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Choiceone Financial Services Inc (COFS) SEC Filing 10-K Annual report for the fiscal year ending Sunday, December 31, 2017

Choiceone Financial Services Inc

CIK: 803164 Ticker: COFS

 

EXHIBIT 99.1

 

 

 

News Release

 

Contact: Tom Lampen, ChoiceOne Bank
(616) 887-2337
tlampen@choiceone.com

 

ChoiceOne Financial Announces Earnings For fourth Quarter 2017

 

Sparta, Michigan – January 24, 2018

– ChoiceOne Financial Services, Inc. (OTC:COFS), the parent company for ChoiceOne Bank, reported net income of $1,367,000 for the fourth quarter of 2017 compared to $1,688,000 in the same period in 2016. Earnings per share were $0.40 in the fourth quarter of 2017 compared to an adjusted $0.48 per share in the fourth quarter of the prior year. Net income for the full year of 2017 was $6,168,000 or $1.79 per share, compared to $6,090,000 or an adjusted $1.76 per share in the prior year. Per share amounts for 2016 have been adjusted for the 5% stock dividend paid on May 31, 2017.

 

“ChoiceOne is in a season of growth,” said Kelly Potes, President and Chief Executive Officer of ChoiceOne Financial Services, Inc. “We have announced plans for a downtown Grand Rapids, Michigan branch, which we anticipate opening later this year. As we expand our community bank franchise, we continue to increase staff and introduce the latest technology to prepare for this exciting growth.”

 

Total assets as of December 31, 2017, grew to $647 million, compared to $607 million as of December 31, 2016, which represented growth of $39.2 million or 6% during 2017. Net loans have grown $29.5 million since December 31, 2016, which along with higher interest rates on new loans led to interest income in the fourth quarter of 2017 of $4.8 million, which was $593,000 higher than the same period in 2016. Total deposits grew 5% or $27.5 million from December 31, 2016 to December 31, 2017, which helped in the funding of loans.

 

ChoiceOne recorded a $365,000 provision for loan losses during the fourth quarter of 2017 as a result of loan growth and net charge-offs experienced during the year. Nonperforming loans declined $814,000 during 2017 and nonaccrual loans represented just 0.27% of total loans at the end of 2017.

 

Mortgage sales volume was lower in the fourth quarter and full year 2017 than the same periods in 2016. This was primarily due to higher interest rates and a relatively low inventory of homes available for sale in ChoiceOne’s primary markets. Management concluded in the fourth quarter of 2017 to sell securities earning low yields to support the funding of loan growth, decrease the bank’s dependence on wholesale borrowings due to increases in interest rates, and, as a by-product, repurchase higher yielding securities due to excess liquidity. As a result, ChoiceOne sold approximately $35 million in securities and recorded a fourth quarter loss on the sale of $457,000. We believe this decision will be accretive to income in 2018 and recognizing the losses during the current period resulted in beneficial tax treatment. These reductions in noninterest income were offset by a $908,000 gain on the sale of a portion of ChoiceOne’s investment book of business during the fourth quarter of 2017. The ChoiceOne Investment Center is still fully operational and ready to serve our customers.

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Total noninterest expense increased $361,000 in 2017 compared to 2016. Salaries and benefits expense was higher due to additional staff and raises for existing staff. Occupancy and equipment expense increased with higher depreciation costs related to the recent renovation of ChoiceOne’s headquarters in Sparta. The decline in other noninterest expense was caused by $379,000 lower amortization expense in 2017 as intangible assets were fully amortized in the fourth quarter of 2016.

 

In the fourth quarter of 2017, ChoiceOne adjusted its deferred tax asset for the impact of the lower corporate income tax rate which will be effective beginning in 2018. This one-time adjustment caused the recognition of $206,000 of income tax expense, increasing tax expense in the fourth quarter of 2017 compared to the same time period in 2016. Management believes the reduction of the corporate income tax rate will have a positive effect on net income in future periods that will more than offset this one-time expense.

 

“Even with some noise in the fourth quarter, including a large one-time negative tax adjustment, ChoiceOne still posted the best net income in the company’s history.” said Potes. “We hope to continue growing and impressing our customers as we strive to be the best bank in Michigan.”

 

About ChoiceOne

ChoiceOne Financial Services, Inc. is a financial holding company headquartered in Sparta, Michigan and the parent corporation of ChoiceOne Bank, Member FDIC. ChoiceOne Bank operates 12 full service offices and one loan production office in parts of Kent, Ottawa, Muskegon, and Newaygo Counties. ChoiceOne Bank offers insurance and investment products through its subsidiary, ChoiceOne Insurance Agencies, Inc. ChoiceOne Financial Services, Inc. common stock is quoted on the OTC under the symbol “COFS.” For more information, please visit Investor Relations at ChoiceOne’s website at www.choiceone.com.

 

Forward-Looking Statements
This press release contains forward-looking statements. Words such as “anticipates,” “believes,” “estimates,” “expects,” “forecasts,” “intends,” “is likely,” “plans,” “predicts,” “projects,” “may,” “could,” “look forward,” “continue”, “future” and variations of such words and similar expressions are intended to identify such forward-looking statements. Management’s determination of the provision and allowance for loan losses, the carrying value of goodwill and loan servicing rights, and the fair value of investment securities (including whether any impairment on any investment security is temporary or other than temporary and the amount of any impairment) and management’s assumptions concerning pension and other postretirement benefit plans involve judgments that are inherently forward-looking. These statements reflect management’s current beliefs as to the expected outcomes of future events and are not guarantees of future performance. These statements involve certain risks, uncertainties and assumptions (“risk factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed, implied or forecasted in such forward-looking statements. Furthermore, ChoiceOne undertakes no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events, or otherwise.

 

Risk factors include, but are not limited to, the risk factors described in Item 1A in ChoiceOne Financial Services, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2016. These and other factors are representative of the risk factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.

 

# # #

 

EDITORS NOTE: Media interviews with ChoiceOne Bank executives are available by calling Tom Lampen at (616)887-2337 or tlampen@choiceone.com. Electronic versions of bank official headshots are also available.

 

 

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Condensed Balance Sheets
(Unaudited)

 

 

(In thousands) 12/31/2017   9/30/2017   12/31/2016
   Cash and Cash Equivalents $ 36,837   $ 12,725   $ 14,809
   Securities   159,158     176,873     177,955
   Loans Held For Sale   1,721     2,378     1,974
   Loans to Other Financial Institutions   6,802     13,293    
   Loans, Net of Allowance For Loan Losses   394,208     389,874     364,723
   Premises and Equipment   13,040     12,271     12,588
   Cash Surrender Value of Life Insurance Policies   14,514     14,415     14,117
   Goodwill   13,728     13,728     13,728
   Other Assets   6,536     6,495     7,477
                 
        Total Assets $ 646,544   $ 642,052   $ 607,371
                 
   Noninterest-bearing Deposits $ 151,462   $ 136,542   $ 127,611
   Interest-bearing Deposits   388,391     389,296     384,775
   Borrowings   27,416     36,720     20,214
   Other Liabilities   2,725     3,188     3,073
                 
        Total Liabilities   569,994     565,746     535,673
                 
   Shareholders’ Equity   76,550     76,306     71,698
                 
        Total Liabilities and Shareholders’ Equity $ 646,544   $ 642,052   $ 607,371

 

 

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Condensed Statements of Income
(Unaudited)

 

  Three Months Ended   Twelve Months Ended
(In Thousands, Except Per Share Data) 12/31/2017   12/31/2016   12/31/2017   12/31/2016
Interest Income                      
   Loans, including fees $ 4,807   $ 4,214   $ 17,964   $ 16,507
   Securities and other   1,024     972     4,077     3,805
Total Interest Income   5,831     5,186     22,041     20,312
                       
Interest Expense                      
   Deposits   328     192     1,189     790
   Borrowings   111     51     289     179
Total Interest Expense   439     243     1,478     969
                       
Net Interest Income   5,392     4,943     20,563     19,343
Provision for Loan Losses   365         485    
                       
Net Interest Income After Provision                      
     for Loan Losses   5,027     4,943     20,078     19,343
                       
Noninterest Income                      
   Customer service charges   1,054     1,036     4,135     4,056
   Insurance and investment commissions   66     269     826     1,009
   Gains on sales of loans   345     403     1,265     1,748
   Gains on sales of securities   (457 )   58     (280 )   312
   Earnings on life insurance policies   99     90     398     356
   Gain on Sale of Investment Book of
      Business
  908         908    
   Other income   139     65     559     400
Total Noninterest Income   2,154     1,921     7,811     7,881
                       
Noninterest Expense                      
   Salaries and benefits   2,523     2,464     10,248     9,982
   Occupancy and equipment   797     629     2,896     2,588
   Data processing   598     619     2,279     2,273
   Professional fees   388     235     1,166     935
   Other expenses   789     659     2,745     3,195
Total Noninterest Expense   5,095     4,606     19,334     18,973
                       
Income Before Income Tax   2,086     2,258     8,555     8,251
Income Tax Expense   719     570     2,387     2,161
                       
Net Income $ 1,367   $ 1,688   $ 6,168   $ 6,090
                       
Basic Earnings Per Share $ 0.40   $ 0.48   $ 1.79   $ 1.76
Diluted Earnings Per Share $ 0.40   $ 0.48   $ 1.79   $ 1.76

 

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The following information was filed by Choiceone Financial Services Inc (COFS) on Wednesday, January 24, 2018 as an 8K 2.02 statement, which is an earnings press release pertaining to results of operations and financial condition. It may be helpful to assess the quality of management by comparing the information in the press release to the information in the accompanying 10-K Annual Report statement of earnings and operation as management may choose to highlight particular information in the press release.

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

 

FORM 10-K

 

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
   
  For the fiscal year ended December 31, 2017
   
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
   
  For the transition period from__________________ to __________________

 

Commission File Number:  000-19202

 

ChoiceOne Financial Services, Inc.

(Exact Name of Registrant as Specified in its Charter)

 

  Michigan
(State or Other Jurisdiction of
Incorporation or Organization)
  38-2659066
(I.R.S. Employer Identification No.)
 
         
  109 East Division Street, Sparta, Michigan
(Address of Principal Executive Offices)
  49345
(Zip Code)
 

 

(616) 887-7366
(Registrant’s Telephone Number, Including Area Code)

 

Securities registered pursuant to Section 12(g) of the Securities Exchange Act of 1934:

 

Common Stock
(Title of Class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes   ☐  No  ☒

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes   ☐  No  ☒

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes   ☒  No  ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes   ☒  No  ☐

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained in this form, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ☒

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth. See definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ☐ Accelerated filer   ☐
   

Non-accelerated filer   ☐

 

Emerging growth company   ☐

Smaller reporting company   ☒

  

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes   ☐  No  ☒

 

As of June 30, 2017, the aggregate market value of common stock held by non-affiliates of the Registrant was $73.5 million. This amount is based on an average bid price of $23.44 per share for the Registrant’s stock as of such date.

 

As of February 28, 2018, the Registrant had 3,374,279 shares of common stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive Proxy Statement of ChoiceOne Financial Services, Inc. for the Annual Meeting of Shareholders to be held on May 23, 2018 are incorporated by reference into Part III of this Form 10-K.

 

 

 

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ChoiceOne Financial Services, Inc. 

