather clause for financial institutions with less than $15 billion in assets as of December 31, 2009; and new restrictions on how mortgage brokers and loan originators may be compensated. Certain provisions of the Dodd-Frank Act only apply to institutions with more than $10 billion in assets. The Dodd-Frank Act has had (and we expect it will continue to have) a significant impact on the banking industry, including our organization.

On June 4, 2012, the Board of Governors of the Federal Reserve System issued Notices of Proposed Rulemaking (“NPR”) – Enhancements to the Regulatory Capital Requirements (the “Proposed New Capital Requirements”). These Proposed New Capital Requirements, if adopted as outlined in the NPR, would have a material impact on the banking industry, including our organization. In general the Proposed New Capital Requirements would significantly increase the need for Tier 1 common equity capital and substantially impact the calculation of risk-weighted assets. See “Liquidity and Capital Resources.”

Index

It is against this backdrop that we discuss our results of operations for the third quarter and first nine months of 2012 as compared to 2011 and our financial condition as of September 30, 2012.

Results of Operations

Summary. We recorded net income of $6.4 million and net income applicable to common stock of $5.4 million during the three months ended September 30, 2012 compared to a net loss of $4.1 million and a net loss applicable to common stock of $5.2 million during the comparable period in 2011. The improvement in 2012 results as compared to 2011 primarily reflects decreases in the provision for loan losses and non-interest expenses and an increase in non-interest income that were partially offset by a decrease in net interest income.

We recorded net income of $14.3 million and net income applicable to common stock of $11.0 million during the nine months ended September 30, 2012 compared to a net loss of $11.5 million and a net loss applicable to common stock of $14.6 million during the comparable period in 2011. The reasons for the changes in the year-to-date comparative periods are generally commensurate with the quarterly comparative periods.

Key performance ratios
	Three months ended						Nine months ended
	September 30,						September 30,
	2012			2011			2012			2011
Net income (loss) (annualized) to(1)
Average assets		0.89	%		(0.89	)%		0.62	%		(0.81	)%
Average common shareholders’ equity		62.71			(56.07	)		52.38			(52.57	)

Net income (loss) per common share(1)
Basic	$	0.61		$	(0.61	)	$	1.28		$	(1.78	)
Diluted		0.16			(0.61	)		0.36			(1.78	)

(1) These amounts are calculated using net income (loss) applicable to common stock.

Net interest income. Net interest income is the most important source of our earnings and thus is critical in evaluating our results of operations. Changes in our net interest income are primarily influenced by our level of interest-earning assets and the income or yield that we earn on those assets and the manner and cost of funding our interest-earning assets. Certain macro-economic factors can also influence our net interest income such as the level and direction of interest rates, the difference between short-term and long-term interest rates (the steepness of the yield curve) and the general strength of the economies in which we are doing business. Finally, risk management plays an important role in our level of net interest income. The ineffective management of credit risk and interest-rate risk in particular can adversely impact our net interest income.

Our net interest income totaled $21.5 million during the third quarter of 2012, a decrease of $2.3 million, or 9.8% from the year-ago period. Our net interest income as a percent of average interest-earning assets (the “net interest margin”) was 3.92% during the third quarter of 2012, compared to 4.59% in the year-ago period. The net interest margin decreased due primarily to a change in asset mix, as higher yielding loans declined and lower yielding short-term investments increased. The quarterly year-over-year decrease in net interest income was partially offset by an increase in average interest-earning assets, which rose to $2.18 billion in the third quarter of 2012 compared to $2.06 billion in the year-ago quarter. The increase in average interest-earning assets primarily reflects a rise in securities available for sale and overnight interest bearing balances at the Federal Reserve Bank that were partially offset by a decline in loans.

Index

For the first nine months of 2012, net interest income totaled $65.4 million, a decrease of $6.2 million, or 8.7% from 2011. The Company’s net interest margin for the first nine months of 2012 decreased to 4.03% compared to 4.43% in 2011. The reasons for the decline in net interest income for the first nine months of 2012 are generally consistent with those described above for the comparative quarterly periods.

Beginning in the last half of 2009 and continuing into the first nine months of 2012, we increased our level of lower-yielding interest bearing cash balances and investment securities to augment our liquidity in response to our stressed financial condition (see “Liquidity and capital resources”) and to provide the future funding needed for the pending Branch Sale. In addition, due to the challenges facing Mepco (see “Noninterest expense”), we have been reducing the balance of payment plan receivables beginning in late 2009 and continuing into the first nine months of 2012. These payment plan receivables are the highest yielding segment of our loan portfolio, with an average yield of approximately 13% to 14%. The combination of these items (an increase in the level of lower-yielding interest bearing cash balances and investment securities and a decrease in the level of higher-yielding loans, including payment plan receivables) has had an adverse impact on our 2012 net interest income and net interest margin.

Our net interest income is also adversely impacted by our level of non-accrual loans. In the third quarter and first nine months of 2012 non-accrual loans averaged $41.7 million and $48.5 million, respectively compared to $53.4 million and $57.8 million, respectively for the same periods in 2011. In addition, in the third quarter and first nine months of 2012 we had net recoveries of $0.2 million and $0.2 million, respectively, of accrued and unpaid interest on loans placed on or taken off non-accrual during each period compared to net reversals of $0.1 million and $0.2 million, respectively during the same periods in 2011.

Index


Average Balances and Rates
		Three Months Ended
		September 30,
		2012						2011
		Average						Average
		Balance		Interest	Rate(3)			Balance		Interest	Rate(3)
Assets (1)		(Dollars in thousands)
Taxable loans	$	1,532,773	$	23,312	6.05	%	$	1,668,940	$	27,140	6.47	%
Tax-exempt loans (2)		6,709		73	4.33			7,728		82	4.21
Taxable securities		217,427		655	1.20			49,911		297	2.36
Tax-exempt securities (2)		26,116		261	3.98			29,259		301	4.08
Cash – interest bearing		377,899		243	0.26			282,170		179	0.25
Other investments		20,494		189	3.67			21,005		188	3.55
Interest Earning Assets		2,181,418		24,733	4.52			2,059,013		28,187	5.44
Cash and due from banks		56,289						56,233
Other assets, net		161,971						192,282
Total Assets	$	2,399,678					$	2,307,528

Liabilities
Savings and NOW	$	1,079,389		494	0.18		$	1,008,525		608	0.24
Time deposits		549,319		1,729	1.25			577,723		2,622	1.80
Other borrowings		67,994		1,059	6.20			86,696		1,183	5.41
Interest Bearing Liabilities		1,696,702		3,282	0.77			1,672,944		4,413	1.05
Demand deposits		545,945						477,093
Other liabilities		40,477						42,614
Shareholders’ equity		116,554						114,877
Total liabilities and shareholders’ equity	$	2,399,678					$	2,307,528

Net Interest Income			$	21,451					$	23,774

Net Interest Income as a Percent of Earning Assets					3.92	%					4.59	%

(1)	All domestic, except for none and $0.01 million for the three months ended September 30, 2012 and 2011, respectively, of average payment plan receivables included in taxable loans for customers domiciled in Canada.

(2)	Interest on tax-exempt loans and securities is not presented on a fully tax equivalent basis due to the current net operating loss carryforward position and the deferred tax asset valuation allowance.

(3)	Annualized.

Index

Average Balances and Rates
		Nine Months Ended
		September 30,
		2012						2011
		Average						Average
		Balance		Interest	Rate(3)			Balance		Interest	Rate(3)
Assets (1)		(Dollars in thousands)
Taxable loans	$	1,557,164	$	71,209	6.11	%	$	1,728,076	$	84,554	6.54	%
Tax-exempt loans (2)		7,010		218	4.15			8,064		254	4.21
Taxable securities		221,245		2,246	1.36			51,010		1,108	2.90
Tax-exempt securities (2)		26,563		801	4.03			30,087		931	4.14
Cash – interest bearing		334,426		638	0.25			319,288		605	0.25
Other investments		20,628		572	3.70			22,486		580	3.45
Interest Earning Assets		2,167,036		75,684	4.67			2,159,011		88,032	5.45
Cash and due from banks		54,619						52,475
Other assets, net		163,058						191,215
Total Assets	$	2,384,713					$	2,402,701

Liabilities
Savings and NOW	$	1,071,169		1,452	0.18		$	1,005,436		1,805	0.24
Time deposits		565,731		5,500	1.30			687,043		10,881	2.12
Other borrowings		73,714		3,351	6.07			95,337		3,738	5.24
Interest Bearing Liabilities		1,710,614		10,303	0.80			1,787,816		16,424	1.23
Demand deposits		524,615						456,514
Other liabilities		39,810						43,977
Shareholders’ equity		109,674						114,394
Total liabilities and shareholders’ equity	$	2,384,713					$	2,402,701

Net Interest Income			$	65,381					$	71,608

Net Interest Income as a Percent of Earning Assets					4.03	%					4.43	%

(1)	All domestic, except for none and $0.02 million for the nine months ended September 30, 2012 and 2011, respectively, of average payment plan receivables included in taxable loans for customers domiciled in Canada.

(2)	Interest on tax-exempt loans and securities is not presented on a fully tax equivalent basis due to the current net operating loss carryforward position and the deferred tax asset valuation allowance.

(3)	Annualized.

Provision for loan losses. The provision for loan losses was $0.3 million and $6.2 million during the three months ended September 30, 2012 and 2011, respectively. During the nine-month periods ended September 30, 2012 and 2011, the provision was $6.4 million and $21.0 million, respectively. The provision reflects our assessment of the allowance for loan losses taking into consideration factors such as loan mix, levels of non-performing and classified loans and loan net charge-offs. While we use relevant information to recognize losses on loans, additional provisions for related losses may be necessary based on changes in economic conditions, customer circumstances and other credit risk factors. The decrease in the provision for loan losses in the third quarter and first nine months of 2012 primarily reflects reduced levels of non-performing loans, lower total loan balances and a decline in loan net charge-offs. See “Portfolio Loans and asset quality” for a discussion of the various components of the allowance for loan losses and their impact on the provision for loan losses in the third quarter and first nine months of 2012.

Index

Non-interest income. Non-interest income is a significant element in assessing our results of operations. We regard net gains on mortgage loans as a core recurring source of revenue but they are quite cyclical and thus can be volatile. We regard net gains (losses) on securities as a “non-operating” component of non-interest income.

Non-interest income totaled $14.5 million during the three months ended September 30, 2012, a $5.3 million increase from the comparable period in 2011. For the first nine months of 2012 non-interest income totaled $42.2 million, a $7.7 million increase from the comparable period in 2011. The increase in non-interest income is primarily due to a significant rise in net gains on mortgage loans and a reduced loss from mortgage loan servicing.

Non-Interest Income
	Three months ended						Nine months ended
	September 30,						September 30,
	2012			2011			2012			2011
	(In thousands)
Service charges on deposit accounts	$	4,739		$	4,623		$	13,492		$	13,689
Interchange income		2,324			2,356			7,053			6,832
Net gains (losses) on assets:
Mortgage loans		4,602			2,025			12,041			5,753
Securities		301			(57	)		1,154			271
Other than temporary loss on securities available for sale:
Total impairment loss		(70	)		(4	)		(332	)		(146	)
Recognized in other comprehensive loss		-			-			-			-
Net impairment loss in earnings		(70	)		(4	)		(332	)		(146	)
Mortgage loan servicing		(364	)		(2,655	)		(716	)		(1,885	)
Investment and insurance commissions		491			534			1,586			1,613
Bank owned life insurance		398			496			1,221			1,385
Title insurance fees		482			299			1,479			1,090
Change in U.S. Treasury Warrant fair value		(32	)		29			(211	)		1,025
Other		1,671			1,609			5,401			4,795
Total non-interest income	$	14,542		$	9,255		$	42,168		$	34,422

Service charges on deposit accounts increased slightly during the three-month period and declined slightly during the nine-month period ended September 30, 2012, respectively, from the comparable periods in 2011. The quarterly growth in such service charges primarily reflects increases in certain account level fees (primarily on treasury management products) that were implemented in the third quarter of 2012. The decrease in such service charges on a year-to-date comparative basis primarily relates to a decline in non-sufficient funds (”NSF”) occurrences and related NSF fees. We believe the decline in NSF occurrences is principally due to our customers managing their finances more closely in order to reduce NSF activity and avoid the associated fees.

Index

Interchange income was relatively unchanged on a comparative quarterly basis and increased by 3.2% on a year-to-date basis in 2012 compared to 2011. The year-to-date growth in interchange income primarily reflects an increase in debit card transaction volumes, although such transaction volumes did level off in the third quarter of 2012. As described earlier, the Dodd-Frank Act includes a provision under which interchange fees for debit cards are set by the Federal Reserve under a restrictive “reasonable and proportional cost” per transaction standard. On June 29, 2011 the Federal Reserve issued final rules (that were effective October 1, 2011) on interchange fees for debit cards. Overall, these final rules established price caps for debit card interchange fees that were approximately 50% lower than previous averages. However, debit card issuers with less than $10 billion in assets (like us) are exempt from this rule. On a long-term basis, it is not clear how competitive market factors may impact debit card issuers who are exempt from the rule. As a result, at the present time, we cannot predict if our interchange income will be lower in the future because of such price caps.

Net gains on mortgage loans increased significantly on both a quarterly and a year-to-date basis. Mortgage loan activity is summarized as follows:

Mortgage Loan Activity
	Three months ended						Nine months ended
	September 30,						September 30,
	2012			2011			2012			2011
	(Dollars in thousands)
Mortgage loans originated	$	135,263		$	89,526		$	384,896		$	259,711
Mortgage loans sold		128,196			80,993			367,350			265,850
Mortgage loans sold with servicing rights released		21,942			25,179			59,837			60,179
Net gains on mortgage loans		4,602			2,025			12,041			5,753
Net gains as a percent of mortgage loans sold (“Loan Sales Margin”)		3.59	%		2.50	%		3.28	%		2.16	%
Fair value adjustments included in the Loan Sales Margin		0.29			0.15			0.45			(0.14	)

The volume of loans sold is dependent upon our ability to originate mortgage loans as well as the demand for fixed-rate obligations and other loans that we choose to not put into portfolio because of our established interest-rate risk parameters. (See “Portfolio Loans and asset quality.”) Net gains on mortgage loans are also dependent upon economic and competitive factors as well as our ability to effectively manage exposure to changes in interest rates and thus can often be a volatile part of our overall revenues.

Net gains as a percentage of mortgage loans sold (our “Loan Sales Margin”) are impacted by several factors including competition and the manner in which the loan is sold (with servicing rights retained or released). Our decision to sell or retain mortgage loan servicing rights is primarily influenced by an evaluation of the price being paid for mortgage loan servicing by outside third parties compared to our calculation of the economic value of retaining such servicing. The sale of mortgage loan servicing rights may result in declines in mortgage loan servicing income in future periods. Net gains on mortgage loans are also impacted by recording fair value accounting adjustments. Excluding the aforementioned accounting adjustments, the Loan Sales Margin would have been 3.30% and 2.35% in the third quarters of 2012 and 2011, respectively and 2.83% and 2.30% for the comparative 2012 and 2011 year-to-date periods, respectively. The increase in the Loan Sales Margin (excluding fair value adjustments) in 2012 was generally due to more favorable competitive conditions including wider primary-to-secondary market pricing spreads. The changes in the fair value accounting adjustments are primarily due to changes in the amount of commitments to originate mortgage loans for sale.

Index

Net gains on securities were $0.3 million and $1.2 million during the three and nine months ended September 30, 2012, respectively, and $0.3 million for the nine months ended September 30, 2011. We recorded a net loss on securities of $0.1 million in the third quarter of 2011. The 2012 net gains on securities were due primarily to the sale of U.S. agency residential mortgage-backed investment securities. The third quarter 2011 net loss on securities was due primarily to a decline in the fair value of trading securities. The year to date 2011 net gain on securities was due primarily to the sale of U.S. agency residential mortgage-backed investment securities and a U.S. Treasury security.

We recorded net other than temporary impairment charges on securities available for sale of $0.1 million and $0.3 million during the three and nine months ended September 30, 2012, respectively, and $0.004 million and $0.1 million for the respective comparable periods in 2011. These impairment charges related to private label residential mortgage-backed investment securities. (See “Securities.”)

Mortgage loan servicing generated a loss of $0.4 million and $0.7 million in the third quarter and first nine months of 2012, respectively, compared to a loss of $2.7 million and $1.9 million in the corresponding periods of 2011, respectively. These variances are primarily due to changes in the valuation allowance on and the amortization of capitalized mortgage loan servicing rights. The period end valuation allowance is based on the valuation of the mortgage loan servicing portfolio. The impairment charges incurred in the third quarters of both 2012 and 2011 primarily reflect lower mortgage loan interest rates during those quarters resulting in higher estimated future prepayment rates being used in the quarter end valuation. Activity related to capitalized mortgage loan servicing rights is as follows:

Capitalized Mortgage Loan Servicing Rights
		Three months ended September 30,						Nine months ended September 30,
		2012			2011			2012			2011
		(In thousands)
Balance at beginning of period	$	10,651		$	14,741		$	11,229		$	14,661
Originated servicing rights capitalized		996			573			2,948			2,068
Amortization		(1,052	)		(688	)		(3,351	)		(2,011	)
(Increase)/decrease in impairment reserve		(390	)		(3,077	)		(621	)		(3,169	)
Balance at end of period	$	10,205		$	11,549		$	10,205		$	11,549
Impairment reserve at end of period	$	7,165		$	6,379		$	7,165		$	6,379

At September 30, 2012 we were servicing approximately $1.76 billion in mortgage loans for others on which servicing rights have been capitalized. This servicing portfolio had a weighted average coupon rate of 4.93% and a weighted average service fee of approximately 25.4 basis points. Remaining capitalized mortgage loan servicing rights at September 30, 2012 totaled $10.2 million, representing approximately 58 basis points on the related amount of mortgage loans serviced for others. The capitalized mortgage loan servicing had an estimated fair market value of $10.4 million at September 30, 2012.

Nearly all of our mortgage loans serviced for others at September 30, 2012 are for either Fannie Mae or Freddie Mac. If our Bank were to fall below “well capitalized” (as defined by banking regulations) it is possible that Fannie Mae and Freddie Mac could require us to very quickly sell or transfer such servicing rights to a third party or unilaterally strip us of such servicing rights if we cannot complete an approved transfer. Depending on the terms of any such transaction, this forced sale or transfer of such mortgage loan servicing rights could have a material adverse impact on our financial condition and results of operations.

Index

Investment and insurance commissions were down slightly on a comparative quarterly and year-to-date basis in 2012 compared to 2011. Although we have made efforts to expand this business, this decline in 2012 is due primarily to the loss of an experienced investment representative in one of our markets.

Income from bank owned life insurance decreased on both a comparative quarterly and year-to-date basis in 2012 compared to 2011 primarily reflecting a lower average crediting rate on our cash surrender value due to reduced total returns on the underlying separate account assets. Our separate account is primarily invested in U.S. agency residential mortgage-backed securities and managed by PIMCO. The crediting rate (on which the earnings are based) reflects the performance of the separate account. The total cash surrender value of our bank owned life insurance was $50.5 million and $49.3 million at September 30, 2012 and December 31, 2011, respectively.

Title insurance fees were higher on both a comparative quarterly and year-to-date basis in 2012 compared to 2011 primarily as a result of an increase in mortgage lending origination volume.

Changes in the fair value of the amended warrant issued to the U.S. Department of the Treasury (“UST”) in April 2010 are recorded as a component of non-interest income. The fair value of this amended warrant is included in accrued expenses and other liabilities in our Condensed Consolidated Statements of Financial Condition. (See “Liquidity and capital resources.”) Two significant inputs in our valuation model for the amended warrant are our common stock price and the probability percentage of triggering anti-dilution provisions in this instrument related to certain equity transactions. The third quarter and first nine months of 2012, included $0.03 million and $0.2 million of expense, respectively, related to an increase in the fair value of the warrant due primarily to a rise in our common stock price. The third quarter and first nine months of 2011, included $0.03 million and $1.0 million of income, respectively, related to a decline in the fair value of the warrant due primarily to the use of a lower probability of triggering the anti-dilution provisions. (See “Liquidity and capital resources.”)

Other non-interest income increased slightly on a comparative quarterly basis and by $0.6 million on a year-to-date basis in 2012 compared to 2011. The year-to-date increase in 2012 is due to improvement ($0.15 million of earnings in 2012 compared to a $0.04 million loss in 2011) in the performance of our private mortgage reinsurance captive, a $0.25 million increase in rental income (which is generated primarily on ORE properties) and a $0.17 million increase in ATM fees. The improved 2012 performance of our private mortgage reinsurance captive reflects a decline in mortgage loan defaults and lower private mortgage insurance claims.

Non-interest expense. Non-interest expense is an important component of our results of operations. We strive to efficiently manage our cost structure and management is focused on a number of initiatives to reduce and contain non-interest expenses.