Form 10-K ANNUAL REPORT

 

Contents

 

      Page
PART 1      
Item 1: Business   3
Item 1A: Risk Factors   13
Item 1B: Unresolved Staff Comments   16
Item 2: Properties   17
Item 3: Legal Proceedings   18
Item 4: Mine Safety Disclosures   18
       
PART II      
Item 5: Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   18
Item 6: Selected Financial Data   20
Item 7: Management’s Discussion and Analysis of Results of Operations and Financial Condition   21
Item 7A: Quantitative and Qualitative Disclosures About Market Risk   32
Item 8: Financial Statements and Supplementary Data   34
Item 9: Changes in and Disagreements With Accountants on Accounting and Financial Disclosure   69
Item 9A: Controls and Procedures   69
Item 9B: Other Information   69
       
PART III      
Item 10: Directors, Executive Officers and Corporate Governance   69
Item 11: Executive Compensation   70
Item 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   70
Item 13: Certain Relationships and Related Transactions, and Director Independence   70
Item 14: Principal Accountant Fees and Services   70
       
PART IV      
Item 15: Exhibits and Financial Statement Schedules   71
       
SIGNATURES     73
 

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FORWARD-LOOKING STATEMENTS

 

This report and the documents incorporated into this report contain forward-looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy, and ChoiceOne Financial Services, Inc. Words such as “anticipates,” “believes,” “expects,” “forecasts,” “intends,” “is likely,” “plans,” “predicts,” “projects,” “may,” “could,” “estimates,” and variations of such words and similar expressions are intended to identify such forward-looking statements. Management’s determination of the provision and allowance for loan losses, the carrying value of goodwill, loan servicing rights and other real estate owned, and the fair value of investment securities (including whether any impairment on any investment security is temporary or other than temporary and the amount of any impairment) and management’s assumptions concerning pension and other postretirement benefit plans involve judgments that are inherently forward-looking. All of the information concerning interest rate sensitivity is forward-looking. All statements with references to future time periods are forward-looking. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“risk factors”) that are difficult to predict with regard to timing, extent, likelihood, and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed, implied or forecasted in such forward-looking statements. Furthermore, ChoiceOne Financial Services, Inc. undertakes no obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events, or otherwise.

 

Risk factors include, but are not limited to, the risk factors disclosed in Item 1A of this report. These are representative of the risk factors that could cause a difference between an ultimate actual outcome and a preceding forward-looking statement.

 

PART I

 

Item 1. Business

 

General

ChoiceOne Financial Services, Inc. (“ChoiceOne” or the “Company”) is a financial holding company registered under the Bank Holding Company Act of 1956, as amended (“BHC Act”). The Company was incorporated on February 24, 1986, as a Michigan corporation. The Company was formed to create a bank holding company for the purpose of acquiring all of the capital stock of ChoiceOne Bank (formerly Sparta State Bank), which became a wholly owned subsidiary of the Company on April 6, 1987. The Company’s only subsidiary and significant asset as of December 31, 2017, was ChoiceOne Bank (the “Bank”). Effective November 1, 2006, the Company merged with Valley Ridge Financial Corp. (“VRFC”), a one-bank holding company for Valley Ridge Bank (“VRB”). In the merger, the Company issued shares of its common stock in exchange for all outstanding shares of VRFC. In December 2006, VRB was consolidated into the Bank. The Bank owns all of the outstanding common stock of ChoiceOne Insurance Agencies, Inc., an independent insurance agency headquartered in Sparta, Michigan (the “Insurance Agency”).

 

The Company’s business is primarily concentrated in a single industry segment - banking. The Bank is a full-service banking institution that offers a variety of deposit, payment, credit and other financial services to all types of customers. These services include time, savings, and demand deposits, safe deposit services, and automated transaction machine services. Loans, both commercial and consumer, are extended primarily on a secured basis to corporations, partnerships and individuals. Commercial lending covers such categories as business, industry, agricultural, construction, inventory and real estate. The Bank’s consumer loan department makes direct and indirect loans to consumers and purchasers of residential and real property. No material part of the business of the Company or the Bank is dependent upon a single customer or very few customers, the loss of which would have a materially adverse effect on the Company.

 

The Bank’s primary market area lies within Kent, Muskegon, Newaygo, and Ottawa counties in Michigan in the communities where the Bank’s offices are located. Currently the Bank serves these markets through twelve full-service offices and one loan production office. The Bank is in the process of establishing two additional full-service offices which are scheduled to open in 2018. The Company and the Bank have no foreign assets or income except for foreign debt securities.

 

At December 31, 2017, the Company had consolidated total assets of $646.5 million, net loans of $394.2 million, total deposits of $539.9 million and total shareholders’ equity of $76.6 million. For the year ended December 31, 2017, the Company recognized consolidated net income of $6.2 million. The principal source of revenue for the Company and the Bank is interest and fees on loans. On a consolidated basis, interest and fees on loans accounted for 60%, 59%, and 59% of total revenues in 2017, 2016, and 2015, respectively. Interest on securities accounted for 13%, 13%, and 12% of total revenues in 2017, 2016, and 2015, respectively. For more information about the Company’s financial condition and results of operations, see the consolidated financial statements and related notes included in Part II, Item 8 of this report.

 

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Competition

The Bank’s competition primarily comes from other financial institutions located within Kent, Muskegon, Newaygo, and Ottawa counties in western Michigan. There are a number of larger commercial banks within the Bank’s primary market area. The Bank also competes with a large number of other financial institutions, such as savings and loan associations, insurance companies, consumer finance companies, credit unions and commercial finance and leasing companies for deposits, loans and service business. Money market mutual funds, brokerage houses and nonfinancial institutions provide many of the financial services offered by the Bank. Many of these competitors have substantially greater resources than the Bank. The principal methods of competition for financial services are price (the rates of interest charged for loans, the rates of interest paid for deposits and the fees charged for services) and the convenience and quality of services rendered to customers.

 

Supervision and Regulation

Banks and bank holding companies are extensively regulated. The Company is subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). The Company’s activities are generally limited to owning or controlling banks and engaging in such other activities as the Federal Reserve Board may determine to be closely related to banking. Prior approval of the Federal Reserve Board, and in some cases various other government agencies, is required for the Company to acquire control of any additional bank holding companies, banks or other operating subsidiaries. Under Federal Reserve Board policy, the Company is expected to act as a source of financial strength to the Bank and to commit resources to support it.

 

The Bank is chartered under state law and is subject to regulation by the Michigan Department of Insurance and Financial Services (“DIFS”). State banking laws place restrictions on various aspects of banking, including permitted activities, loan interest rates, branching, payment of dividends and capital and surplus requirements. The Bank is a member of the Federal Reserve System and is also subject to regulation by the Federal Reserve Board. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”) to the maximum extent provided by law. The Bank is a member of the Federal Home Loan Bank system, which provides certain advantages to the Bank, including favorable borrowing rates for certain funds.

 

The Company is a legal entity separate and distinct from the Bank. The Company’s primary source of funds available to pay dividends to shareholders is dividends paid to it by the Bank. There are legal limitations on the extent to which the Bank can lend or otherwise supply funds to the Company. In addition, payment of dividends to the Company by the Bank is subject to various state and federal regulatory limitations.

 

The FDIC formed the Deposit Insurance Fund (“DIF”) in accordance with the Federal Deposit Insurance Reform Act of 2005 (“Reform Act”) to create a stronger and more stable insurance system. The FDIC maintains the insurance reserves of the DIF by assessing depository institutions an insurance premium. The DIF insures deposit accounts of the Bank up to a maximum amount of $250,000 per separately insured depositor. FDIC insured depository institutions are required to pay deposit insurance premiums based on the risk an institution poses to the DIF. In February 2011, the FDIC finalized rules, effective for assessments occurring after April 1, 2011, which redefined an institution’s assessment base as average consolidated total assets minus average Tier 1 capital. The new rules also established the initial base assessment rate for Risk Category 1 institutions, such as the Bank, at 5 to 9 basis points (annualized). Effective July 1, 2016, the FDIC amended its rules to eliminate Risk Categories for small banks, replacing them with a method based on a bank’s CAMELS composite rating and several financial ratios. On that date, the Bank’s initial base assessment rate was reduced to 3 basis points, since the Federal Deposit Insurance Reserve Ratio reached 1.15% as of June 30, 2016.

 

The Deposit Insurance Funds Act of 1996 authorized the Financing Corporation (“FICO”) to impose periodic assessments on all depository institutions. The purpose of these periodic assessments is to spread the cost of the interest payments on the outstanding FICO bonds issued to recapitalize the Savings Association Insurance Fund (“SAIF”) over a larger number of institutions.

 

The federal banking agencies have adopted guidelines to promote the safety and soundness of federally-insured depository institutions. These guidelines establish standards for, among other things, internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, asset quality and earnings.

 

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The Company and the Bank are subject to regulatory “risk-based” capital guidelines. Failure to meet these capital guidelines could subject the Company or the Bank to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting brokered deposits, and other restrictions on its business. In addition, the Bank would generally not receive regulatory approval of any application that requires the consideration of capital adequacy, such as a branch or merger application, unless it could demonstrate a reasonable plan to meet the capital requirement within a reasonable period of time.

 

Under Federal Reserve Board policy, the Company is expected to act as a source of financial strength to the Bank and to commit resources to support the Bank. In addition, if DIFS deems the Bank’s capital to be impaired, DIFS may require the Bank to restore its capital by a special assessment on the Company as the Bank’s sole shareholder. If the Company fails to pay any assessment, the Company’s directors will be required, under Michigan law, to sell the shares of the Bank’s stock owned by the Company to the highest bidder at either a public or private auction and use the proceeds of the sale to restore the Bank’s capital.

 

The Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) requires, among other things, federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. FDICIA sets forth the following five capital categories: “well-capitalized,” “adequately-capitalized,” “undercapitalized,” “significantly-undercapitalized” and “critically-undercapitalized.” A depository institution’s capital category will depend upon how its capital levels compare with various relevant capital measures as established by regulation, which include Tier 1 and total risk-based capital ratio measures and a leverage capital ratio measure.  Under certain circumstances, the appropriate banking agency may treat a well-capitalized, adequately-capitalized, or undercapitalized institution as if the institution were in the next lower capital category.

 

Federal banking regulators are required to take specified mandatory supervisory actions and are authorized to take other discretionary actions with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Subject to a narrow exception, the banking regulator must generally appoint a receiver or conservator for an institution that is critically undercapitalized. An institution in any of the undercapitalized categories is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. An undercapitalized institution is also generally prohibited from paying any dividends, increasing its average total assets, making acquisitions, establishing any branches, accepting or renewing any brokered deposits or engaging in any new line of business, except under an accepted capital restoration plan or with FDIC approval.

 

On July 3, 2013, the FDIC Board of Directors approved the Regulatory Capital Interim Final Rule, implementing Basel III.  This rule redefines Tier 1 capital as two components (Common Equity Tier 1 and Additional Tier 1), creates a new capital ratio (Common Equity Tier 1 Risk-based Capital Ratio) and implements a capital conservation buffer. It also revises the prompt corrective action thresholds and makes changes to risk weights for certain assets and off-balance-sheet exposures. The Bank was required to transition into the new rule beginning on January 1, 2015.

 

Banks are subject to a number of federal and state laws and regulations, which have a material impact on their business. These include, among others, minimum capital requirements, state usury laws, state laws relating to fiduciaries, the Truth in Lending Act, the Truth in Savings Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Fair Credit Reporting Act, the Expedited Funds Availability Act, the Community Reinvestment Act, the Real Estate Settlement Procedures Act, the Service Members Civil Relief Act, the USA PATRIOT Act, the Bank Secrecy Act, regulations of the Office of Foreign Assets Controls, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, electronic funds transfer laws, redlining laws, predatory lending laws, antitrust laws, environmental laws, money laundering laws and privacy laws. The monetary policy of the Federal Reserve Board may influence the growth and distribution of bank loans, investments and deposits, and may also affect interest rates on loans and deposits. These policies may have a significant effect on the operating results of banks.

 

In general, the BHC Act limits the business of bank holding companies to banking, managing or controlling banks and other activities that the Federal Reserve Board has determined to be closely related to the business of banking. In addition, bank holding companies that qualify and elect to be financial holding companies may engage in any activities that are financial in nature or complementary to a financial activity and do not pose a substantial risk to the safety and soundness of depository institutions or the financial system without prior approval of the Federal Reserve Board. Activities that are financial in nature include securities underwriting and dealing, insurance underwriting and making merchant banking investments.