Index

Non-interest expense decreased by $2.2 million to $29.3 million and by $10.4 million to $86.8 million during the three- and nine-month periods ended September 30, 2012, respectively, compared to the like periods in 2011. These decreases are primarily due to declines in loan and collection costs (year-to-date only), occupancy and furniture, fixtures and equipment expenses, net losses on ORE and repossessed assets, credit card and bank service fees, vehicle service contract counterparty contingencies, and other non-interest expenses.

Non-Interest Expense
	Three months ended						Nine months ended
	September 30,						September 30,
	2012			2011			2012			2011
	(in thousands)
Compensation	$	9,702		$	10,158		$	29,198		$	29,990
Performance-based compensation		1,712			281			3,532			772
Payroll taxes and employee benefits		2,196			2,215			6,868			7,270
Compensation and employee benefits		13,610			12,654			39,598			38,032
Loan and collection		2,832			2,658			8,129			10,105
Occupancy, net		2,482			2,651			7,688			8,415
Data processing		2,492			2,502			7,281			7,227
Furniture, fixtures and equipment		1,194			1,308			3,795			4,228
Legal and professional		952			751			3,117			2,330
Communications		785			863			2,486			2,700
FDIC deposit insurance		816			885			2,489			2,772
Net losses on ORE and repossessed assets		291			1,931			1,911			4,114
Credit card and bank service fees		433			869			1,708			2,929
Advertising		647			740			1,842			1,964
Vehicle service contract counterparty contingencies		281			1,345			1,078			5,002
Supplies		299			376			1,033			1,170
Provision for loss reimbursement on sold loans		193			251			751			1,020
Write-down of property and equipment held for sale		860			-			860			-
Amortization of intangible assets		272			343			816			1,029
Costs (recoveries) related to unfunded lending commitments		(538	)		(172	)		(597	)		12
Other		1,395			1,507			2,843			4,186
Total non-interest expense	$	29,296		$	31,462		$	86,828		$	97,235

Compensation and employee benefits expenses increased by $1.0 million to $13.6 million and by $1.6 million to $39.6 million during the three- and nine-month periods ended September 30, 2012, respectively, compared to 2011. Compensation expense declined due primarily to a reduction in our average number of full time equivalent employees in 2012 compared to year ago levels. Also payroll taxes and employee benefits declined due primarily to a decrease in medical insurance costs due to both a reduction in the number of insured employees as well as somewhat reduced claims. However, more than offsetting the aforementioned decreases was an increase in performance based compensation due primarily to accruals recorded in the third quarter and first nine months of 2012 of $0.9 million and $1.8 million, respectively, for anticipated incentive based compensation and $0.4 million and $0.8 million, respectively, for an anticipated employee stock ownership plan contribution. These accruals were recorded because of our improved overall performance in 2012, which is now expected to lead to the payout of incentive based compensation.

Index

Loan and collection expenses increased by $0.2 million to $2.8 million and decreased by $2.0 million to $8.1 million during the three- and nine-month periods ended September 30, 2012, respectively, compared to 2011. Loan and collection expenses primarily reflect costs related to the management and collection of non-performing loans and other problem credits. These expenses (although still at an elevated level compared to historic norms) have declined on a year-to-date basis in 2012, which primarily reflects the overall decrease in the volume of problem credits (non-performing loans and “watch” credits). (See “Portfolio Loans and asset quality.”)

Occupancy, net decreased on both a comparative quarterly and year-to-date basis due primarily to lower snow removal and utilities costs in 2012 which reflect an unseasonably warm winter in Michigan in 2012 as well as a reduction in the number of branch offices due to the consolidation or closing of certain locations in late 2011 and early 2012.

The current year levels of data processing, furniture, fixtures and equipment, communications, advertising and supplies were generally comparable to or lower than the prior year. Collectively, these expense categories declined by $0.4 million, or 6.4%, and by $0.9 million, or 4.9%, during the third quarter and first nine months of 2012, respectively, compared to the year ago periods due primarily to our cost reduction efforts.

Legal and professional fees increased on both a comparative quarterly and year-to-date basis. This increase is primarily due to expenses associated with certain consulting services, various regulatory matters, the Branch Sale, and legal costs at Mepco associated with litigation being pursued against certain business counterparties.

FDIC deposit insurance expense decreased on both a comparative quarterly and year-to-date basis principally reflecting a new rate structure implemented by the FDIC, which became effective at the beginning of the second quarter of 2011. The new rate structure has a lower assessment rate but is based on total assets as compared to the prior structure that was based primarily on total deposits but had a higher assessment rate. In addition, the third quarter of 2011 included $0.1 million of additional expense related to the final actual second quarter 2011 assessment compared to what had been accrued for at June 30, 2011.

Net losses on ORE and repossessed assets primarily represent the loss on the sale or additional write downs on these assets subsequent to the transfer of the asset from our loan portfolio. This transfer occurs at the time we acquire the collateral that secured the loan. At the time of acquisition, the other real estate or repossessed asset is valued at fair value, less estimated costs to sell, which becomes the new basis for the asset. Any write-downs at the time of acquisition are charged to the allowance for loan losses. The reduced net losses in 2012, as compared to 2011, primarily reflects some stability in real estate prices during the last twelve months, with some markets even experiencing modest price increases. However, foreclosed properties generally continue to have distressed valuations.

Credit card and bank service fees decreased on both a comparative quarterly and year-to-date basis primarily due to a decline in the number of payment plans being serviced by Mepco in 2012 compared to 2011. In addition, in the third quarter of 2012, Mepco entered into a new contract with a different vendor for credit card processing services that has a significantly lower fee structure.

Index

We record estimated incurred losses associated with Mepco’s vehicle service contract payment plan receivables in our provision for loan losses and establish a related allowance for loan losses. (See “Portfolio Loans and asset quality.”) We record estimated incurred losses associated with defaults by Mepco’s counterparties as “vehicle service contract counterparty contingencies expense,” which is included in non-interest expenses in our Condensed Consolidated Statements of Operations.

We recorded an expense of $0.3 million and $1.1 million for vehicle service contract payment plan counterparty contingencies in the third quarter and first nine months of 2012, respectively, compared to $1.3 million and $5.0 million, respectively, for the comparable periods in 2011. The lower expense in 2012 is attributed to a decline in the actual and expected level of cancellations giving rise to potential amounts due from counterparties.

Our estimate of probable incurred losses from vehicle service contract counterparty contingencies requires a significant amount of judgment because a number of factors can influence the amount of loss that we may ultimately incur. These factors include our estimate of future cancellations of vehicle service contracts, our evaluation of collateral that may be available to recover funds due from our counterparties, and our assessment of the amount that may ultimately be collected from counterparties in connection with their contractual obligations. We apply a rigorous process, based upon historical payment plan activity and past experience, to estimate probable incurred losses and quantify the necessary reserves for our vehicle service contract counterparty contingencies, but there can be no assurance that our modeling process will successfully identify all such losses.

In particular, as noted in our Risk Factors included in Part I - Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011, Mepco has had to initiate litigation against certain counterparties, including one of the respective third party insurers, to collect amounts owed to Mepco as a result of those parties' dispute of their contractual obligations to Mepco. Vehicle service contract counterparty receivables totaled $18.8 million at September 30, 2012 compared to $29.3 million at December 31, 2011. The decline in such receivables is due primarily to the receipt (in September 2012) of assets (cash and real estate) from the bankruptcy estate of a former counterparty. In addition, see Note #14 to the Interim Condensed Consolidated Financial Statements included within this report for more information about Mepco's business, certain risks and difficulties we currently face with respect to that business, and reserves we have established (through vehicle service contract counterparty contingencies expense) for losses related to the business.

During the third quarter of 2012 we adopted a plan to close or consolidate several branch offices. We expect that these branch offices will be closed prior to year end 2012. We recorded a $0.9 million write-down of property and equipment in the third quarter of 2012 based on the expected disposal price of these branch offices.

The amortization of intangible assets primarily relates to branch acquisitions and the amortization of the deposit customer relationship value, including core deposit value, which was acquired in connection with those acquisitions. We had remaining unamortized intangible assets of $6.8 million and $7.6 million at September 30, 2012 and December 31, 2011, respectively. See Note #8 to the Interim Condensed Consolidated Financial Statements for a schedule of future amortization of intangible assets.

Index

The provision for loss reimbursement on sold loans represents our estimate of incurred losses related to mortgage loans that we have sold to investors (primarily Fannie Mae and Freddie Mac). Since we sell mortgage loans without recourse, loss reimbursements only occur in those instances where we have breached a representation or warranty or other contractual requirement related to the loan sale. Historically, loss reimbursements on mortgage loans sold without recourse were very rare. In 2009, we had only one actual loss reimbursement (for $0.06 million). Prior to 2009, we had years in which we incurred no such loss reimbursements. However, our loss reimbursements have increased since 2009. Over the past two years Fannie Mae and Freddie Mac, in particular, have been doing more reviews of mortgage loans where they have incurred or expect to incur a loss and have been more aggressive in pursuing loss reimbursements from the sellers of such mortgage loans. Although we are successful in the vast majority of cases where file reviews are conducted on mortgage loans that we have sold to investors and actual loss reimbursements have been relatively modest, the levels of such file reviews and loss reimbursement requests have increased. As a result, we have established a reserve (which totaled $1.1 million and $1.5 million at September 30, 2012 and December 31, 2011, respectively) for loss reimbursements on sold mortgage loans. This reserve is included in accrued expenses and other liabilities in our Condensed Consolidated Statements of Financial Condition. This reserve is based on an analysis of mortgage loans that we have sold which are further categorized by delinquency status, loan to value, and year of origination. The calculation includes factors such as probability of default, probability of loss reimbursement (breach of representation or warranty) and estimated loss severity. The decline in the reserve during 2012 is primarily due to a reduction in specific reserves (due to fewer pending loss reimbursements). While we believe that the amounts we have accrued for incurred losses on sold loans are appropriate given these analyses, future losses could exceed our current estimate.

The changes in costs (recoveries) related to unfunded lending commitments are primarily impacted by changes in the amounts of such commitments to originate portfolio loans as well as (for commercial loan commitments) the grade (pursuant to our loan rating system) of such commitments. In addition, in the third quarter of 2012, we enhanced our methodology for computing the allowance for loan losses on retail loans (residential mortgage loans and consumer loans). This enhanced methodology uses borrower credit scores and a migration analysis to estimate a probability of default. The entire recovery of $0.5 million related to unfunded lending commitments recorded in the third quarter of 2012 is due to the implementation of this enhanced methodology.

Other non-interest expenses were relatively unchanged between the third quarters of 2012 and 2011, but declined by $1.3 million in the first nine months of 2012 compared to the like period in 2011. This year to date decline principally reflects the first quarter 2012 reversal of a previously established accrual at Mepco that was determined to no longer be necessary.

Income tax expense (benefit). As a result of being in a net operating loss carryforward position, we have established a deferred tax asset valuation allowance against all of our net deferred tax assets. Accordingly, the income tax expense (benefit) related to any income (loss) before income tax is largely being offset by changes in the deferred tax valuation allowance. See Note #10 to the Interim Condensed Consolidated Financial Statements.

Index

Certain of the capital initiatives detailed below under “Liquidity and capital resources” may trigger an ownership change that would negatively affect our ability to utilize our net operating loss carryforwards and other deferred tax assets in the future. If such an ownership change were to occur, we may suffer higher-than-anticipated tax expense, and consequently lower net income and cash flow, in those future years. As of September 30, 2012, we had federal loss carryforwards of approximately $76.1 million (which includes $0.3 million of federal capital loss carryforwards). Companies are subject to a change of ownership test under Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), that, if met, would limit the annual utilization of tax losses and credits carrying forward from pre-change of ownership periods, as well as the ability to use certain unrealized built-in losses. Generally, under Section 382, the yearly limitation on our ability to utilize such deductions will be equal to the product of the applicable long-term tax exempt rate (presently 2.80%) and the sum of the values of our common shares and of our outstanding convertible preferred stock, immediately before the ownership change. In addition to limits on the use of net operating loss carryforwards, our ability to utilize deductions related to bad debts and other losses for up to a five-year period following such an ownership change would also be limited under Section 382, to the extent that such deductions reflect a net loss that was “built-in” to our assets immediately prior to the ownership change. We are presently seeking to limit the size of any future equity offering in order to avoid triggering any Section 382 limitations.

Since we currently have a valuation allowance intended to fully offset these net operating loss carryforwards and most other deferred tax assets, we do not expect these tax rules to cause a material impact to our net income or loss in the near term.

Our actual federal income tax expense (benefit) is different than the amount computed by applying our statutory federal income tax rate to our pre-tax income (loss) primarily due to tax-exempt interest income and tax-exempt income from the increase in the cash surrender value on life insurance, as well as the impact of the change in the deferred tax asset valuation allowance.

Business Segments. Our reportable segments are based upon legal entities. We currently have two reportable segments: Independent Bank and Mepco. These business segments are also differentiated based on the products and services provided. We evaluate performance based principally on net income (loss) of the respective reportable segments.

The following table presents net income (loss) by business segment.

Business Segments
		Three months ended September 30,						Nine months ended September 30
		2012			2011			2012			2011
		(in thousands)
Independent Bank	$	7,125		$	(3,164	)	$	15,726		$	(9,097	)
Mepco		268			(96	)		1,517			(678	)
Other(1)		(923	)		(838	)		(2,889	)		(1,640	)
Elimination		(24	)		(24	)		(71	)		(71	)
Net income (loss)	$	6,446		$	(4,122	)	$	14,283		$	(11,486	)

(1) Includes amounts relating to our parent company and certain insignificant operations.

Index

The improvement in the results of operations of Independent Bank in 2012 compared to 2011 is primarily due to a lower provision for loan losses, an increase in non-interest income and a decrease in non-interest expenses that were partially offset by a decline in net interest income. (See “Provision for loan losses,” “Portfolio Loans and asset quality,” “Net interest income,” “Non-interest income,” and “Non-interest expense.”)

The change in Mepco’s results is due to a decline in non-interest expenses that was partially offset by a decrease in net interest income that is due principally to a decline in payment plan receivables (see “Net interest income” and “Non-interest expense”). All of Mepco’s funding is provided by Independent Bank through an intercompany loan (that is eliminated in consolidation). The rate on this intercompany loan is based on the Prime Rate (currently 3.25%). Mepco might not be able to obtain such favorable funding costs on its own in the open market.

The change in other in the table above (increased loss of $0.1 million and $1.2 million in the third quarter and first nine months of 2012, respectively, as compared to 2011) is due primarily to the change in the fair value of the amended warrant issued to the UST in each respective period (see “Non-interest income”).

Financial Condition

Summary. Our total assets increased by $93.4 million during the first nine months of 2012 due primarily to increases in cash and cash equivalents and in securities available for sale. Loans, excluding loans held for sale ("Portfolio Loans"), totaled $1.43 billion at September 30, 2012, down 9.2% from $1.58 billion at December 31, 2011. (See "Portfolio Loans and asset quality").

Deposits (including deposits held for sale related to the pending Branch Sale) totaled $2.17 billion at September 30, 2012, compared to $2.09 billion at December 31, 2011. This increase is primarily due to growth in checking and savings account balances. Other borrowings totaled $17.7 million at September 30, 2012, a decrease of $15.7 million from December 31, 2011. This decrease primarily reflects reduced borrowings from the Federal Home Loan Bank of Indianapolis.

Securities. We maintain diversified securities portfolios, which include obligations of U.S. government-sponsored agencies, securities issued by states and political subdivisions, residential mortgage-backed securities and trust preferred securities. We regularly evaluate asset/liability management needs and attempt to maintain a portfolio structure that provides sufficient liquidity and cash flow. Except as discussed below, we believe that the unrealized losses on securities available for sale are temporary in nature and are expected to be recovered within a reasonable time period. We have the ability to hold securities with unrealized losses to maturity or until such time as the unrealized losses reverse. (See “Asset/liability management.”)

Securities
			Unrealized
	Amortized						Fair
	Cost		Gains		Losses		Value
	(In thousands)
Securities available for sale
September 30, 2012	$	230,980	$	1,980	$	2,774	$	230,186
December 31, 2011		161,023		1,575		5,154		157,444

Index

Securities available for sale increased during the first nine months of 2012 due primarily to the purchase of U.S. government-sponsored agency residential mortgage-backed securities, U.S. government-sponsored agency structured notes and obligations of states and political subdivisions. The securities were purchased to utilize some of the funds generated from the continued decline in Portfolio Loans. (See “Deposits” and “Liquidity and capital resources.”)

Our portfolio of available-for-sale securities is reviewed quarterly for impairment in value. In performing this review, management considers (1) the length of time and extent that fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) the impact of changes in market interest rates on the market value of the security and (4) an assessment of whether we intend to sell, or it is more likely than not that we will be required to sell a security in an unrealized loss position before recovery of its amortized cost basis. For securities that do not meet these recovery criteria, the amount of impairment recognized in earnings is limited to the amount related to credit losses, while impairment related to other factors is recognized in other comprehensive income or loss.

We recorded net other than temporary impairment charges on securities of $0.1 million and $0.004 million in the third quarters of 2012 and 2011, respectively. We recorded net other than temporary impairment charges on securities of $0.3 million and $0.1 million in the first nine months of 2012 and 2011, respectively. In these instances we believe that the decline in value is directly due to matters other than changes in interest rates, are not expected to be recovered within a reasonable timeframe based upon available information and are therefore other than temporary in nature. These net other than temporary impairment charges are all related to private label residential mortgage-backed securities. (See “Non-interest income” and “Asset/liability management.”)

Sales of securities were as follows (See “Non-interest income.”):

	Nine months ended
	September 30,
	2012			2011
	(In thousands)
Proceeds	$	37,176		$	70,322

Gross gains	$	1,193		$	279
Gross losses		-			(75	)
Net impairment charges		(332	)		(146	)
Fair value adjustments		(39	)		67
Net gains	$	822		$	125

Portfolio Loans and asset quality. In addition to the communities served by our Bank branch network, our principal lending markets also include nearby communities and metropolitan areas. Subject to established underwriting criteria, we also historically participated in commercial lending transactions with certain non-affiliated banks and also purchased mortgage loans from third-party originators. Currently, we are not engaging in any new commercial loan participations with non-affiliated banks or purchasing any mortgage loans from third party originators.

Index

The senior management and board of directors of our Bank retain authority and responsibility for credit decisions and we have adopted uniform underwriting standards. Our loan committee structure and the loan review process attempt to provide requisite controls and promote compliance with such established underwriting standards. There can be no assurance that the aforementioned lending procedures and the use of uniform underwriting standards will prevent us from the possibility of incurring significant credit losses in our lending activities and, in fact, we recorded a significant provision for loan losses over the past five years as compared to prior historical levels, although provision levels have been declining since 2009.

We generally retain loans that may be profitably funded within established risk parameters. (See “Asset/liability management.”) As a result, we may hold adjustable-rate and balloon mortgage loans as Portfolio Loans, while 15- and 30-year, fixed-rate obligations are generally sold to mitigate exposure to changes in interest rates. (See “Non-interest income.”)

Future growth of overall Portfolio Loans is dependent upon a number of competitive and economic factors. Although economic conditions have generally improved in Michigan over the past two years, overall loan demand has remained somewhat subdued, reflecting still somewhat weak economic conditions in the State. Further, it is our desire to reduce certain loan categories in order to preserve our regulatory capital ratios or for risk management reasons. For example, construction and land development loans have been declining because we are seeking to shrink this portion of our Portfolio Loans due to a generally poor economic climate for real estate development, particularly residential real estate. In addition, payment plan receivables have declined as we seek to reduce Mepco’s vehicle service contract payment plan business. Further declines in Portfolio Loans may continue to adversely impact our future net interest income.

Non-performing assets(1)
	September 30,			December 31,
	2012			2011
	(Dollars in thousands)
Non-accrual loans	$	38,785		$	59,309
Loans 90 days or more past due and still accruing interest		62			574
Total non-performing loans		38,847			59,883
Other real estate and repossessed assets		30,347			34,042
Total non-performing assets	$	69,194		$	93,925
As a percent of Portfolio Loans
Non-performing loans		2.71	%		3.80	%
Allowance for loan losses		3.35			3.73
Non-performing assets to total assets		2.88			4.07
Allowance for loan losses as a percent of non-performing loans		123.62			98.33

(1)	Excludes loans classified as “troubled debt restructured” that are not past due and vehicle service contract counterparty receivables, net.

Index

Troubled debt restructurings (“TDR”)
	September 30, 2012
	Commercial		Retail			Total
	(In thousands)
Performing TDR’s	$	44,061	$	88,441		$	132,502
Non-performing TDR’s (1)		10,738		9,237	(2)		19,975
Total	$	54,799	$	97,678		$	152,477

	December 31, 2011
	Commercial		Retail			Total
	(In thousands)
Performing TDR’s	$	29,799	$	86,770		$	116,569
Non-performing TDR’s (1)		14,567		14,081	(2)		28,648
Total	$	44,366	$	100,851		$	145,217

(1) Included in non-performing loans in the “Non-performing assets” table above.

(2) Also includes loans on non-accrual at the time of modification until six payments are received on a timely basis.