 

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In order for the Comany to maintain financial holding company status, both the Company and the Bank must be categorized as “well-capitalized” and “well-managed” under applicable regulatory guidelines. If the Company or the Bank ceases to meet these requirements, the Federal Reserve Board may impose corrective capital and/or managerial requirements and place limitations on the Company’s ability to conduct the broader financial activities permissible for financial holding companies. In addition, if the deficiencies persist, the Federal Reserve Board may require the Company to divest of the Bank. The Company and the Bank were both categorized as “well-capitalized” and “well-managed” as of December 31, 2017.

 

Bank holding companies may acquire banks and other bank holding companies located in any state in the United States without regard to geographic restrictions or reciprocity requirements imposed by state banking law. Banks may also establish interstate branch networks through acquisitions of and mergers with other banks. The establishment of de novo interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is allowed only if specifically authorized by state law.

 

Michigan banking laws do not significantly restrict interstate banking. The Michigan Banking Code permits, in appropriate circumstances and with the approval of the Department of Insurance and Financial Services, (1) acquisition of Michigan banks by FDIC-insured banks, savings banks or savings and loan associations located in other states, (2) sale by a Michigan bank of branches to an FDIC-insured bank, savings bank or savings and loan association located in a state in which a Michigan bank could purchase branches of the purchasing entity, (3) consolidation of Michigan banks and FDIC-insured banks, savings banks or savings and loan associations located in other states having laws permitting such consolidation, (4) establishment of branches in Michigan by FDIC-insured banks located in other states, the District of Columbia or U.S. territories or protectorates having laws permitting a Michigan bank to establish a branch in such jurisdiction, and (5) establishment by foreign banks of branches located in Michigan.

 

Banks are subject to the provisions of the Community Reinvestment Act (“CRA”). Under the terms of the CRA, the appropriate federal bank regulatory agency is required, in connection with its examination of a bank, to assess the bank’s record in meeting the credit needs of the community served by that bank, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of the institution. Under the CRA, institutions are assigned a rating of “outstanding,” “satisfactory,” “needs to improve,” or “substantial non-compliance.” The regulatory agency’s assessment of the bank’s record is made available to the public. Further, a bank’s federal regulatory agency is required to assess the CRA compliance record of any bank that has applied to establish a new branch office that will accept deposits, relocate an office, or merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. In the case of a bank holding company applying for approval to acquire a bank or another bank holding company, the Federal Reserve Board will assess the CRA compliance record of each subsidiary bank of the applicant bank holding company, and such compliance records may be the basis for denying the application. Upon receiving notice that a subsidiary bank is rated less than “satisfactory,” a financial holding company will be prohibited from additional activities that are permitted to be conducted by a financial holding company and from acquiring any company engaged in such activities. The Bank’s CRA rating was “Satisfactory” as of its more recent examination.

 

Effects of Compliance With Environmental Regulations

The nature of the business of the Bank is such that it holds title, on a temporary or permanent basis, to a number of parcels of real property. These include properties owned for branch offices and other business purposes as well as properties taken in or in lieu of foreclosure to satisfy loans in default. Under current state and federal laws, present and past owners of real property may be exposed to liability for the cost of cleanup of environmental contamination on or originating from those properties, even if they are wholly innocent of the actions that caused the contamination. These liabilities can be material and can exceed the value of the contaminated property. Management is not presently aware of any instances where compliance with these provisions will have a material effect on the capital expenditures, earnings or competitive position of the Company or the Bank, or where compliance with these provisions will adversely affect a borrower’s ability to comply with the terms of loan contracts.

 

Employees

As of February 28, 2018, the Company, the Bank and the Insurance Agency employed 173 employees, of which 135 were full-time employees. The Company, the Bank, and the Insurance Agency believe their overall relations with their employees are good.

 

Statistical Information

Additional statistical information describing the business of the Company appears on the following pages and in Management’s Discussion and Analysis of Financial Condition and Results of Operations and in Item 7 of this report and in the Consolidated Financial Statements and the notes thereto in Item 8 of this report. The following statistical information should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and notes in this report.

 

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Securities Portfolio

The carrying value of securities categorized by type at December 31 was as follows:

 

(Dollars in thousands)  2017   2016   2015 
             
U.S. Government and federal agency  $35,126   $59,052   $57,207 
U.S. Treasury notes and bonds   1,960    4,072    6,100 
State and municipal   100,048    88,973    77,754 
Mortgage-backed securities   9,820    7,789    6,970 
Corporate   5,151    7,041    8,387 
Foreign debt securities       4,400    995 
Equity securities   3,392    2,883    2,453 
Asset-backed securities   94    178    270 
Total  $155,591   $174,388   $160,136 

 

The Company did not hold investment securities from any one issuer at December 31, 2017, that were greater than 10% of the Company’s shareholders’ equity, exclusive of U.S. Government and U.S. Government agency securities.

 

Presented below is the fair value of securities as of December 31, 2017 and 2016, a schedule of maturities of securities as of December 31, 2017, and the weighted average yields of securities as of December 31, 2017:

 

         Securities maturing within:                
                        Fair Value    Fair Value 
    Less than    1 Year -    5 Years -    More than    at Dec. 31,    at Dec. 31, 
(Dollars in thousands)   1 Year    5 Years    10 Years    10 Years    2017    2016 
                               
U.S. Government and federal agency  $19,175   $10,019   $5,932   $   $35,126   $59,052 
U.S. Treasury notes and bonds       1,960            1,960    4,072 
State and municipal   8,221    51,656    37,722    2,449    100,048    88,973 
Corporate       5,151            5,151    7,041 
Foreign debt securities                       4,400 
Asset-backed securities   94                94    178 
Total debt securities   27,490    68,786    43,654    2,449    142,379    163,716 
                               
Mortgage-backed securities       9,732    88        9,820    7,789 
Equity securities (2)           1,000    2,392    3,392    2,883 
Total  $27,490   $78,518   $44,742   $4,841   $155,591   $174,388 

 

 

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   Weighted average yields:         
   Less than   1 Year -   5 Years -   More than             
   1 Year   5 Years   10 Years   10 Years   Total         
U.S. Government and federal agency   2.08%   1.78%   2.59%   %   2.08%        
U.S. Treasury notes and bonds       1.85            1.85         
State and municipal (1)   3.73    3.06    3.44    4.46    3.29         
Corporate       2.25            2.25         
Foreign debt securities                            
Asset-backed securities   1.92                1.92         
Mortgage-backed securities   5.50    2.60    3.06        2.60         
Equity securities (2)           4.62    0.99    2.01         

  

(1)The yield is computed for tax-exempt securities on a fully tax-equivalent basis at an incremental tax rate of 34%.
(2)Equity securities are preferred and common stock that may or may not have a stated maturity.

 

Loan Portfolio

The Bank’s loan portfolio categorized by loan type (excluding loans held for sale) as of December 31, 2017 is presented below:

 

(Dollars in thousands)                    
   2017   2016   2015   2014   2013 
Agricultural  $48,464   $44,614   $40,232   $41,098   $37,048 
Commercial and industrial   104,386    96,088    94,347    88,062    68,530 
Consumer   24,513    21,596    20,090    20,752    19,931 
Real estate - commercial   123,487    110,762    97,736    99,807    96,987 
Real estate - construction   6,613    6,153    5,390    2,691    890 
Real estate - residential   91,322    89,787    91,509    93,703    92,580 
Total loans, gross  $398,785   $369,000   $349,304   $346,113   $315,966 

 

Maturities and Sensitivities of Loans to Changes in Interest Rates

The following schedule presents the maturities of loans (excluding residential real estate and consumer loans) as of December 31, 2017. All loans over one year in maturity (excluding residential real estate and consumer loans) are also presented classified according to the sensitivity to changes in interest rates as of December 31, 2017.

 

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(Dollars in thousands)  Less than   1 Year -   More than     
   1 Year   5 Years   5 Years   Total 
Loan Type                    
Agricultural  $11,729   $16,594   $20,141   $48,464 
Commercial and industrial   31,676    61,042    11,668    104,386 
Real estate - commercial   13,803    56,355    53,329    123,487 
Real estate - construction   6,408    205        6,613 
Totals  $63,616   $134,196   $85,138   $282,950 

 

(Dollars in thousands)                    
    Less than    1 Year -    More than      
Loan Sensitivity to Changes in Interest Rates   1 Year    5 Years    5 Years    Total 
Loans with fixed interest rates  $19,170   $116,042   $73,332   $208,544 
Loans with floating or adjustable interest rates   44,446    18,154    11,806    74,406 
Totals  $63,616   $134,196   $85,138   $282,950 

 

Loan maturities are classified according to the contractual maturity date or the anticipated amortization period, whichever is appropriate. The anticipated amortization period is used in the case of loans where a balloon payment is due before the end of the loan’s normal amortization period. At the time the balloon payment is due, the loan can either be rewritten or payment in full can be requested. The decision regarding whether the loan will be rewritten or a payment in full will be requested will be based upon the loan’s payment history, the borrower’s current financial condition, and other relevant factors.

 

Risk Elements

The following loans were classified as nonperforming as of December 31:

 

(Dollars in thousands)                    
   2017   2016   2015   2014   2013 
Loans accounted for on a nonaccrual basis  $1,096   $1,983   $2,198   $3,361   $3,123 
Accruing loans which are contractually past due 90 days or more as to principal or interest payments   258    229    29    58    11 
Loans defined as “troubled debt restructurings”   2,896    2,853    3,271    3,175    4,523 
Totals  $4,250   $5,065   $5,498   $6,594   $7,657 

 

A loan is placed on nonaccrual status at the point in time at which the collectability of principal or interest is considered doubtful.

 

The table below illustrates interest forgone and interest recorded on nonperforming loans for the years presented:

 

(Dollars in thousands)                    
   2017   2016   2015   2014   2013 
                     
 Interest on non-performing loans that would have been earned had the loans been in an accrual or performing status  $73   $107   $150   $204   $251 
 Interest on non-performing loans that was actually recorded when received  $   $   $   $   $ 

  

Potential Problem Loans

At December 31, 2017, there were $3.6 million of loans not disclosed above where some concern existed as to the borrowers’ abilities to comply with original loan terms. Specific loss allocations totaling $302,000 from the allowance for loan losses had been allocated for all nonperforming and potential problem loans as of December 31, 2017. However, the entire allowance for loan losses is also available for these potential problem loans.

 

Loan Concentrations

As of December 31, 2017, there was no concentration of loans exceeding 10% of total loans that is not otherwise disclosed as a category of loans pursuant to Item III.A. of Industry Guide 3.

 

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Other Interest-Bearing Assets

As of December 31, 2017, there were no other interest-bearing assets requiring disclosure under Item III.C.1. or 2. of Industry Guide 3 if such assets were loans.

 

Summary of Loan Loss Experience

The following schedule presents a summary of activity in the allowance for loan losses for the periods shown and the percentage of net charge-offs during each period to average gross loans outstanding during the period:

 

(Dollars in thousands)  2017   2016   2015   2014   2013 
                     
Allowance for loan losses at beginning of year  $4,277   $4,194   $4,173   $4,735   $5,852 
                          
Charge-offs:                         
  Agricultural                   88 
  Commercial and industrial   439    37    30    1    122 
  Consumer   253    218    291    273    351 
  Real estate - commercial               665    858 
  Real estate - construction                    
  Real estate - residential   43    102    140    133    732 
    Total charge-offs   735    357    461    1,072    2,151 
                          
Recoveries:                         
  Agricultural           1    20    6 
  Commercial and industrial   21    31    64    119    337 
  Consumer   169    149    121    179    175 
  Real estate - commercial   258    89    47    48    84 
  Real estate - construction   40                 
  Real estate - residential   62    171    149    44    132 
    Total recoveries   550    440    382    410    734 
                          
Net charge-offs (recoveries)   185    (83)   79    662    1,417 
                          
Provision for loan losses (1)   485        100    100    300 
                          
Allowance for loan losses at end of year  $4,577   $4,277   $4,194   $4,173   $4,735 
                          
Allowance for loan losses as a percentage of:                          
Total loans as of year end   1.15%   1.16%   1.20%   1.21%   1.50%
Nonaccrual loans, accrual loans past due 90 days or more and troubled debt restructurings   108%   84%   76%   63%   62%
Ratio of net charge-offs during the period to average loans outstanding during the period   0.05%   (0.02)%   0.02%   0.20%   0.45%
Loan recoveries as a percentage of prior year’s charge-offs   154%   95%   36%   19%   29%

 

(1)Additions to the allowance for loan losses charged to operations during the periods shown were based on management’s judgment after considering factors such as loan loss experience, evaluation of the loan portfolio, and prevailing and anticipated economic conditions. The evaluation of the loan portfolio is based upon various risk factors such as the financial condition of the borrower, the value of collateral and other considerations, which, in the opinion of management, deserve current recognition in estimating loan losses.