Non-performing loans declined by $21.0 million, or 35.1%, during the first nine months of 2012 due principally to declines in non-performing commercial loans and residential mortgage loans. These declines primarily reflect loan net charge-offs, pay-offs, negotiated transactions, and the migration of loans into ORE. Non-performing commercial loans relate largely to delinquencies caused by cash-flow difficulties encountered by owners of income-producing properties (due to higher vacancy rates and/or lower rental rates). Non-performing residential mortgage loans are primarily due to delinquencies reflecting both somewhat still weak economic conditions and soft real estate values in many parts of Michigan and in certain markets where we have mortgage loans secured by resort properties (see Note #4 to the Interim Condensed Consolidated Financial Statements). Non-performing loans exclude performing loans that are classified as troubled debt restructurings (“TDRs”). Performing TDRs totaled $132.5 million, or 9.3% of total Portfolio Loans, and $116.6 million, or 7.4% of total Portfolio Loans, at September 30, 2012 and December 31, 2011, respectively. The increase in the amount of performing TDRs in the first nine months of 2012 primarily reflects an increase in commercial loan TDR’s.

ORE and repossessed assets totaled $30.3 million at September 30, 2012, compared to $34.0 million at December 31, 2011. This decrease is primarily the result of sales and write-downs of ORE being in excess of the migration of non-performing loans secured by real estate into ORE as the foreclosure process is completed and any redemption period expires. High foreclosure rates are evident nationwide, but Michigan has consistently had one of the higher foreclosure rates in the U.S. during the past few years. We believe that this high foreclosure rate is due to both somewhat weak economic conditions and declines in residential real estate values (which has eroded or eliminated the equity that many mortgagors had in their home).

We will place a loan that is 90 days or more past due on non-accrual, unless we believe the loan is both well secured and in the process of collection. Accordingly, we have determined that the collection of the accrued and unpaid interest on any loans that are 90 days or more past due and still accruing interest is probable.

Index

The ratio of loan net charge-offs to average loans was 1.46% on an annualized basis in the first nine months of 2012 compared to 2.35% in the first nine months of 2011. The $13.4 million decline in loan net charge-offs primarily reflects a decrease of $9.2 million for commercial loans and $3.2 million for mortgage loans. The loan net charge-offs primarily reflect our levels of non-performing loans and collateral liquidation values, particularly on residential real estate or income-producing commercial properties.

Allowance for loan losses	Nine months ended
	September 30,
	2012						2011
				Unfunded						Unfunded
	Loans			Commitments			Loans			Commitments
	(Dollars in thousands)
Balance at beginning of period	$	58,884		$	1,286		$	67,915		$	1,322
Additions (deduction)
Provision for loan losses		6,438			-			21,029			-
Recoveries credited to allowance		4,603			-			3,080			-
Loans charged against the allowance		(21,294	)		-			(33,204	)		-
Reclassification to loans held for sale		(610	)		-			-			-
Additions (deductions) included in non-interest expense		-			(597	)		-			12
Balance at end of period	$	48,021		$	689		$	58,820		$	1,334

Net loans charged against the allowance to average Portfolio Loans (annualized)		1.46	%					2.35	%

Allocation of the Allowance for Loan Losses
	September 30,		December 31,
	2012		2011
	(In thousands)
Specific allocations	$	23,059	$	22,299
Other adversely rated commercial loans		2,750		4,430
Historical loss allocations		13,643		20,682
Additional allocations based on subjective factors		8,569		11,473
Total	$	48,021	$	58,884

Some loans will not be repaid in full. Therefore, an allowance for loan losses (“AFLL”) is maintained at a level which represents our best estimate of losses incurred. In determining the allowance and the related provision for loan losses, we consider four principal elements: (i) specific allocations based upon probable losses identified during the review of the loan portfolio, (ii) allocations established for other adversely rated loans, (iii) allocations based principally on historical loan loss experience, and (iv) additional allowances based on subjective factors, including local and general economic business factors and trends, portfolio concentrations and changes in the size and/or the general terms of the loan portfolios.

Index

The first AFLL element (specific allocations) reflects our estimate of probable incurred losses based upon our systematic review of specific loans. These estimates are based upon a number of objective factors, such as payment history, financial condition of the borrower, discounted collateral exposure and discounted cash flow analysis. Impaired commercial, mortgage and installment loans are allocated allowance amounts using this first element. The second AFLL element (other adversely rated commercial loans) reflects the application of our loan rating system. This rating system is similar to those employed by state and federal banking regulators. Commercial loans that are rated below a certain predetermined classification are assigned a loss allocation factor for each loan classification category that is based upon a historical analysis of both the probability of default and the expected loss rate (“loss given default”). The lower the rating assigned to a loan or category, the greater the allocation percentage that is applied. The third AFLL element (historical loss allocations) is determined by assigning allocations to higher rated (“non-watch credit”) commercial loans using a probability of default and loss given default similar to the second AFLL element and to homogenous mortgage and installment loan groups based upon borrower credit score and portfolio segment. For homogenous mortgage and installment loans a probability of default for each homogenous pool is calculated by way of credit score migration. Historical loss data for each homogenous pool coupled with the associated probability of default is utilized to calculate an expected loss allocation rate. The fourth AFLL element (additional allocations based on subjective factors) is based on factors that cannot be associated with a specific credit or loan category and reflects our attempt to ensure that the overall allowance for loan losses appropriately reflects a margin for the imprecision necessarily inherent in the estimates of expected credit losses. We consider a number of subjective factors when determining this fourth element, including local and general economic business factors and trends, portfolio concentrations and changes in the size, mix and the general terms of the overall loan portfolio.

Increases in the AFLL are recorded by a provision for loan losses charged to expense. Although we periodically allocate portions of the AFLL to specific loans and loan portfolios, the entire AFLL is available for incurred losses. We generally charge-off commercial, homogenous residential mortgage, and installment loans and payment plan receivables when they are deemed uncollectible or reach a predetermined number of days past due based on product, industry practice and other factors. Collection efforts may continue and recoveries may occur after a loan is charged against the allowance.

While we use relevant information to recognize losses on loans, additional provisions for related losses may be necessary based on changes in economic conditions, customer circumstances and other credit risk factors.

Mepco’s allowance for losses is determined in a similar manner as discussed above, and primarily takes into account historical loss experience and other subjective factors deemed relevant to Mepco’s payment plan business. Estimated incurred losses associated with Mepco’s outstanding vehicle service contract payment plans are included in the provision for loan losses. Mepco recorded a provision of $0.002 million and $0.04 million in the first nine months of 2012 and 2011, respectively, for its provision for loan losses. These lower provision levels are due primarily to declines ($21.4 million and $66.2 million in the first nine months of 2012 and 2011, respectively) in the balance of payment plan receivables. Mepco’s allowance for loan losses totaled $0.2 million at both September 30, 2012 and December 31, 2011, respectively. Mepco has established procedures for vehicle service contract payment plan servicing, administration and collections, including the timely cancellation of the vehicle service contract, in order to protect our position in the event of payment default or voluntary cancellation by the customer. Mepco has also established procedures to attempt to prevent and detect fraud since the payment plan origination activities and initial customer contacts are done entirely through unrelated third parties (vehicle service contract administrators and sellers or automobile dealerships). However, there can be no assurance that the aforementioned risk management policies and procedures will prevent us from the possibility of incurring significant credit or fraud related losses in this business segment. The estimated incurred losses described in this paragraph should be distinguished from the possible losses we may incur from counterparties failing to pay their obligations to Mepco. See Note #14 to the Interim Condensed Consolidated Financial Statements included within this report.

Index

The allowance for loan losses decreased $10.9 million to $48.0 million at September 30, 2012 from $58.9 million at December 31, 2011 and was equal to 3.35% of total Portfolio Loans at September 30, 2012 compared to 3.73% at December 31, 2011. Three of the four components of the allowance for loan losses outlined above declined during the first nine months of 2012. The specific allocations for loan losses increased due principally to an increase in specific reserves on mortgage loans. The allowance for loan losses related to other adversely rated loans decreased from December 31, 2011 to September 30, 2012 due primarily to a 29.8% decrease in the level of such loans. The allowance for loan losses related to historical losses decreased due to lower adjustments for delinquent loans, declines in loan balances and net charge-offs, as well as a refinement in the calculation methodology for this component of the AFLL that was implemented in the third quarter of 2012. This refinement now uses borrower credit scores and a migration analysis to estimate a probability of default as described above. Finally, the allowance for loan losses related to subjective factors decreased due to the improvement in certain economic indicators used in computing this portion of the allowance as well as an overall decline in Portfolio Loans. In addition to the aforementioned changes, the AFLL was reduced by approximately $0.6 million (of which $0.3 million related to historical losses and $0.3 million related to subjective factors) due to loans that were transferred to held for sale as a part of the pending Branch Sale.

Deposits and borrowings. Historically, the loyalty of our customer base has allowed us to price deposits competitively, contributing to a net interest margin that compares favorably to our peers. However, we still face a significant amount of competition for deposits within many of the markets served by our branch network, which limits our ability to materially increase deposits without adversely impacting the weighted-average cost of core deposits.

To attract new core deposits, we have implemented a direct mail account acquisition program as well as branch staff sales training. Our new account acquisition initiatives have historically generated increases in customer relationships. Over the past three to four years we have also expanded our treasury management products and services for commercial businesses and municipalities or other governmental units and have also increased our sales calling efforts in order to attract additional deposit relationships from these sectors. We view long-term core deposit growth as an important objective. Core deposits generally provide a more stable and lower cost source of funds than alternative sources such as borrowings. During the first nine months of 2012, total deposits (including deposits classified as held for sale related to the pending Branch Sale) increased by $84.4 million, or 4.0% due primarily to growth in checking and savings account balances. (See “Liquidity and capital resources.”)

During the fourth quarter of 2009 we prepaid our estimated quarterly deposit insurance premium assessments to the FDIC for periods through the fourth quarter of 2012. These estimated quarterly deposit insurance premium assessments were based on projected deposit balances over the assessment periods. The remaining prepaid deposit insurance premium assessments totaled $10.2 million and $12.6 million at September 30, 2012 and December 31, 2011, respectively. The actual expense over the assessment periods may be different from this prepaid amount due to various factors including variances in the estimated compared to the actual assessment base and rates used during each assessment period.

Index

We have also implemented strategies that incorporate using federal funds purchased, other borrowings and Brokered CDs to fund a portion of our interest earning assets. The use of such alternate sources of funds supplements our core deposits and is a part of our asset/liability management efforts.

Alternative Sources of Funds
	September 30,						December 31,
	2012						2011
			Average						Average
	Amount		Maturity	Rate			Amount		Maturity	Rate
	(Dollars in thousands)
Brokered CDs(1)	$	48,859	0.8 years		1.10	%	$	42,279	1.0 years		1.59	%
Fixed rate FHLB advances		17,714	4.8 years		6.38			30,384	3.3 years		3.99
Variable rate FHLB advances(1)		-						3,000	2.3 years		0.51
Total	$	66,573	1.9 years		2.51	%	$	75,663	2.0 years		2.51	%

(1)

Certain of these items have had their average maturity and rate altered through the use of derivative instruments, including pay-fixed interest rate swaps.

Other borrowings, comprised of advances from the Federal Home Loan Bank (the “FHLB”), totaled $17.7 million at September 30, 2012, compared to $33.4 million at December 31, 2011. The decrease in other borrowed funds reflects reduced borrowings from the FHLB.

As described above, we utilize wholesale funding, including FHLB borrowings and Brokered CDs to augment our core deposits and fund a portion of our assets. At September 30, 2012, our use of such wholesale funding sources amounted to approximately $66.6 million, or 3.0% of total funding (deposits and total borrowings, excluding subordinated debentures). Because wholesale funding sources are affected by general market conditions, the availability of such funding may be dependent on the confidence these sources have in our financial condition and operations. The continued availability to us of these funding sources is uncertain, and Brokered CDs may be difficult for us to retain or replace at attractive rates as they mature. Our liquidity may be constrained if we are unable to renew our wholesale funding sources or if adequate financing is not available in the future at acceptable rates of interest or at all. Additionally, we may not have sufficient liquidity to continue to fund new loans, and we may need to liquidate loans or other assets unexpectedly, in order to repay obligations as they mature.

If we fail to remain “well-capitalized” (under federal regulatory standards) we will be prohibited from accepting or renewing Brokered CDs, without the prior consent of the FDIC. At September 30, 2012, we had Brokered CDs of approximately $48.9 million, or 2.3% of total deposits. Of this amount $32.1 million mature during the next twelve months. We currently have ample liquidity in the form of interest-bearing deposits at the FRB or other short-term investments to retire maturing Brokered CDs. As a result, any potential future restrictions on our ability to access Brokered CDs are not expected to adversely impact our business or financial condition.

Index

We cannot be sure that we will be able to maintain our current level of core deposits. In particular, those deposits that are currently uninsured or those deposits that are in non-interest bearing transaction accounts and have unlimited deposit insurance only through December 31, 2012 (in accordance with provisions in the Dodd-Frank Act), may be particularly susceptible to outflow. At September 30, 2012 we had an estimated $138.2 million of uninsured deposits and an additional $208.7 million of deposits that were in non-interest bearing transaction accounts and fully insured only through December 31, 2012 under the Dodd-Frank Act. A reduction in core deposits would increase our need to rely on wholesale funding sources, at a time when our ability to do so may be more restricted, as described above.

We historically employed derivative financial instruments to manage our exposure to changes in interest rates. We discontinued the active use of derivative financial instruments during 2008, in part, because we could no longer get unsecured credit from our derivatives counterparties. At September 30, 2012, we had remaining one interest-rate swap with an aggregate notional amount of $10.0 million.

Liquidity and capital resources. Liquidity risk is the risk of being unable to timely meet obligations as they come due at a reasonable funding cost or without incurring unacceptable losses. Our liquidity management involves the measurement and monitoring of a variety of sources and uses of funds. Our Condensed Consolidated Statements of Cash Flows categorize these sources and uses into operating, investing and financing activities. We primarily focus our liquidity management on maintaining adequate levels of liquid assets (primarily funds on deposit with the FRB and certain investment securities) as well as developing access to a variety of borrowing sources to supplement our deposit gathering activities and provide funds for purchasing investment securities or originating Portfolio Loans as well as to be able to respond to unforeseen liquidity needs.

Our primary sources of funds include our deposit base, secured advances from the FHLB, a federal funds purchased borrowing facility with another commercial bank, and access to the capital markets (for Brokered CDs).

At September 30, 2012 we had $371.7 million of time deposits that mature in the next twelve months. Historically, a majority of these maturing time deposits are renewed by our customers. Additionally $1.63 billion (including $291.5 million of deposits held for sale related to the pending Branch Sale) of our deposits at September 30, 2012 were in account types from which the customer could withdraw the funds on demand. Changes in the balances of deposits that can be withdrawn upon demand are usually predictable and the total balances of these accounts have generally grown or have been stable over time as a result of our marketing and promotional activities. However, there can be no assurance that historical patterns of renewing time deposits or overall growth or stability in deposits will continue in the future.

In particular, media reports about bank failures have created concerns among depositors at banks throughout the country, including certain of our customers, particularly those with deposit balances in excess of deposit insurance limits. In response, the deposit insurance limit was permanently increased from $100,000 to $250,000 and unlimited deposit insurance is currently provided (only through December 31, 2012) for balances in non-interest bearing demand deposit accounts under provisions in the Dodd-Frank Act. We have proactively sought to provide appropriate information to our deposit customers about our organization in order to retain our business and deposit relationships. Despite the increases in deposit insurance limits and our proactive communications efforts, the potential outflow of deposits remains as a significant liquidity risk, particularly since our past losses and our elevated level of non-performing assets have reduced some of the financial ratings of our Bank that are followed by our larger deposit customers, such as municipalities. The potential outflow of significant amounts of deposits could have an adverse impact on our liquidity and results of operations.

Index

We have developed contingency funding plans that stress tests our liquidity needs that may arise from certain events such as an adverse change in our financial metrics (for example, credit quality or regulatory capital ratios). Our liquidity management also includes periodic monitoring that measures quick assets (defined generally as short-term assets with maturities less than 30 days and loans held for sale) to total assets; short-term liability dependence and basic surplus (defined as quick assets compared to short-term liabilities). Policy limits have been established for our various liquidity measurements and are monitored on a monthly basis. In addition, we also prepare cash flow forecasts that include a variety of different scenarios.

As a result of the liquidity risks described above and in “Deposits and borrowings” and now the pending Branch Sale, we have generally maintained elevated levels of overnight cash balances in interest-bearing deposits, which totaled $403.6 million and $278.3 million at September 30, 2012 and December 31, 2011, respectively. We expect the pending Branch Sale will require the use of approximately $330 to $340 million of interest bearing deposits or short-term securities available for sale. We believe that we will continue to have adequate liquidity after the Branch Sale despite the reduction in our cash and cash equivalents because of our remaining securities available for sale, our access to secured advances from the FHLB, our ability to issue Brokered CDs and our improved financial metrics.

As described in greater detail below, we are deferring interest on our subordinated debentures and are not currently paying any dividends on our preferred or common stock. Interest on the subordinated debentures can continue to be deferred until the fourth quarter of 2014. Thus, the only use of cash at the parent company at the present time is for operating expenses. Because of the past losses that our Bank has experienced and the Bank’s regulatory capital requirements, we do not anticipate that the Bank will be able to pay any dividends up to the parent company for at least through the end of 2012. As a result, the only substantial near term source of cash to our parent company is under an equity line facility that is described below. We believe that the available cash and cash equivalents on hand as well as access to the equity line facility provide sufficient liquidity at the parent company to meet its operating expenses until the fourth quarter of 2014 (at which point the parent company can no longer defer interest on its subordinated debentures).

Effective management of capital resources is critical to our mission to create value for our shareholders. The cost of capital is an important factor in creating shareholder value and, accordingly, our capital structure includes cumulative trust preferred securities and cumulative convertible preferred stock.

Index

Capitalization
	September 30,			December 31,
	2012			2011
	(In thousands)
Subordinated debentures	$	50,175		$	50,175
Amount not qualifying as regulatory capital		(1,507	)		(1,507	)
Amount qualifying as regulatory capital		48,668			48,668
Shareholders’ Equity
Convertible preferred stock		83,097			79,857
Common stock		250,080			248,950
Accumulated deficit		(203,217	)		(214,259	)
Accumulated other comprehensive loss		(8,432	)		(11,921	)
Total shareholders’ equity		121,528			102,627
Total capitalization	$	170,196		$	151,295

We have four special purpose entities that originally issued $90.1 million of cumulative trust preferred securities. On June 23, 2010, we issued 5.1 million shares of our common stock (having a fair value of approximately $23.5 million on the date of the exchange) in exchange for $41.4 million in liquidation amount of trust preferred securities and $2.3 million of accrued and unpaid interest on such securities. As a result, at September 30, 2012 and December 31, 2011, $48.7 million of cumulative trust preferred securities remained outstanding. These special purpose entities issued common securities and provided cash to our parent company that in turn, issued subordinated debentures to these special purpose entities equal to the trust preferred securities and common securities. The subordinated debentures represent the sole asset of the special purpose entities. The common securities and subordinated debentures are included in our Condensed Consolidated Statements of Financial Condition.

The Federal Reserve Board has issued rules regarding trust preferred securities as a component of the Tier 1 capital of bank holding companies. The aggregate amount of trust preferred securities (and certain other capital elements) are limited to 25 percent of Tier 1 capital elements, net of goodwill (net of any associated deferred tax liability). The amount of trust preferred securities and certain other elements in excess of the limit can be included in Tier 2 capital, subject to restrictions. At the parent company, $43.3 million of these securities qualified as Tier 1 capital at September 30, 2012. Although the Dodd-Frank Act further limited Tier 1 treatment for trust preferred securities, those new limits will not apply to our outstanding trust preferred securities.

The Proposed New Capital Requirements described above, if adopted, would have a significant impact on our capital requirements, and include provisions that would eventually eliminate trust preferred securities as Tier 1 capital.

In December 2008, we issued 72,000 shares of Series A, Fixed Rate Cumulative Perpetual Preferred Stock, with an original liquidation preference of $1,000 per share (“Series A Preferred Stock”), and a warrant to purchase 346,154 shares (at $31.20 per share) of our common stock (“Original Warrant”) to the UST in return for $72.0 million under the Troubled Asset Relief Program’s Capital Purchase Program. Of the total proceeds, $68.4 million was originally allocated to the Series A Preferred Stock and $3.6 million was allocated to the Original Warrant (included in capital surplus) based on the relative fair value of each. The $3.6 million discount on the Series A Preferred Stock was being accreted using an effective yield method over five years. The accretion had been recorded as part of the Series A Preferred Stock dividend.