 

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The following schedule presents an allocation of the allowance for loan losses to the various loan categories as of the years ended December 31:

  

(Dollars in thousands)  2017   2016   2015   2014   2013 
Agricultural  $506   $433   $420   $186   $178 
Commercial and industrial   1,001    688    586    527    562 
Consumer   262    305    297    184    192 
Real estate - commercial   1,761    1,438    1,030    1,641    1,842 
Real estate - construction   35    62    46    9    12 
Real estate - residential   726    1,013    1,388    1,193    1,626 
Unallocated   286    338    427    433    323 
    Total allowance  $4,577   $4,277   $4,194   $4,173   $4,735 

 

The increase in the allowance allocation to commercial and industrial loans and commercial real estate loans was due to growth in these categories and an increase in the inherent risk. The decline in the allocation to residential real estate loans was caused by lower historical charge-off levels. Changes in historical charge-off levels and environmental factors affected all loan categories.

 

Management periodically reviews the assumptions, loss ratios and delinquency trends in estimating the appropriate level of its allowance for loan losses and believes the unallocated portion of the total allowance was sufficient at December 31, 2017.

 

The following schedule presents the stratification of the loan portfolio by category, based on the amount of loans outstanding as a percentage of total loans for the respective years ended December 31:

 

   2017   2016   2015   2014   2013 
Agricultural   12%   12%   12%   12%   12%
Commercial and industrial   26    26    26    25    22 
Consumer   6    6    6    6    6 
Real estate - commercial   31    30    28    29    31 
Real estate - construction   2    2    2    1     
Real estate - residential   23    24    26    27    29 
    Total allowance   100%   100%   100%   100%   100%

 

Deposits

The following schedule presents the average deposit balances by category and the average rates paid thereon for the respective years:

 

(Dollars in thousands)                        
   2017   2016   2015 
Noninterest-bearing demand  $136,353    %  $123,848    %  $115,488    %
Interest-bearing demand and money market deposits   208,049    0.18    196,662    0.13    165,767    0.14 
Savings   76,107    0.02    73,118    0.03    67,826    0.04 
Certificates of deposit   104,936    0.75    86,042    0.60    94,891    0.66 
Total  $525,445    0.23%  $479,670    0.16%  $443,972    0.20%

 

The following table illustrates the maturities of certificates of deposits issued in denominations of $100,000 or more as of December 31, 2017:

 

(Dollars in thousands)     
      
Maturing in less than 3 months  $22,918 
Maturing in 3 to 6 months   14,309 
Maturing in 6 to 12 months   13,066 
Maturing in more than 12 months   9,313 
Total  $59,606 

 

At December 31, 2017, the Bank had no material foreign deposits.

 

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Short-Term Borrowings

Federal funds purchased by the Company are unsecured overnight borrowings from correspondent banks. Federal funds purchased are due the next business day. The table below provides additional information regarding these short-term borrowings:

 

(Dollars in thousands)            
   2017   2016   2015 
Outstanding balance at December 31  $   $   $ 
Average interest rate at December 31   %   %   %
Average balance during the year  $703   $610   $ 
Average interest rate during the year   1.47%   0.70%   %
Maximum month end balance during the year  $5,470   $4,100   $1,857 

 

Repurchase agreements include advances by Bank customers that are not covered by federal deposit insurance. These agreements are direct obligations of the Company and are secured by securities held in safekeeping at a correspondent bank. The table below provides additional information regarding these short-term borrowings:

 

(Dollars in thousands)            
   2017   2016   2015 
Outstanding balance at December 31  $7,148   $7,913   $9,460 
Average interest rate at December 31   0.05%   0.05%   0.04%
Average balance during the year  $4,958   $7,762   $17,825 
Average interest rate during the year   0.05%   0.05%   0.17%
Maximum month end balance during the year  $8,440   $10,539   $26,743 

 

Advances from the Federal Home Loan Bank (“FHLB”) with original repayment terms less than one year are considered short-term borrowings for the Company. These advances are secured by residential real estate mortgage loans and U.S. government agency securities. The advances have maturities ranging from 1 month to 12 months from the date of issue.

 

The table below provides additional information regarding these short-term borrowings:

 

(Dollars in thousands)            
   2017   2016   2015 
Outstanding balance at December 31  $20,268   $12,000   $ 
Average interest rate at December 31   1.36%   0.86%   0.57%
Average balance during the year  $22,830   $25,732   $11,332 
Average interest rate during the year   1.21%   0.61%   0.73%
Maximum month end balance during the year  $40,273   $45,000   $31,873 

 

There were no other categories of short-term borrowings whose average balance outstanding exceeded 30% of shareholders’ equity in 2017, 2016 or 2015.

 

Return on Equity and Assets 

The following schedule presents certain financial ratios of the Company for the years ended December 31:

 

   2017   2016   2015 
Return on assets (net income divided by average total assets)   0.98%   1.04%   1.04%
                
Return on equity (net income dividend by average equity)   8.22%   8.44%   8.39%
                
Dividend payout ratio (dividends declared per share divided by net income per share)   37.57%   36.63%   37.79%
                
Equity to assets ratio (average equity divided by average total assets)   11.91%   12.30%   12.40%

 

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Item 1A. Risk Factors

 

The Company is subject to many risks and uncertainties. Although the Company seeks ways to manage these risks and develop programs to control risks to the extent that management can control them, the Company cannot predict the future. Actual results may differ materially from management’s expectations. Some of these significant risks and uncertainties are discussed below. The risks and uncertainties described below are not the only ones that the Company faces. Additional risks and uncertainties of which the Company is unaware, or that it currently does not consider to be material, also may become important factors that affect the Company and its business. If any of these risks were to occur, the Company’s business, financial condition or results of operations could be materially and adversely affected.

 

Investments in the Company’s common stock involve risk.

 

The market price of the Company’s common stock may fluctuate significantly in response to a number of factors, including:

 

Variations in quarterly or annual operating results
Changes in dividends per share
Changes in interest rates
New developments, laws or regulations in the banking industry
Acquisitions or business combinations involving the Company or its competition
Regulatory actions, including changes to regulatory capital levels, the components of regulatory capital and how regulatory capital is calculated
Volatility of stock market prices and volumes
Changes in market valuations of similar companies
New litigation or contingencies or changes in existing litigation or contingencies
Changes in accounting policies or procedures as may be required by the Financial Accounting Standards Board or other regulatory agencies
Rumors or erroneous information
Credit and capital availability
Issuance of additional shares of common stock or other debt or equity securities of the Company

 

Asset quality could be less favorable than expected.

 

A significant source of risk for the Company arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loan agreements. Most loans originated by the Company are secured, but some loans are unsecured depending on the nature of the loan. With respect to secured loans, the collateral securing the repayment of these loans includes a wide variety of real and personal property that may be insufficient to cover the obligations owed under such loans. Collateral values may be adversely affected by changes in prevailing economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government, terrorist activity, environmental contamination and other external events.

 

The Company’s allowance for loan losses may not be adequate to cover actual loan losses.

 

The risk of nonpayment of loans is inherent in all lending activities and nonpayment of loans may have a material adverse effect on the Company’s earnings and overall financial condition, and the value of its common stock. The Company makes various assumptions and judgments about the collectability of its loan portfolio and provides an allowance for potential losses based on a number of factors. If its assumptions are wrong, the allowance for loan losses may not be sufficient to cover losses, which could have an adverse effect on the Company’s operating results, and may cause it to increase the allowance in the future. The actual amount of future provisions for loan losses cannot now be determined and may exceed the amounts of past provisions for loan losses. Federal and state banking regulators, as an integral part of their supervisory function, periodically review the allowance for loan losses. These regulatory agencies may require the Company to increase its provision for loan losses or to recognize further loan charge-offs based upon their judgments, which may be different from the Company’s judgments. Any increase in the allowance for loan losses could have a negative effect on the Company’s regulatory capital ratios, net income, financial condition and results of operations.

 

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General economic conditions in the state of Michigan could be less favorable than expected.

 

The Company is affected by general economic conditions in the United States, although most directly within Michigan. An economic downturn within Michigan could negatively impact household and corporate incomes. This impact may lead to decreased demand for both loan and deposit products and increase the number of customers who fail to pay interest or principal on their loans.

 

The Company could be adversely affected by the soundness of other financial institutions, including defaults by larger financial institutions.

 

The Company’s ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of credit, trading, clearing, counterparty or other relationships between financial institutions. The Company has exposure to multiple counterparties, and it routinely executes transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to market-wide liquidity problems and losses or defaults by the Company or by other institutions. This is sometimes referred to as “systemic risk” and may adversely affect financial intermediaries, such as clearing agencies, clearing houses, banks, securities firms and exchanges, with which the Company interacts on a daily basis, and therefore could adversely affect the Company.

 

If the Company does not adjust to changes in the financial services industry, its financial performance may suffer.

 

The Company’s ability to maintain its financial performance and return on investment to shareholders will depend in part on its ability to maintain and grow its core deposit customer base and expand its financial services to its existing customers. In addition to other banks, competitors include credit unions, securities dealers, brokers, mortgage bankers, investment advisors and finance and insurance companies. The increasingly competitive environment is, in part, a result of changes in the economic environment within the state of Michigan, regulation, changes in technology and product delivery systems and the accelerating pace of consolidation among financial service providers. New competitors may emerge to increase the degree of competition for the Company’s customers and services. Financial services and products are also constantly changing. The Company’s financial performance will also depend in part upon customer demand for the Company’s products and services and the Company’s ability to develop and offer competitive financial products and services.

 

Changes in interest rates could reduce the Company’s income and cash flow.

 

The Company’s income and cash flow depends, to a great extent, on the difference between the interest earned on loans and securities, and the interest paid on deposits and other borrowings. Market interest rates are beyond the Company’s control, and they fluctuate in response to general economic conditions and the policies of various governmental and regulatory agencies including, in particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates and interest rate relationships, will influence the origination of loans, the purchase of investments, the generation of deposits and the rate received on loans and securities and paid on deposits and other borrowings.

 

The Company is subject to liquidity risk in its operations, which could adversely affect its ability to fund various obligations.

 

Liquidity risk is the possibility of being unable to meet obligations as they come due or capitalize on growth opportunities as they arise because of an inability to liquidate assets or obtain adequate funding on a timely basis, at a reasonable cost and within acceptable risk tolerances. Liquidity is required to fund various obligations, including credit obligations to borrowers, loan originations, withdrawals by depositors, repayment of debt, dividends to shareholders, operating expenses and capital expenditures. Liquidity is derived primarily from retail deposit growth and earnings retention, principal and interest payments on loans and investment securities, net cash provided from operations and access to other funding. If the Company is unable to maintain adequate liquidity, then its business, financial condition and results of operations would be negatively affected.

 

Legislative or regulatory changes or actions could adversely impact the Company or the businesses in which it is engaged.