Index

On April 16, 2010, we exchanged the Series A Preferred Stock (including accumulated but unpaid dividends) for 74,426 shares of our Series B Fixed Rate Cumulative Mandatorily Convertible Preferred Stock, with an original liquidation preference of $1,000 per share (“Series B Preferred Stock”). As part of the terms of the exchange agreement, we also agreed to amend and restate the terms of the Original Warrant and issued an Amended and Restated Warrant to purchase 346,154 shares of our common stock at an exercise price of $7.234 per share and expiring on December 12, 2018. The Series B Preferred Stock and the Amended Warrant were issued in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act of 1933. We did not receive any cash proceeds from the issuance of the Series B Preferred Stock or the Amended Warrant. In general, the terms of the Series B Preferred Stock are substantially similar to the terms of the Series A Preferred Stock that was held by the UST, except that the Series B Preferred Stock is convertible into our common stock. See Note #15 to the Interim Condensed Consolidated Financial Statements included within this report for information about the terms of the Series B Preferred Stock and the Amended and Restated Warrant.

Shareholders’ equity applicable to common stock increased to $38.4 million at September 30, 2012 from $22.8 million at December 31, 2011 due primarily to our net income during the first nine months of 2012. Our tangible common equity (“TCE”) totaled $31.6 million and $15.2 million, respectively, at those same dates. Our ratio of TCE to tangible assets was 1.32% at September 30, 2012 compared to 0.66% at December 31, 2011. Although our Bank’s regulatory capital ratios remain at levels above “well capitalized” standards, because of the past losses that we have incurred, our elevated levels of non-performing loans and other real estate, and the ongoing economic stress in Michigan, we have taken the following actions to maintain and improve our regulatory capital ratios and preserve liquidity at our parent company level:

Eliminated the cash dividend on our common stock: Beginning in November 2009, we eliminated the $0.10 per share quarterly cash dividend on our common stock.

Deferred dividends on our preferred stock: Beginning in December 2009, we suspended payment of quarterly dividends on the preferred stock held by the UST. The cash dividends payable to the UST on the Series B Preferred Stock amount to approximately $4.2 million per year until December of 2013, at which time they would increase to approximately $7.6 million per year. Accrued and unpaid dividends were $9.7 million at September 30, 2012.

Deferred dividends on our subordinated debentures: Beginning in December 2009, we exercised our right to defer all quarterly interest payments on the subordinated debentures we issued to our trust subsidiaries. As a result, all quarterly dividends on the related trust preferred securities were also deferred. Based on current dividend rates, the cash dividends on all outstanding trust preferred securities as of September 30, 2012, amount to approximately $2.3 million per year. Accrued and unpaid dividends on trust preferred securities at September 30, 2012 and December 31, 2011 were $6.0 million and $4.4 million, respectively.

Exchanged the Series A Preferred Stock held by the UST for Series B Preferred Stock: In April 2010, we completed the exchange of Series A Preferred Stock held by the UST (plus accrued and unpaid dividends on such stock) for new shares of convertible Series B Preferred Stock, as described above.

Exchanged certain trust preferred securities for our common stock: In June 2010, we completed the exchange of 5.1 million shares of our common stock for $41.4 million in liquidation amount of trust preferred securities and $2.3 million of accrued and unpaid interest on such securities.

Index

Branch Sale: As described above, on May 23, 2012 we executed a definitive agreement to sell 21 branches. This transaction is expected to close prior to year-end 2012 and will significantly increase our regulatory capital ratios.

Many of these actions have preserved cash at our parent company as we do not expect our Bank to be able to pay any cash dividends in the near term. Dividends from the Bank are restricted by federal and state law and are further restricted by the board resolutions adopted in December 2009 (as subsequently amended) and by the Memorandum of Understanding (“MOU”) described in Note #11 to the Interim Condensed Consolidated Financial Statements included within this report. In particular, those resolutions and the MOU prohibit the Bank from paying any dividends to the parent company without the prior written approval of the FRB and the Michigan Office of Financial and Insurance Regulation (“OFIR”). Also see “Regulatory development.”

Our parent company is also currently prohibited from paying any dividends on our common stock or the convertible preferred stock held by the UST or any distributions on our trust preferred securities. Although there are no specific regulations restricting dividend payments by bank holding companies (other than state corporate laws) the FRB, our primary federal regulator, has issued a policy statement on cash dividend payments. The FRB’s view is that: “an organization experiencing earnings weaknesses or other financial pressures should not maintain a level of cash dividends that exceeds its net income, that is inconsistent with the organization’s capital position, or that can only be funded in ways that may weaken the organization’s financial health.” Moreover, the resolutions adopted by our Board in 2009 and the MOU referenced above specifically prohibit the parent company from paying any dividends on our common stock or the preferred stock held by the UST or any distributions on our trust preferred securities without, in each case, the prior written approval of the FRB and the OFIR.

Payment of dividends and distributions on the outstanding common stock, convertible preferred stock, and trust preferred securities is also restricted and governed by the terms of those instruments, as follows:

The terms of the subordinated debentures and trust indentures (the “Indentures”) related to our trust preferred securities allow us to defer payment of interest at any time or from time to time for up to 20 consecutive quarters provided no event of default (as defined in the Indentures) has occurred and is continuing. We are not in default with respect to the Indentures, and the deferral of interest does not constitute an event of default under the Indentures. While we defer the payment of interest, we will continue to accrue the interest expense owed at the applicable interest rate. Upon the expiration of the deferral, all accrued and unpaid interest is due and payable. During the deferral period on the Indentures, we may not declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to, any of our capital stock.

Index

So long as any shares of the Series B Preferred Stock remain outstanding, unless all accrued and unpaid dividends for all prior dividend periods have been paid or are contemporaneously declared and paid in full, (a) no dividend may be paid or declared on our common stock or other junior stock, other than a dividend payable solely in common stock and other than certain dividends or distributions of rights in connection with a shareholders’ rights plan; and (b) with limited exceptions, neither we nor any of our subsidiaries may purchase, redeem or otherwise acquire for consideration any shares of our common stock or other junior stock unless we have paid in full all accrued dividends on the Series B Preferred Stock for all prior dividend periods.

We do not have any current plans to resume interest payments on our outstanding trust preferred securities or dividend payments on the outstanding shares of any convertible preferred stock or common stock. We do not know if or when any such payments will resume. However, as described in Note #11 to the Interim Condensed Consolidated Financial Statements included within this report, our Board adopted a Joint Revised Capital Plan (the “Capital Plan”) in November 2011 (as subsequently amended in February 2012). The primary objective of our Capital Plan is to achieve and thereafter maintain the minimum capital ratios required by the December 2009 board resolutions referenced above (as subsequently amended).

As of September 30, 2012, our Bank continued to meet the requirements to be considered “well-capitalized” under federal regulatory standards and has also achieved one of the two minimum capital ratios established by our Board (that are higher than the ratios required in order to be considered “well-capitalized” under federal standards). The Board imposed these higher ratios in order to ensure that we have sufficient capital to withstand potential future losses based on our elevated level of non-performing assets and given certain other risks and uncertainties we face. Set forth below are the actual capital ratios of our Bank as of September 30, 2012, the minimum capital ratios imposed by the board resolutions, and the minimum ratios necessary to be considered “well-capitalized” under federal regulatory standards.

Regulatory Capital Ratios	Independent Bank Actual at September 30, 2012			Minimum Ratios Established by our Board			Required to be Well-Capitalized
Tier 1 capital to average total assets		7.29	%		8.00	%		5.00	%
Total capital to risk-weighted assets		13.22			11.00			10.00

The Capital Plan includes projections that reflect forecasted financial data through 2014. At the present time, based on these forecasts and our expectations, we believe that our Bank can remain above “well-capitalized” for regulatory purposes and meet the minimum capital ratios established by our Board, even without additional capital, primarily because of the impact of the pending Branch Sale as well as some further projected decline in total assets (principally loans). Further, credit costs have abated sufficiently so that we have returned to profitability in the first nine months of 2012. These forecasts are susceptible to significant variations, particularly if the Michigan economy were to further deteriorate and credit costs were to be higher than anticipated or if we incur any significant future losses at Mepco related to the collection of vehicle service contract counterparty receivables (see “Non-interest expense”). Because of such uncertainties, it is possible that our Bank may not be able to remain well-capitalized as we work through asset quality issues and seek to return to consistent profitability. Any significant deterioration in or inability to improve our capital position would make it very difficult for us to withstand future losses that we could incur and that may be increased or made more likely as a result of continued economic difficulties and other factors. Please see page 1 of this report for cautionary information about these forward-looking statements and factors that may cause actual results to differ from our current expectations.

Index

Our Capital Plan also outlines various contingency plans in case we do not succeed in meeting the required minimum capital ratios. These contingency plans include a possible further reduction in our assets (such as through another sale of branches, loans, and/or operating divisions or subsidiaries), more significant expense reductions than those that have already been implemented, and a sale of the Bank. These contingency plans were considered and included within the Capital Plan in recognition of the possibility that market conditions for these transactions may improve and that such transactions may be necessary or required by our regulators if we are unable to attain the required minimum capital ratios described above through other means.

In addition to the measures outlined in the Capital Plan, on July 7, 2010 we executed an Investment Agreement and Registration Rights Agreement with Dutchess Opportunity Fund, II, LP (“Dutchess”) for the sale of shares of our common stock. These agreements serve to establish an equity line facility as a contingent source of liquidity at the parent company level. Pursuant to the Investment Agreement, Dutchess committed to purchase up to $15.0 million of our common stock over a 36-month period ending November 1, 2013. We have the right, but no obligation, to draw on this equity line facility from time to time during such 36-month period by selling shares of our common stock to Dutchess. The sales price is at a 5% discount to the market price of our common stock at the time of the draw (as such market price is determined pursuant to the terms of the Investment Agreement). To date, we have sold a total of 967,549 shares (including 22,340 shares in the third quarter of 2012) of our common stock to Dutchess under this equity line for total net proceeds of approximately $2.4 million. At the present time, we have shareholder approval to sell approximately 3.0 million additional shares under this equity line.

Our bank holding company and our Bank both remain “well capitalized” (as defined by banking regulations) at September 30, 2012.

Asset/liability management. Interest-rate risk is created by differences in the cash flow characteristics of our assets and liabilities. Options embedded in certain financial instruments, including caps on adjustable-rate loans as well as borrowers’ rights to prepay fixed-rate loans, also create interest-rate risk.

Our asset/liability management efforts identify and evaluate opportunities to structure our statement of financial condition in a manner that is consistent with our mission to maintain profitable financial leverage within established risk parameters. We evaluate various opportunities and alternate asset/liability management strategies carefully and consider the likely impact on our risk profile as well as the anticipated contribution to earnings. The marginal cost of funds is a principal consideration in the implementation of our asset/liability management strategies, but such evaluations further consider interest-rate and liquidity risk as well as other pertinent factors. We have established parameters for interest-rate risk. We regularly monitor our interest-rate risk and report at least quarterly to our board of directors.

Index

We employ simulation analyses to monitor our interest-rate risk profile and evaluate potential changes in our net interest income and market value of portfolio equity that result from changes in interest rates. The purpose of these simulations is to identify sources of interest-rate risk inherent in our Statement of Financial Condition. The simulations do not anticipate any actions that we might initiate in response to changes in interest rates and, accordingly, the simulations do not provide a reliable forecast of anticipated results. The simulations are predicated on immediate, permanent and parallel shifts in interest rates and generally assume that current loan and deposit pricing relationships remain constant. The simulations further incorporate assumptions relating to changes in customer behavior, including changes in prepayment rates on certain assets and liabilities.

Changes in Market Value of Portfolio Equity and Net Interest Income

	Market Value
Change in Interest	Of Portfolio		Percent			Net Interest		Percent
Rates	Equity(1)		Change			Income(2)		Change
	(Dollars in thousands)
September 30, 2012
200 basis point rise	$	272,600		33.76	%	$	87,500		9.51	%
100 basis point rise		242,100		18.79			83,300		4.26
Base-rate scenario		203,800		-			79,900		-
100 basis point decline		168,800		(17.17	)		78,900		(1.25	)

December 31, 2011
200 basis point rise	$	277,500		26.08	%	$	91,200		6.17	%
100 basis point rise		252,200		14.58			88,200		2.68
Base-rate scenario		220,100		-			85,900		-
100 basis point decline		181,700		(17.45	)		85,000		(1.05	)

(1)

Simulation analyses calculate the change in the net present value of our assets and liabilities, including debt and related financial derivative instruments, under parallel shifts in interest rates by discounting the estimated future cash flows using a market-based discount rate. Cash flow estimates incorporate anticipated changes in prepayment speeds and other embedded options.

(2)	Simulation analyses calculate the change in net interest income under immediate parallel shifts in interest rates over the next twelve months, based upon a static statement of financial condition, which includes debt and related financial derivative instruments, and do not consider loan fees.

Accounting standards update. See Note #2 to the Interim Condensed Consolidated Financial Statements included elsewhere in this report for details on recently issued accounting pronouncements and their impact on our financial statements.

Fair valuation of financial instruments. Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) topic 820 - “Fair Value Measurements and Disclosures” (“FASB ASC topic 820”) defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

Index

We utilize fair value measurements to record fair value adjustments to certain financial instruments and to determine fair value disclosures. FASB ASC topic 820 differentiates between those assets and liabilities required to be carried at fair value at every reporting period (“recurring”) and those assets and liabilities that are only required to be adjusted to fair value under certain circumstances (“nonrecurring”). Trading securities, securities available-for-sale, loans held for sale, and derivatives are financial instruments recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other financial assets on a nonrecurring basis, such as loans held for investment, capitalized mortgage loan servicing rights and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or fair value accounting or write-downs of individual assets. See Note #12 to the Interim Condensed Consolidated Financial Statements included within this report for a complete discussion on our use of fair valuation of financial instruments and the related measurement techniques.

Regulatory developments. On October 25, 2011, the respective Boards of Directors of the Company and the Bank entered into an MOU with the FRB and OFIR. The MOU largely duplicates certain of the provisions in the Board resolutions described above, but also has the following specific requirements:

●

Submission of a joint revised capital plan by November 30, 2011 to maintain sufficient capital at the Company on a consolidated basis and at the Bank on a stand-alone basis;

●

Submission of quarterly progress reports regarding disposition plans for any assets in excess of $1.0 million that are in ORE, are 90 days or more past due, are on our “watch list,” or were adversely classified in our most recent examination;

●

Enhanced reporting and monitoring at Mepco regarding risk management and the internal classification of assets; and

●

Enhanced interest rate risk modeling practices.

We believe that we are generally in compliance with the provisions of the MOU, however we must still close the Branch Sale, which is one of the strategies outlined in the Capital Plan.

Management plans and expectations. Elevated credit costs, including our provision for loan losses, loan and collection costs, net losses on ORE, and losses related to vehicle service contract counterparty contingencies, resulted in substantial losses over the period from 2008 through 2011 and reduced our capital. Management continues to focus on reducing non-performing assets and continuing the profitability that has been achieved in 2012. Further, as discussed above, we have adopted a Capital Plan, which includes a series of actions designed to increase our regulatory capital ratios, decrease our expenses and enable us to withstand and better respond to current market conditions and the potential for worsening market conditions. At the present time, based on our current forecasts and expectations, we believe that our Bank can remain above “well-capitalized” for regulatory purposes for the foreseeable future, even without additional capital, primarily because of the impact of the pending Branch Sale, some projected further decline in total assets (principally loans) and a return to profitability in 2012 and beyond. As a result of these expectations with respect to the Bank’s regulatory capital ratios, and in light of our improvements in asset quality and other positive indicators, we continue to evaluate our alternatives in connection with the timing and size of any common stock offering. This evaluation will take into account our ongoing operating results, as well as input from our financial advisors and the UST.

Index

Litigation Matters

We are involved in various litigation matters in the ordinary course of business. At the present time, we do not believe any of these matters will have a significant impact on our consolidated financial position or results of operations. The aggregate amount we have accrued for losses we consider probable as a result of these litigation matters is immaterial. However, because of the inherent uncertainty of outcomes from any litigation matter, we believe it is reasonably possible we may incur losses in addition to the amounts we have accrued. At this time, we estimate the maximum amount of additional losses that are reasonably possible is approximately $0.4 million. However, because of a number of factors, including the fact that certain of these litigation matters are still in their early stages and involve claims for which, at this point, we believe have little to no merit, this maximum amount may change in the future.

Critical Accounting Policies

Our accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Accounting and reporting policies for other than temporary impairment of investment securities, the allowance for loan losses, originated mortgage loan servicing rights, vehicle service contract payment plan counterparty contingencies, and income taxes are deemed critical since they involve the use of estimates and require significant management judgments. Application of assumptions different than those that we have used could result in material changes in our consolidated financial position or results of operations. There have been no material changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011.

Index

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

See applicable disclaimers set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 2 under the caption “Asset/liability management.”

Item 4.

Controls and Procedures

(a)	Evaluation of Disclosure Controls and Procedures.

With the participation of management, our chief executive officer and chief financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a – 15(e) and 15d – 15(e)) for the period ended September 30, 2012, have concluded that, as of such date, our disclosure controls and procedures were effective.

(b)	Changes in Internal Controls.

During the quarter ended September 30, 2012, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Index

Part II

Item 1A.

Risk Factors

There have been no material changes to the risk factors disclosed in Item 1A. Risk Factors of our Annual Report on Form 10-K for the year ended December 31, 2011.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

During the quarter ended September 30, 2012, the Company sold 22,340 shares of its common stock in a sale not registered under the Securities Act of 1933. These shares were sold on August 27, 2012, to Dutchess Opportunity Fund, II, LP ("Dutchess") pursuant to the Investment Agreement described in Note #15. The shares were sold at a price of $2.70 per share, which represents a 5% discount to the market price of our common stock at the time of the draw; as such market price is determined pursuant to the terms of the Investment Agreement. The Company issued the shares of Common Stock to Dutchess under the Investment Agreement pursuant to an exemption from registration under Section 4(2) of the Securities Act of 1933 due to the fact that the offering of the shares was made on a private basis to a single purchaser and in accordance with written guidance of the SEC's Division of Corporation Finance pertaining to equity line facility transactions.

The Company maintains a Deferred Compensation and Stock Purchase Plan for Non-Employee Directors (the "Plan") pursuant to which non-employee directors can elect to receive shares of the Company's common stock in lieu of fees otherwise payable to the director for his or her service as a director. A director can elect to receive shares on a current basis or to defer receipt of the shares, in which case the shares are issued to a trust to be held for the account of the director and then generally distributed to the director after his or her retirement from the Board. Pursuant to this Plan, during the third quarter of 2012, the Company issued 20,970 shares of common stock to non-employee directors on a current basis and 21,578 shares of common stock to the trust for distribution to directors on a deferred basis. The shares were issued on July 1, 2012, at a price of $2.47 per share, representing aggregate consideration to the Company of $0.1 million. The price per share was the consolidated closing bid price per share of the Company's common stock as of the date of issuance, as determined in accordance with NASDAQ Marketplace Rules. The Company issued the shares pursuant to an exemption from registration under Section 4(2) of the Securities Act of 1933 due to the fact that the issuance of the shares was made on a private basis pursuant to the Plan.

Index

The following table shows certain information relating to purchases of common stock for the three-months ended September 30, 2012, pursuant to any share repurchase plans:

						Total Number of		Remaining
						Shares Purchased		Number of
						as Part of a		Shares Authorized
	Total Number of			Average Price		Publicly		for Purchase
Period	Shares Purchased			Paid Per Share		Announced Plan		Under the Plan
July 2012		2,402	(1)	$	2.83		-	NA
August 2012		2,520	(1)		2.70		-	NA
September 2012		2,401	(1)		2.83		-	NA
Total		7,323		$	2.79		-	NA

(1)

A portion of the salary payable to our Chief Executive Officer, Michael M. Magee, and to our President, William B. Kessel, is payable in salary stock, which is issued on a bi-weekly basis in connection with our regular pay periods. The shares disclosed in this table are shares withheld from the shares that would otherwise be issued to Mr. Magee and Mr. Kessel in order to satisfy tax withholding obligations.

Item 3b.

Defaults Upon Senior Securities

As of September 30, 2012, the Company was in arrears in the aggregate amount of $9.1 million with respect to the Series B Preferred Stock it issued to the U.S. Department of the Treasury as a result of the Company’s decision to defer these dividends in the fourth quarter of 2009.

Item 6.

Exhibits

(a)

The following exhibits (listed by number corresponding to the Exhibit Table as Item 601 in Regulation S-K) are filed with this report:

	11.	Computation of Earnings Per Share.
	31.1	Certificate of the Chief Executive Officer of Independent Bank Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
	31.2	Certificate of the Chief Financial Officer of Independent Bank Corporation pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
	32.1	Certificate of the Chief Executive Officer of Independent Bank Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
	32.2	Certificate of the Chief Financial Officer of Independent Bank Corporation pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
	101. INS Instance Document
	101. SCH XBRL Taxonomy Extension Schema Document
	101. CAL XBRL Taxonomy Extension Calculation Linkbase Document
	101. DEF XBRL Taxonomy Extension Definition Linkbase Document
	101. LAB XBRL Taxonomy Extension Label Linkbase Document
	101. PRE XBRL Taxonomy Extension Presentation Linkbase Document

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Index

SIGNATURES

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

Date	November 9, 2012	By	/s/ Robert N. Shuster
			Robert N. Shuster, Principal Financial
			Officer

Date	November 9, 2012	By	/s/ James J. Twarozynski
			James J. Twarozynski, Principal
			Accounting Officer

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