 

The financial services industry is extensively regulated. The Company and the Bank are subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of their operations. Laws and regulations may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance fund, and not to benefit the Company’s shareholders. The impact of any changes to laws and regulations or other actions by regulatory agencies may negatively impact the Company or its ability to increase the value of its business. Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of an institution, the classification of assets by the institution and the adequacy of an institution’s allowance for loan losses. Future regulatory changes or accounting pronouncements may increase the Company’s regulatory capital requirements or adversely affect its regulatory capital levels. Additionally, actions by regulatory agencies against the Company or the Bank could require the Company to devote significant time and resources to defending its business and may lead to penalties that materially affect the Company.

 

Page | 14

 

 

The Company relies heavily on its management and other key personnel, and the loss of any of them may adversely affect its operations.

 

The Company is and will continue to be dependent upon the services of its management team and other key personnel.  Losing the services of one or more key members of the Company’s management team could adversely affect its operations.

 

The Company may be a defendant in a variety of litigation and other actions, which may have a material adverse effect on the Company’s financial condition and results of operations.

 

The Company and the Bank are regularly involved in a variety of litigation arising out of the normal course of business. The Company’s insurance may not cover all claims that may be asserted against it, and any claims asserted against it, regardless of merit or eventual outcome, may harm its reputation or cause the Company to incur unexpected expenses, which could be material in amount. Should the ultimate expenses, judgments or settlements in any litigation exceed the Company’s insurance coverage, they could have a material adverse effect on the Company’s financial condition and results of operations. In addition, the Company may not be able to obtain appropriate types or levels of insurance in the future, nor may it be able to obtain adequate replacement policies with acceptable terms, if at all.

 

If the Company cannot raise additional capital when needed, its ability to further expand its operations through organic growth or acquisitions could be materially impaired.

 

The Company is required by federal and state regulatory authorities to maintain specified levels of capital to support its operations.  The Company may need to raise additional capital to support its current level of assets or its growth.  The Company’s ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside its control, and on its financial performance.  The Company cannot assure that it will be able to raise additional capital in the future on terms acceptable to it or at all.  If the Company cannot raise additional capital when needed, its ability to maintain its current level of assets or to expand its operations through organic growth or acquisitions could be materially limited.

 

Unauthorized disclosure of sensitive or confidential client or customer information, whether through a breach of computer systems or otherwise, could severely harm the Company’s business.

 

As part of its business, the Company collects, processes and retains sensitive and confidential client and customer information on behalf of itself and other third parties. Despite the security measures the Company has in place for its facilities and systems, and the security measures of its third party service providers, the Company may be vulnerable to security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming and/or human errors or other similar events. Any security breach involving the misappropriation, loss or other unauthorized disclosure of confidential customer information, whether by the Company or by its vendors, could severely damage the Company’s reputation, expose it to the risks of litigation and liability, disrupt the Company’s operations and have a material adverse effect on the Company’s business.

 

The Company’s information systems may experience an interruption or breach in security.

 

The Company relies heavily on communications and information systems to conduct its business and deliver its products. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Company’s customer relationship management, general ledger, deposit, loan and other systems. While the Company has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches of the Company’s information systems or its customers’ information or computer systems would not damage the Company’s reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, or expose the Company to civil litigation and financial liability, any of which could have a material adverse effect on the Company’s financial condition and results of operations.

 

Environmental liability associated with commercial lending could result in losses.

 

In the course of its business, the Company may acquire, through foreclosure, properties securing loans it has originated or purchased that are in default. Particularly in commercial real estate lending, there is a risk that hazardous substances could be discovered on these properties. In this event, the Company might be required to remove these substances from the affected properties at the Company’s sole cost and expense. The cost of this removal could substantially exceed the value of affected properties. The Company may not have adequate remedies against the prior owner or other responsible parties and could find it difficult or impossible to sell the affected properties. These events could have an adverse effect on the Company’s business, results of operations and financial condition.

 

Page | 15

 

 

The Company depends upon the accuracy and completeness of information about customers.

 

In deciding whether to extend credit to customers, the Company relies on information provided to it by its customers, including financial statements and other financial information. The Company may also rely on representations of customers as to the accuracy and completeness of that information and on reports of independent auditors on financial statements. The Company’s financial condition and results of operations could be negatively impacted to the extent that the Company extends credit in reliance on financial statements that do not comply with generally accepted accounting principles or that are misleading or other information provided by customers that is false or misleading.

 

The Company operates in a highly competitive industry and market area.

 

The Company faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national and regional banks within the various markets where the Company operates, as well as internet banks and other Fintech companies. The Company also faces competition from many other types of financial institutions, including savings and loan associations, credit unions, finance companies, brokerage firms, insurance companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. The Company competes with these institutions both in attracting deposits and in making new loans. Technology has lowered barriers to entry into the market and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of the Company’s competitors have fewer regulatory constraints and may have lower cost structures, such as credit unions that are not subject to federal income tax. Due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Company can.

 

Severe weather, natural disasters, acts of war or terrorism and other external events could significantly impact the Company’s business.

 

Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on the Company’s ability to conduct business. Such events could affect the stability of the Company’s deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause the Company to incur additional expenses.

 

The Company relies on dividends from the Bank for most of its revenue.

 

The Company is a separate and distinct legal entity from the Bank. It receives substantially all of its revenue from dividends from the Bank. These dividends are the principal source of funds to pay cash dividends on the Company’s common stock. Various federal and/or state laws and regulations limit the amount of dividends that the Bank may pay to the Company. If the Bank is unable to pay dividends to the Company, the Company may not be able to pay cash dividends on its common stock. The earnings of the Bank have been the principal source of funds to pay cash dividends to shareholders. Over the long-term, cash dividends to shareholders are dependent upon earnings, as well as capital requirements, regulatory restraints and other factors affecting the Company and the Bank.

 

Additional risks and uncertainties could have a negative effect on financial performance.

 

Additional factors could have a negative effect on the financial performance of the Company and the Company’s common stock. Some of these factors are financial market conditions, changes in financial accounting and reporting standards, new litigation or changes in existing litigation, regulatory actions and losses.

 

Item 1B. Unresolved Staff Comments

 

None.

 

Page | 16

 

 

Item 2.

Properties

 

The offices of the Company as of February 28, 2018, were as follows:

 

Company’s main office:
     109 East Division, Sparta, Michigan
     Office is owned by the Bank and comprises 24,000 square feet.

 

Bank’s branch office:
     416 West Division, Sparta, Michigan
     Office is leased by the Bank and comprises 3,000 square feet.

 

Bank’s branch office:
     4170 - 17 Mile Road, Cedar Springs, Michigan
     Office is owned by the Bank and comprises 3,000 square feet.

 

Bank’s branch office:
     6795 Courtland Drive, Rockford, Michigan
     Office is owned by the Bank and comprises 2,400 square feet.

 

Bank’s branch office:
     5050 Alpine Avenue NW, Comstock Park, Michigan
     Office is owned by the Bank and comprises 2,400 square feet.

 

Bank’s branch office:
     450 West Muskegon, Kent City, Michigan
     Office is owned by the Bank and comprises 27,300 square feet.

 

Bank’s branch office:
     3069 Slocum Road, Ravenna, Michigan
     Office is owned by the Bank and comprises 4,800 square feet.

 

Bank’s branch office:
     5475 East Apple Avenue, Muskegon, Michigan
     Office is owned by the Bank and comprises 4,800 square feet.

 

Bank’s branch office:
     661 West Randall, Coopersville, Michigan
     Office is owned by the Bank and comprises 2,700 square feet.

 

Bank’s branch office:
     10 West Main Street, Grant, Michigan
     Office is owned by the Bank and comprises 4,800 square feet.

 

Bank’s branch office:
     246 West River Valley Drive, Newaygo, Michigan
     Office is owned by the Bank and comprises 2,600 square feet.

 

Bank’s branch office:
     1423 West Main Street, Fremont, Michigan
     Office is owned by the Bank and comprises 1,600 square feet.

 

Bank’s loan production office:
     237 Fulton West, Grand Rapids, Michigan
     Office is leased by the Bank and comprises 1,800 square feet.

 

The Company believes that the offices are suitable and adequate for future needs and are in good condition. The Company’s management believes all offices are adequately covered by property insurance.

 

Page | 17

 

 

Item 3. Legal Proceedings

As of December 31, 2017, there were no significant pending legal proceedings to which the Company or the Bank is a party or to which any of their properties were subject, except for legal proceedings arising in the ordinary course of business. In the opinion of management, pending legal proceedings will not have a material adverse effect on the consolidated financial condition of the Company.

 

Item 4. Mine Safety Disclosures

Not applicable.

 

PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Stock Information

 

Several brokers trade ChoiceOne’s common shares in the OTC Pink marketplace. There is no well-established public trading market for the shares and trading activity is infrequent. ChoiceOne’s trading volume and recent share price information can be viewed under the symbol ’COFS’ on certain financial websites.

 

The range of high and low bid prices for shares of common stock for each quarterly period during the past two years is as follows:

 

   2017   2016 
   Low   High   Low   High 
First Quarter  $21.43   $23.33   $21.27   $22.67 
Second Quarter   21.67    23.99    21.05    22.71 
Third Quarter   21.95    23.55    20.97    22.61 
Fourth Quarter   22.03    24.10    20.57    22.86 

 

The prices listed above are over-the-counter market quotations reported to ChoiceOne by its market makers. The over-the-counter market quotations reflect inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions. As of February 28, 2018, the average bid price for shares of ChoiceOne common stock was $24.65.

 

As of February 28, 2018, there were 678 shareholders of record of ChoiceOne common stock.

 

The following table summarizes the quarterly cash dividends declared per share of common stock during 2017 and 2016:

 

   2017   2016 
First Quarter  $0.16   $0.16 
Second Quarter   0.17    0.16 
Third Quarter   0.17    0.16 
Fourth Quarter   0.17    0.16 
     Total  $0.67   $0.64 

 

ChoiceOne’s principal source of funds to pay cash dividends is the earnings and dividends paid by the Bank. The Bank is restricted in its ability to pay cash dividends under current banking regulations. See Note 20 to the consolidated financial statements for a description of these restrictions. Based on information presently available, management expects ChoiceOne to declare and pay regular quarterly cash dividends in 2018, although the amount of the quarterly dividends will be dependent on market conditions and ChoiceOne’s requirements for cash and capital, among other things.

 

On October 25, 2017, the Company issued 542 shares of common stock to its directors pursuant to the Directors’ Stock Purchase Plan for an aggregate cash price of $13,000. The Company relied on the exemption contained in Section 4(6) of the Securities Act of 1933 in connection with these sales.

 

Page | 18

 

 

ISSUER PURCHASES OF EQUITY SECURITIES

 

           Total Number   Maximum 
           of Shares   Number of 
           Purchased as   Shares that 
  Total Number   Average   Part of a   May Yet be 
   of Shares   Price Paid   Publicly   Purchased 
Period  Purchased   per Share   Announced Plan   Under the Plan 
                 
October 1 - October 31, 2017                    
Employee Transactions      $          
Repurchase Plan      $        20,424 
November 1 - November 30, 2017                    
Employee Transactions (1)   587   $23.00          
Repurchase Plan (2)   5,000   $23.00    5,000    15,424 
December 1 - December 31, 2017                    
Employee Transactions      $          
Repurchase Plan      $        15,424 

 

(1)Shares submitted for cancellation to satisfy tax withholding obligations that occur upon the vesting of restricted units. The value of the shares delivered or withheld is determined by the applicable stock compensation plan.

(2)The Company purchased 5,000 shares of its own common stock during the quarter ended December 31, 2017. As of December 31, 2017, there were 15,424 shares remaining that may yet be purchased under approved plans or programs. The repurchase plan was adopted and announced on July 26, 2007. There is no stated expiration date. The plan authorized the repurchase of up to 100,000 shares.

 

The information under Item 12 of this report regarding equity compensation plans is incorporated herein by reference.

 

Page | 19

 

 

Item 6. Selected Financial Data

 

ChoiceOne Financial Services, Inc.
Selected Financial Data

 

(Dollars in thousands, except per share data)                    
   2017   2016   2015   2014   2013 
For the year                         
Net interest income  $20,563   $19,343   $18,362   $17,863   $17,596 
Provision for loan losses   485        100    100    300 
Noninterest income   7,811    7,881    7,702    6,802    6,245 
Noninterest expense   19,334    18,972    18,276    16,794    16,664 
Income before income taxes   8,555    8,252    7,688    7,771    6,877 
Income tax expense   2,387    2,162    1,945    2,076    1,783 
Net income   6,168    6,090    5,743    5,695    5,094 
Cash dividends declared   2,317    2,231    2,170    1,945    1,780 
                          
Per share                         
Basic earnings  $1.79   $1.76   $1.67   $1.65   $1.48 
Diluted earnings   1.78    1.76    1.66    1.64    1.47 
Cash dividends declared   0.67    0.64    0.63    0.56    0.51 
Shareholders’ equity (at year end)   22.20    20.72    20.18    19.12    17.79 
                          
Average for the year                         
Securities  $177,125   $173,119   $152,361   $142,361   $133,704 
Gross loans   388,609    357,880    342,382    330,355    312,798 
Deposits   525,445    479,670    443,972    422,737    410,462 
Federal Home Loan Bank advances   22,830    26,049    19,989    14,555    7,415 
Shareholders’ equity   75,026    72,134    68,439    64,143    61,317 
Assets   629,748    586,299    551,762    526,669    502,333 
                          
At year end                         
Securities  $159,158   $177,955   $163,323   $145,706   $139,832 
Gross loans   398,785    369,000    349,304    346,113    315,966 
Deposits   539,853    512,386    474,696    434,828    418,127 
Federal Home Loan Bank advances   20,268    12,301    11,332    18,363    6,392 
Shareholders’ equity   76,550    71,698    69,842    66,190    61,558 
Assets   646,544    607,371    567,746    549,640    514,575 
                          
Selected financial ratios                         
Return on average assets   0.98%   1.04%   1.04%   1.08%   1.01%
Return on average shareholders’ equity   8.22    8.44    8.39    8.88    8.31 
Cash dividend payout as a percentage of net income   37.57    36.63    37.79    34.15    34.93 
Shareholders’ equity to assets (at year end)   11.84    11.80    12.30    12.04    11.96 

  

Page | 20

 

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion is designed to provide a review of the consolidated financial condition and results of operations of ChoiceOne, and its wholly-owned subsidiaries. This discussion should be read in conjunction with the consolidated financial statements and related footnotes.

 

RESULTS OF OPERATIONS

 

Summary
Net income for 2017 was $6,168,000, which represented a $78,000 or 1% increase from 2016. The growth in net income resulted primarily from an increase in net interest income in 2017 compared to 2016, which was partially offset by a higher provision for loan losses and higher noninterest expense. The effect of $39.8 million of growth in average earning assets in 2017 compared to 2016 was partially offset by a 5 basis point decrease in the rate earned on average earning assets. A combination of an increase in net charge-offs in 2017 compared to the prior year and loan growth in 2017 caused ChoiceOne to recognize $485,000 in provision expense for loan losses in 2017 compared to no provision in 2016. ChoiceOne had $185,000 in net loan charge-offs in 2017, compared to net loan recoveries of $83,000 in 2016. A decline in noninterest income of $70,000 in 2017 compared to 2016 was mainly caused by a decrease in gains on sales of loans and net losses on sales of securities in 2017 in contrast to net gains recognized in 2016. This was offset by a $908,000 gain on the sale of a portion of ChoiceOne’s investment book of business discussed further in the noninterest income section below. The increase of $362,000 in noninterest expense in 2017 compared to the prior year was primarily due to higher salaries and benefits expense as well as increased occupancy expense and professional fees.

 

Net income for 2016 was $6,090,000, which represented a $347,000 or 6% increase from 2015. The growth in net income resulted primarily from an increase in interest income in 2016 compared to 2015, which was partially offset by higher noninterest expense. The effect of $34.6 million of growth in average earning assets in 2016 compared to 2015 was partially offset by an 8 basis point decrease in the rate earned on average assets. Net loan charge-offs continued to be low in 2016, which allowed for no provision expense for loan losses in 2016 compared to $100,000 in 2015. ChoiceOne had $83,000 in net loan recoveries in 2016, compared to net loan charge-offs of $79,000 in 2015. Growth in noninterest income of $179,000 in 2016 compared to 2015 was mainly caused by higher gains on sales of loans. The increase of $696,000 in noninterest expense in 2016 compared to the prior year was primarily due to higher salaries and benefits.

 

Dividends
Cash dividends of $2,317,000 or $0.67 per common share were declared in 2017, compared to $2,231,000 or $0.64 per common share in 2016 and $2,170,000 or $0.63 per common share in 2015. The dividend yield on ChoiceOne’s common stock was 2.86% as of year-end 2017, compared to 2.86% in 2016 and 2.77% in 2015. The cash dividend payout as a percentage of net income was 38% in 2017, compared to 37% in 2016 and 38% in 2015. In addition, a 5% stock dividend was paid on May 31, 2017, which caused $3,779,000 to be transferred from retained earnings to paid-in capital.

 

Page | 21

 

 

 

Table 1 – Average Balances and Tax-Equivalent Interest Rates

 

   Year ended December 31, 
   2017   2016   2015 
(Dollars in thousands)  Average           Average           Average         
   Balance   Interest   Rate   Balance   Interest   Rate   Balance   Interest   Rate 
Assets:                                    
Loans (1) (2)  $388,609   $17,974    4.63%  $357,880   $16,518    4.62%  $342,382   $15,982    4.67%
Taxable securities (3)   122,150    2,371    1.94    118,787    2,171    1.83    102,550    1,783    1.74 
Nontaxable securities (1)   54,975    2,142    3.90    54,332    2,190    4.03    49,952    2,156    4.32 
Other   9,465    102    1.08    4,231    21    0.49    5,753    14    0.25 
Interest-earning assets   575,199    22,589    3.93    535,230    20,900    3.91    500,637    19,935    3.98 
Noninterest-earning assets (4)   54,549              51,069              51,125           
Total assets  $629,748             $586,299             $551,762           
                                              
Liabilities and Shareholders’ Equity:                                             
Interest-bearing demand deposits  $208,049   $385    0.18%  $196,662   $253    0.13%  $165,767   $226    0.14%
Savings deposits   76,107    14    0.02    73,118    20    0.03    67,826    26    0.04 
Certificates of deposit   104,936    790    0.75    86,042    517    0.60    94,891    625    0.66 
Advances from Federal Home Loan Bank   22,830    276    1.21    26,049    171    0.66    19,989    83    0.41 
Other   5,661    13    0.23    8,372    8    0.10    18,156    30    0.17 
Interest-bearing liabilities   417,583    1,478    0.36    390,243    969    0.25    366,629    990    0.27 
Demand deposits   136,353              123,848              115,488           
Other noninterest-bearing liabilities   786              74              1,206           
Total liabilities   554,722              514,165              483,323           
Shareholders’ equity   75,026              72,134              68,439           
Total liabilities and shareholders’ equity  $629,748             $586,299             $551,762           
                                              
Net interest income (tax-equivalent basis)-interest spread        21,111    3.57%        19,931    3.66%        18,944    3.71%
Tax-equivalent adjustment (1)        (548)             (591)             (582)     
Net interest income       $20,563             $19,340             $18,362      
Net interest income as a percentage of earning assets (tax-equivalent basis)             3.67%             3.72%             3.78%

 

(1)Interest on nontaxable securities and loans has been adjusted to a fully tax-equivalent basis to facilitate comparison to the taxable interest-earning assets. The adjustment uses an incremental tax rate of 34% for the years presented.

(2)Interest on loans included net origination fees charged on loans of approximately $1,003,000, $1,054,000, and $957,000 in 2017, 2016, and 2015, respectively.

(3)Interest on taxable securities includes dividends on Federal Home Loan Bank and Federal Reserve Bank stock.

(4)Noninterest-earning assets include loans on a nonaccrual status, which averaged approximately $1,486,000, $2,416,000, and $2,145,000 in 2017, 2016, and 2015, respectively.

 

Page | 22

 

Table 2 – Changes in Tax-Equivalent Net Interest Income

 

   Year ended December 31, 
(Dollars in thousands)  2017 Over 2016   2016 Over 2015 
   Total   Volume   Rate   Total   Volume   Rate 
Increase (decrease) in interest income (1)                              
Loans (2)  $1,456   $1,421   $35   $536   $717   $(181)
Taxable securities   200    63    137    388    293    95 
Nontaxable securities (2)   (48)   26    (74)   34    182    (148)
Other   81    41    40    8    (4)   12 
Net change in interest income   1,689    1,551    138    966    1,188    (222)
                               
Increase (decrease) in interest expense (1)                              
Interest-bearing demand deposits   132    16    116    27    40    (13)
Savings deposits   (6)   1    (7)   (6)   2    (8)
Certificates of deposit   273    127    146    (108)   (56)   (52)
Advances from Federal Home Loan Bank   105    (23)   128    88    30    58 
Other   5    (4)   9    (22)   (12)   (10)
Net change in interest expense   509    117    392    (21)   4    (25)
Net change in tax-equivalent net interest income  $1,180   $1,434   $(254)  $987   $1,184   $(197)

  

(1)The volume variance is computed as the change in volume (average balance) multiplied by the previous year’s interest rate. The rate variance is computed as the change in interest rate multiplied by the previous year’s volume (average balance). The change in interest due to both volume and rate has been allocated to the volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

(2)Interest on tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis using an incremental tax rate of 34% for the years presented.

 

Net Interest Income

Tax-equivalent net interest income increased $1,180,000 in 2017 compared to 2016. The increase was attributed to an increase of $40.0 million in interest-earning assets, which was partially offset by a 5 basis point decrease in the rate earned on these assets and a 9 basis point increase in interest bearing liabilities. ChoiceOne’s net interest spread declined 9 basis points in 2017 compared to 2016.

 

The average balance of loans increased $30.7 million in 2017 compared to 2016. Most of the increase resulted from growth of $12.7 million in commercial real estate loans and $8.3 million of commercial and industrial loans. Partially offsetting the effect of the loan growth was a 4 basis point decrease in the average rate earned on loans. Tax-equivalent interest income on loans increased $1.5 million in 2017 compared to the prior year. The average balance of total securities increased by $4.0 million in 2017 compared to 2016 as securities were purchased to provide earning assets growth. Interest income from securities increased $152,000 in 2017 compared to the prior year.

 

The average balance of interest-bearing demand deposits increased $11.4 million in 2017 compared to 2016. The effect of this increase and a 4 basis point increase in the average rate paid caused interest expense to be $132,000 higher in 2017 than in the prior year. The effect of the $3.0 million increase in average savings deposits was partially offset by a 2 basis point decline in the average rate paid. The average balance of certificates of deposit was $18.9 million higher in 2017 than in the prior year. The average balance increase plus the impact of a 9 basis point increase in the average rate paid caused interest expense to grow $273,000. A $3.2 million decline in the average balance of Federal Home Loan Bank advances, partially offset by an 80 basis point increase in the average rate paid, caused interest expense to increase $105,000 in 2017 compared to the prior year.

 

ChoiceOne’s tax-equivalent net interest income spread was 3.57% for 2017 and 3.66% for 2016. The decline in the net interest income spread resulted from the average rate paid on interest-bearing liabilities increased more in 2017 than the average rate earned on interest-earning assets.

 

Tax-equivalent net interest income increased $987,000 in 2016 compared to 2015. The increase was attributed to an increase of $34.6 million in interest-earning assets and a decrease of 2 basis points on interest-bearing liabilities, which were partially offset by an 8 basis point decline in the average rate on interest-earning assets. ChoiceOne’s net interest spread declined 5 basis points in 2016 compared to 2015 as general market rates had more of a downward effect on assets than liabilities.

 

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The average balance of loans increased $15.5 million in 2016 compared to 2015. Most of the increase resulted from growth of $13.6 million in commercial and industrial and commercial real estate loans. Partially offsetting the loan growth was a 5 basis point decrease in the average rate earned on loans, which caused tax-equivalent interest income on loans to increase $536,000 in 2016 compared to the prior year. The average balance of total securities increased by $20.6 million in 2016 compared to 2015 as securities were purchased to provide earning assets growth. This growth in the average balance was partially offset by a lower average rate earned on securities; however, interest income from securities still increased $422,000 in 2016 compared to the prior year.

 

The average balance of interest-bearing demand deposits increased $30.9 million in 2016 compared to 2015. The effect of this increase, partially offset by a 1 basis point decline in the average rate paid, caused interest expense to be $27,000 higher in 2016 than in the prior year. The effect of the $5.3 million increase in average savings deposits was more than offset by a 1 basis point decline in average rate paid which caused a $6,000 decrease in interest expense in 2016 compared to the prior year. The average balance of certificates of deposit was $8.8 million lower in 2016 than in the prior year. The average balance decrease plus the effect of a 6 basis point decline in the average rate paid caused interest expense on certificates of deposit to fall $108,000 in 2016 compared to 2015. A $6.1 million increase in the average balance of Federal Home Loan Bank advances and a 25 basis point increase in the average rate paid caused interest expense to increase $88,000 in 2016 compared to the prior year. The growth experienced in non-interest bearing demand deposits and savings deposits was primarily due to depositors choosing the liquidity afforded by this type of deposit as compared to certificates of deposit or nonbank investments.

 

ChoiceOne’s net interest income spread was 3.66% for 2016 and 3.71% for 2015. The continuation of low general market interest rates in both 2015 and 2016 caused the reduction in rates for both assets and liabilities.

 

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Provision and Allowance For Loan Losses

 

Table 3 – Provision and Allowance For Loan Losses

 

(Dollars in thousands)                    
   2017   2016   2015   2014   2013 
Allowance for loan losses at beginning of year  $4,277   $4,194   $4,173   $4,735   $5,852 
Charge-offs:                         
Agricultural                   88 
Commercial and industrial   439    37    30    1    122 
Real estate - commercial               665    858 
Real estate - construction                    
Real estate - residential   43    102    140    133    732 
Consumer   253    218    291    273    351 
Total   735    357    461    1,072    2,151 
                          
Recoveries:                         
Agricultural           1    20    6 
Commercial and industrial   21    31    64    119    337 
Real estate - commercial   258    89    47    48    84 
Real estate - construction   40                 
Real estate - residential   62    171    149    44    132 
Consumer   169    149    121    179    175 
Total   550    440    382    410    734 
                          
Net charge-offs (recoveries)   185    (83)   79    662    1,417 
                          
Provision for loan losses (1)   485        100    100    300 
                          
Allowance for loan losses at end of year  $4,577   $4,277   $4,194   $4,173   $4,735 
                          
Allowance for loan losses as a percentage of:                         
Total loans as of year end   1.15%   1.16%   1.20%   1.21%   1.50%
Nonaccrual loans, accrual loans past due 90 days or more and troubled debt restructurings   108%   84%   76%   63%   62%
Ratio of net charge-offs (recoveries) to average total loans outstanding during the year   0.05%   (0.02)%   0.02%   0.20%   0.45%
Loan recoveries as a percentage of prior year’s charge-offs   154%   95%   36%   19%   29%

 

The provision for loan losses was $485,000 in 2017 compared to $0 in 2016. The increase to provision during the year was partly due to net charge-offs occurring in 2017 in contrast to net recoveries experienced in 2016. The increase was also caused by loan growth during 2017. The allowance for loan losses as a percentage of total loans decreased slightly from 1.16% as of the end of 2016 to 1.15% as of the end of 2017. The coverage ratio of the allowance for loan losses to nonperforming loans increased from 84% as of December 31, 2016 to 108% as of December 31, 2017. ChoiceOne had $302,000 of specific allowance allocations for problem loans as of the end of 2017, compared to $403,000 as of the prior year end. Specific allowance amounts have been allocated where the fair values of loans were considered to be less than their carrying values. ChoiceOne obtains valuations on collateral dependent loans when the loan is considered by management to be impaired and uses the valuation amounts in the determination of fair value. Management believes the specific reserves allocated to certain problem loans at the end of 2017 and 2016 were reasonable based on the circumstances surrounding each particular borrower.

 

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The following schedule presents an allocation of the allowance for loan losses to the various loan categories as of the years ended December 31:

 

(Dollars in thousands)                    
   2017   2016   2015   2014   2013 
Agricultural  $506   $433   $420   $186   $178 
Commercial and industrial   1,001    688    586    527    562 
Real estate - commercial   1,761    1,438    1,030    1,641    1,842 
Real estate - construction   35    62    46    9    12 
Real estate - residential   726    1,013    1,388    1,193    1,626 
Consumer   262    305    297    184    192 
Unallocated   286    338    427    433    323 
Total allowance for loan losses  $4,577   $4,277   $4,194   $4,173   $4,735 

  

The increase in the allowance allocation to commercial and industrial loans and commercial real estate loans was due to growth in these categories and an increase in the inherent risk. The decline in the allocation to residential real estate loans was caused by lower historical charge-off levels. Changes in historical charge-off levels and environmental factors affected all loan categories.

 

Management maintains the allowance at a level that it believes adequately provides for losses inherent in the loan portfolio. Such losses are estimated by a variety of factors, including specific examination of certain borrowing relationships and consideration of historical losses incurred on certain types of credits. Current economic conditions and collateral values affect loss estimates. Management focuses on early identification of problem credits through ongoing reviews by management and the independent loan review function. Based on the current state of the economy and a recent review of the loan portfolio, management believes that the allowance for loan losses as of December 31, 2017 was adequate. As charge-offs, changes in the level of nonperforming loans, and changes within the composition of the loan portfolio occur, the provision and allowance for loan losses will be reviewed by the Bank’s management and adjusted as necessary.

 

Noninterest Income

Total noninterest income decreased $70,000 in 2017 compared to 2016. Customer service charges increased $79,000 in 2017 due to higher overdraft and debit card fees. Gains on loan sales declined $483,000 in 2017 compared to 2016 as mortgage sales volume was lower in 2017 than in 2016. This was primarily due to higher interest rates and a relatively low inventory of homes available for sale in ChoiceOne’s primary markets. The large decline in gain on sales of securities was caused by ChoiceOne’s decision in the fourth quarter of 2017 to sell securities to support the funding of loan growth and decrease the bank’s dependence on wholesale borrowings due to increases in interest rates. As a result, ChoiceOne sold approximately $35 million in securities and recorded a fourth quarter loss of $457,000 on the sale. Management believes this decision will be accretive to income in 2018 and recognizing the losses during 2017 resulted in beneficial tax treatment. A gain of $908,000 was recognized upon the sale of a portion of ChoiceOne’s investment book of business during the fourth quarter of 2017. This sale was the primary reason for the decrease in insurance and investment commissions from 2016 to 2017. The increase in other noninterest income from 2016 to 2017 was primarily due to a $61,000 improvement in income from ChoiceOne’s investment in a title insurance agency.

 

Total noninterest income increased $179,000 in 2016 compared to 2015. Customer service charges decreased $27,000 in 2016 compared to the prior year due to a slight decline in service charges on checking accounts. A decrease in insurance and investment commissions of $51,000 in 2016 compared to 2015 was caused by lower commission income from sales of REIT investments during 2016 compared to 2015. Gains on sales of loans increased $332,000 in 2016 compared to 2015 as longer-term mortgage rates declined causing a positive impact on mortgage volume. Net gains on sales of securities increased $51,000 as opportunities to harvest gains on the securities portfolio increased in the low interest rate environment that existed during most of 2016. Net losses on sales of other assets were $80,000 lower in 2016 than in the prior year as write-downs of values of other real estate properties and losses on sales of properties were lower in 2016 than in 2015. Earnings on life insurance policies were $295,000 lower in 2016 than 2015 as the result of a death benefit received on a former employee’s life insurance policy in 2015.

 

Noninterest Expense

Total noninterest expense increased $362,000 in 2017 compared to 2016. Salaries and benefits increased $267,000 in 2017 compared to the prior year due to higher costs related to salaries, stock-based compensation, and health insurance. Occupancy and equipment expense grew $308,000 in 2017 compared to the prior year primarily as a result of costs related to remodeling expenses to ChoiceOne’s headquarters in Sparta, Michigan which was completed in 2017. Expense was also affected by a full year’s cost of two new ATM locations that were added during 2016. Professional fees increased $231,000 in 2017 compared to 2016 due in part to higher legal fees related to the sale of the investment book of business and costs associated with the search, purchase, and branch application process on two additional branches that are scheduled to be opened in 2018. Intangible amortization expense was $0 in 2017 as the related intangible assets were fully amortized by the end of 2016. The decrease in other noninterest expense in 2017 compared to the prior year was caused in part by lower recruiting expense and by lower FDIC insurance expense due to a reduced FDIC assessment rate after the Deposit Insurance Fund reached a 1.15% reserve threshold on June 30, 2016.

 

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Total noninterest expense increased $696,000 in 2016 compared to 2015. Salaries and benefits increased $709,000 in 2016 compared to the prior year due to higher costs related to salaries, stock-based compensation, commissions, and health insurance. Occupancy and equipment expense grew $192,000 in 2016 compared to the prior year primarily as a result of costs related to the lease of the loan production office than began in early 2016 and the lease of two new ATM locations that were added during 2016. Data processing expense decreased $47,000 as expenses related to Internet banking were lower in 2016 than in the prior year. Intangible amortization expense decreased by $69,000 in 2016 compared to 2015 as intangible assets were fully amortized by the end of 2016. FDIC insurance expense decreased in the last two quarters of 2016 due to a reduced FDIC assessment rate after the Deposit Insurance Fund reached a 1.15% reserve threshold on June 30, 2016.

 

Income Taxes

In the fourth quarter of 2017, ChoiceOne adjusted its net deferred tax asset for the impact of the lower corporate income tax rate which will be effective beginning in 2018. This adjustment caused the recognition of $206,000 of income tax expense, increasing tax expense in the fourth quarter of 2017 compared to the same time period in 2016. The reduction of the corporate income tax rate will have a positive effect on net income in future periods. Overall, income taxes increased $225,000 in 2017 compared to 2016. The effective tax rate was 28% in 2017, compared to 26% in 2016 and 25% in 2015. Income taxes increased $217,000 in 2016 compared to 2015. The increase in income taxes during 2017 compared to 2016 was primarily due to the adjustment of the deferred tax asset. The increase in tax expense in 2016 was caused by higher income before taxes.

 

Financial Condition

 

Summary
Total assets were $646.5 million as of December 31, 2017, which represented an increase of $39.2 million or 6.5% from the end of 2016. Securities available for sale decreased $18.8 million during 2017 due to the sale of securities in the fourth quarter of 2017. Net loans increased $29.5 million in 2017, with most of the increase occurring in commercial real estate and commercial and industrial loans. The increase of $300,000 in the allowance for loan losses resulted from provision for loan losses in 2017 required as a result of loan growth and higher net charge-offs in the current year compared to 2016. Total deposits increased $27.5 million in 2017 due to growth in checking deposits, savings deposits, and certificates of deposit.

 

Securities

The Bank’s securities available for sale balances as of December 31 were as follows:

 

(Dollars in thousands)        
   2017   2016 
U.S. Government and federal agency  $35,126   $59,052 
U.S. Treasury notes and bonds   1,960    4,072 
State and municipal   100,048    88,973 
Mortgage-backed   9,820    7,789 
Corporate   5,151    7,041 
Foreign debt       4,400 
Equity securities   3,392    2,883 
Asset-backed securities   94    178 
Total  $155,591   $174,388 

 

The securities available for sale portfolio decreased $18.8 million from December 31, 2016 to December 31, 2017. The decline in the securities balance was caused by the sale of $35 million of securities in the fourth quarter of 2017. Approximately $15.2 million in various securities were called or matured in 2017, which was partially offset by securities purchases. Principal payments for municipal and mortgage-backed securities totaling $2.4 million were received during 2017. The Bank’s Investment Committee continues to monitor the portfolio and purchases securities as it considers prudent. Also, certain securities are sold under agreements to repurchase and management plans to continue this practice as a low-cost source of funding.

 

Equity securities included a money market preferred security (MMP) and a trust preferred security totaling $1.5 million, and common stock of $1.9 million as of December 31, 2017. As of December 31, 2016, equity securities included an MMP and trust preferred security totaling $1.5 million, and common stock of $1.4 million.

 

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Loans

The Bank’s loan portfolio as of December 31 was as follows:            

           

(Dollars in thousands)        
   2017   2016 
Agricultural  $48,464   $44,614 
Commercial and industrial   104,386    96,088 
Consumer   24,513    21,596 
Real estate - commercial   123,487    110,762 
Real estate - construction   6,613    6,153 
Real estate - residential   91,322    89,787 
    Total loans  $398,785   $369,000 

 

The loan portfolio (excluding loans held for sale and loans to other financial institutions) increased $29.8 million from December 31, 2016 to December 31, 2017. Economic factors in ChoiceOne’s market are continuing to improve in most industry sectors. Residential mortgage loans volume was lower in 2017 mainly due to higher interest rates and a relatively low inventory of homes available for sale in ChoiceOne’s primary markets. Growth experienced in the commercial and industrial and commercial real estate loan categories was due in part to calling efforts by ChoiceOne’s loan officers.

 

The Bank entered into an agreement at the beginning of 2017 to provide a line of credit to facilitate funding of residential mortgage loan originations at other financial institutions. The loans are short-term in nature and are designed to provide funding for the time period between the loan origination and its subsequent sale in the secondary market. As of December 31, 2017 the balance of the line of credit was $6.8 million.

 

Information regarding impaired loans can be found in Note 3 to the consolidated financial statements included in this report. In addition to its review of the loan portfolio for impaired loans, management also monitors various nonperforming loans. Nonperforming loans are comprised of (1) loans accounted for on a nonaccrual basis; (2) loans, not included in nonaccrual loans, which are contractually past due 90 days or more as to interest or principal payments; and (3) loans, not included in nonaccrual or past due 90 days or more, which are considered troubled debt restructurings. Troubled debt restructurings consist of loans where the terms have been modified to assist the borrowers in making their payments. The modifications can include capitalization of interest onto the principal balance, reduction in interest rate, and extension of the loan term.

 

The balances of these nonperforming loans as of December 31 were as follows:

 

(Dollars in thousands)        
   2017   2016 
Loans accounted for on a nonaccrual basis  $1,096   $1,983 
Loans contractually past due 90 days or more as to principal or interest payments   258    229 
Loans considered troubled debt restructurings which are not included above   2,896    2,853 
Total  $4,250   $5,065 

 

Nonaccrual loans included $423,000 in agricultural loans, $222,000 in commercial and industrial loans, $15,000 in consumer loans, and $436,000 in residential real estate loans as of December 31, 2017. Nonaccrual loans included $482,000 in agricultural loans, $245,000 in commercial and industrial loans, $6,000 in consumer loans, $458,000 in commercial real estate loans, and $792,000 in residential real estate loans as of December 31, 2016. The primary reason for the decline in nonaccrual loans in 2017 was loan paydowns and two charge-offs related to commercial and industrial loans. Loans considered troubled debt restructurings which were not on a nonaccrual basis and were not 90 days or more past due as to principal or interest payments consisted of $24,000 in commercial and industrial loans, $556,000 in commercial real estate loans, $17,000 in consumer loans, and $2,299,000 in residential real estate loans at December 31, 2017, compared to $26,000 in commercial and industrial loans, $615,000 in commercial real estate loans, $20,000 in consumer loans, and $2,192,000 in residential real estate loans at December 31, 2016.

 

Management also maintains a list of loans that are not classified as nonperforming loans but where some concern exists as to the borrowers’ abilities to comply with the original loan terms. These loans totaled $3.6 million as of December 31, 2017, compared to $5.3 million as of December 31, 2016.

 

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Deposits and Other Funding Sources

 

The Bank’s deposit balances as of December 31 were as follows:

 

(Dollars in thousands)        
   2017   2016 
Noninterest-bearing demand deposits  $151,462   $127,611 
Interest-bearing demand deposits   126,363    122,465 
Money market deposits   94,178    99,454 
Savings deposits   75,080    75,835 
Local certificates of deposit   82,598    79,108 
Brokered certificates of deposit   10,172    7,913 
Total deposits  $539,853   $512,386 

 

Total deposits increased $27.5 million from December 31, 2016 to December 31, 2017. The demand deposit categories as well as money market deposits and savings deposits grew $21.7 million as the Bank’s depositors valued liquid funds more than the interest rates paid on certificates of deposit. Local and brokered certificates of deposit also experienced some growth in 2017.

 

Securities sold under agreements to repurchase declined $765,000 during 2017 due to normal fluctuations in overnight balances in sweep repurchase accounts used by the Bank’s local clients. Federal Home Loan Bank advances increased $8.0 million from December 31, 2016 to December 31, 2017 in order to assist with the funding of loan growth. A blanket collateral agreement covering agricultural real estate loans and residential real estate loans was pledged against all outstanding advances at the end of 2017. Approximately $28.2 million of additional advances were available as of December 31, 2017 based on the collateral pledged.

 

In 2018, management will continue to focus its marketing efforts toward growth in local deposits. If local deposit growth is insufficient to support asset growth, management believes that advances from the FHLB and brokered certificates of deposit can address corresponding funding needs.

 

Shareholders’ Equity

Total shareholders’ equity increased $4.9 million from December 31, 2016 to December 31, 2017. The growth in equity resulted from the retention of earnings in 2017 as net income exceeded dividends paid by $3.9 million. Accumulated other comprehensive income increased by $835,000 in 2017 principally as a result of available for sale securities moving from a net unrealized loss at the end of 2016 to a net unrealized gain as of the end of 2017.

 

Note 20 to the consolidated financial statements presents regulatory capital information for the Bank at the end of 2017 and 2016. Management will monitor these capital ratios during 2018 as they relate to asset growth and earnings retention. ChoiceOne’s Board of Directors and management do not plan to allow capital to decrease below those levels necessary to be considered “well capitalized” by regulatory guidelines. At December 31, 2017, the Bank was categorized as “well-capitalized.” On July 3, 2013, the FDIC Board of Directors approved the Regulatory Capital Interim Final Rule, implementing Basel III. This rule redefines Tier 1 capital as two components (Common Equity Tier 1 and Additional Tier 1), creates a new capital ratio (Common Equity Tier 1 Risk-based Capital Ratio) and implements a capital conservation buffer. It also revises the prompt corrective action thresholds and makes changes to risk weights for certain assets and off-balance-sheet exposures. Banks were required to transition into the new rule beginning on January 1, 2015. A 2.5% capital conservation buffer will be phased in over a period of four years beginning in 2016. Based on ChoiceOne’s capital levels and balance sheet composition at December 31, 2017, management believes implementation of the new rule will have no material impact on ChoiceOne’s capital needs.

 

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Table 4 – Contractual Obligations

 

The following table discloses information regarding the maturity of ChoiceOne’s contractual obligations at December 31, 2017:

 

   Payment Due by Period 
       Less           More 
       than   1 - 3   3 - 5   than 
(Dollars in thousands)  Total   1 year   Years   Years   5 Years 
                     
Time deposits  $92,770   $67,698   $18,712   $6,360   $ 
Repurchase agreements   7,148    7,148             
Advances from Federal Home Loan Bank   20,268    20,034    73    79    82 
Operating leases   760    117    241    251    152 
Other obligations   595    99    198    143    155 
  Total  $121,541   $95,096   $19,222   $6,833   $389 

  

Liquidity and Interest Rate Risk

Net cash from operating activities was $8.1 million for 2017 compared to $10.9 million for 2016. Lower net proceeds from loan sales was the main reason for the decrease. Cash used in investing activities was $18.3 million in 2017 compared to $41.5 million in 2016. The large year over year change was caused by sales of securities in 2017, the effect of which was partially offset by higher loan growth in 2017 than in 2016. Cash flows from financing activities were $32.2 million in 2017 compared to $34.2 million in the prior year.

 

ChoiceOne’s primary market risk exposure occurs in the form of interest rate risk. Liquidity risk also can have an impact but to a lesser extent. ChoiceOne’s business is transacted in U.S. dollars with no foreign exchange risk exposure. Agricultural loans comprise a relatively small portion of ChoiceOne’s total assets. Management believes that ChoiceOne’s exposure to changes in commodity prices is insignificant.

 

Management believes that the current level of liquidity is sufficient to meet the Bank’s normal operating needs. This belief is based upon the availability of deposits from both the local and national markets, maturities of securities, normal loan repayments, income retention, federal funds purchased lines of credit from correspondent banks, and advances available from the FHLB. Liquidity risk deals with ChoiceOne’s ability to meet its cash flow requirements. These requirements include depositors desiring to withdraw funds and borrowers seeking credit. Relatively short-term liquid funds exist in the form of lines of credit to purchase federal funds at correspondent banks. As of December 31, 2017, the amount of federal funds available for purchase from the Bank’s correspondent banks totaled approximately $63.0 million. ChoiceOne had no federal funds purchased at the end of 2017 or 2016. The Bank also has a line of credit secured by ChoiceOne’s commercial loans with the Federal Reserve Bank of Chicago for $82.5 million, which is designated for nonrecurring short-term liquidity needs. Longer-term liquidity needs may be met through local deposit growth, maturities of securities, normal loan repayments, advances from the FHLB, brokered certificates of deposit, and income retention. Approximately $28.2 million of borrowing capacity was available from the FHLB based on agricultural real estate loans and residential real estate loans pledged as collateral at year-end 2017. The acceptance of brokered certificates of deposit is not limited as long as the Bank is categorized as “well capitalized” under regulatory guidelines.

 

Critical Accounting Policies And Estimates

 

Management’s discussion and analysis of financial condition and results of operations as well as disclosures found elsewhere in this report are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the market value of securities, the amount of the allowance for loan losses, loan servicing rights, carrying value of goodwill, and income taxes. Actual results could differ from those estimates.

 

Securities

Securities available for sale may be sold prior to maturity due to changes in interest rates, prepayment risks, yield, availability of alternative investments, liquidity needs, credit rating changes, or other factors. Securities classified as available for sale are reported at their fair value with changes flowing through other comprehensive income. Declines in the fair value of securities below their cost that are considered to be “other than temporary” are recorded as losses in the income statement. In estimating whether a fair value decline is considered to be “other than temporary,” management considers the length of time and extent that the security’s fair value has been less than its carrying value, the financial condition and near-term prospects of the issuer, and the Bank’s ability and intent to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value.

 

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Market values for securities available for sale are obtained from outside sources and applied to individual securities within the portfolio. The difference between the amortized cost and the fair value of securities is recorded as a valuation adjustment and reported net of tax effect in other comprehensive income.

 

Allowance for Loan Losses 

The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses inherent in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance for loan losses is an estimate based on reviews of individual loans, assessments of the impact of current economic conditions on the portfolio and historical loss experience of seasoned loan portfolios.

 

Management believes the accounting estimate related to the allowance for loan losses is a “critical accounting estimate” because (1) the estimate is highly susceptible to change from period to period because of assumptions concerning the changes in the types and volumes of the portfolios and current economic conditions and (2) the impact of recognizing an impairment or loan loss could have a material effect on the Company’s assets reported on the balance sheet as well as its net income.