Independent Bank Corporation - 10-Q quarterly report FY

 

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INDEPENDENT BANK CORPORATION AND SUBSIDIARIES

INDEPENDENT BANK CORPORATION AND SUBSIDIARIES
Consolidated Statements of Financial Condition

INDEPENDENT BANK CORPORATION AND SUBSIDIARIES

INDEPENDENT BANK CORPORATION AND SUBSIDIARIES

INDEPENDENT BANK CORPORATION AND SUBSIDIARIES

(unaudited)

1. In our opinion, the accompanying unaudited consolidated financial statements contain all the adjustments necessary to present fairly our consolidated financial condition as of March 31, 2006 and December 31, 2005, and the results of operations for the three-month periods ended March 31, 2006 and 2005. Certain reclassifications have been made in the prior year financial statements to conform to the current year presentation. Our critical accounting policies include the assessment for other than temporary impairment on investment securities, the determination of the allowance for loan losses, the valuation of derivative financial instruments, the valuation of originated mortgage servicing rights, the valuation of deferred tax assets and the valuation of goodwill. Refer to our 2005 Annual Report on Form 10-K for a disclosure of our accounting policies.

2. Our assessment of the allowance for loan losses is based on an evaluation of the loan portfolio, recent loss experience, current economic conditions and other pertinent factors. Loans on non-accrual status, past due more than 90 days, or restructured amounted to $21.6 million at March 31, 2006, and $18.0 million at December 31, 2005. (See Management’s Discussion and Analysis of Financial Condition and Results of Operations).

The net change in unrealized gain on securities available for sale reflect net gains and losses reclassified into earnings as follows:

4. Our reportable segments are based upon legal entities. We have five reportable segments: Independent Bank (“IB”), Independent Bank West Michigan (“IBWM”), Independent Bank South Michigan (“IBSM”), Independent Bank East Michigan (“IBEM”) and Mepco Insurance Premium Financing, Inc. (“Mepco”). We evaluate performance based principally on net income of the respective reportable segments.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

A summary of selected financial information for our reportable segments as of or for the three-month periods ended March 31, follows:

(unaudited)

5. Basic income per share is based on weighted average common shares outstanding during the period. Diluted income per share includes the dilutive effect of additional potential common shares to be issued upon the exercise of stock options and stock units for a deferred compensation plan for non-employee directors.

A reconciliation of basic and diluted earnings per share for the three-month periods ended March 31 follows:

Weighted average stock options outstanding that were anti-dilutive totaled 0.5 million and 0.1 million for the three-months ended March 31, 2006 and 2005, respectively.

Per share data has been restated for a 5% stock dividend in 2005.

6. Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (“SFAS #133”) which was subsequently amended by SFAS #138, requires companies to record derivatives on the balance sheet as assets and liabilities measured at their fair value. The accounting for increases and decreases in the value of derivatives depends upon the use of derivatives and whether the derivatives qualify for hedge accounting.

(unaudited)

Our derivative financial instruments according to the type of hedge in which they are designated under SFAS #133 follows:

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

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

Pay-fixed interest-rate swaps convert the variable-rate cash flows on debt obligations to fixed-rates. Under interest-rate caps, we will receive cash if interest rates rise above a predetermined level. As a result, we effectively have variable rate debt with an established maximum rate.

We record the fair value of Cash Flow Hedges in accrued income and other assets and accrued expenses and other liabilities. On an ongoing basis, we adjust our balance sheet to reflect the then current fair value of Cash Flow Hedges. The related gains or losses are reported in other comprehensive income and are subsequently reclassified into earnings, as a yield adjustment in the same period in which the related interest on the hedged items (primarily variable-rate debt obligations) affect earnings. It is anticipated that approximately $1.9 million, net of tax, of unrealized gains on Cash Flow Hedges at March 31, 2006 will be reclassified to earnings over the next twelve months. To the extent that the Cash Flow Hedges are not effective, the ineffective portion of the Cash Flow Hedges are immediately recognized as interest expense. The maximum term of any Cash Flow Hedge at March 31, 2006 is 6.2 years.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

We also use long-term, fixed-rate brokered CDs to fund a portion of our balance sheet. These instruments expose us to variability in fair value due to changes in interest rates. To meet our objectives, we may enter into derivative financial instruments to mitigate exposure to fluctuations in fair values of such fixed-rate debt instruments (“Fair Value Hedges”). Fair Value Hedges currently include pay-variable interest rate swaps.

Also, we record Fair Value Hedges at fair value in accrued income and other assets and accrued expenses and other liabilities. The hedged items (primarily fixed-rate debt obligations) are also recorded at fair value through the statement of operations, which offsets the adjustment to Fair Value Hedges. On an ongoing basis, we will adjust our balance sheet to reflect the then current fair value of both the Fair Value Hedges and the respective hedged items. To the extent that the change in value of the Fair Value Hedges do not offset the change in the value of the hedged items, the ineffective portion is immediately recognized as interest expense.

Certain financial derivative instruments are not designated as hedges. The fair value of these derivative financial instruments have been recorded on our balance sheet and are adjusted on an ongoing basis to reflect their then current fair value. The changes in the fair value of derivative financial instruments not designated as hedges, are recognized currently in earnings.

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

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

The impact of SFAS #133 on net income and other comprehensive income for the three-month periods ended March 31, 2006 and 2005 is as follows:

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

7. Statement of Financial Accounting Standards No. 141, “Business Combinations,” (“SFAS #141”) and Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” (“SFAS #142”) effects how organizations account for business combinations and for the goodwill and intangible assets that arise from those combinations or are acquired otherwise.

Intangible assets, net of amortization, were comprised of the following at March 31, 2006 and December 31, 2005:

Based on our review of goodwill recorded on the Statement of Financial Condition, no impairment existed as of March 31, 2006.

Amortization of intangibles has been estimated through 2011 and thereafter in the following table, and does not take into consideration any potential future acquisitions or branch purchases.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Changes in the carrying amount of goodwill by reporting segment for the three months ended March 31, 2006 and 2005 were as follows:

8. On January 1, 2006 we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share Based Payment,” (“SFAS #123R”) which is a revision of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS #123”). SFAS #123R supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB #25”) and amends Statement of Financial Accounting Standards No. 95, “Statement of Cash Flows,” (“SFAS #95”). Generally the requirements of SFAS #123R are similar to the requirements described in SFAS #123. However, SFAS #123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. Pro forma disclosure is no longer an alternative.

We adopted SFAS #123R using the “modified prospective” method in which compensation cost is recognized beginning January 1, 2006 (a) based on the requirements of SFAS #123R for all share-based payments granted after January 1, 2006 and (b) based on the requirements of SFAS #123 for all awards granted to employees prior to January 1, 2006 that remain unvested on that date.

Prior to the adoption of SFAS #123R we accounted for stock based compensation under the provisions of SFAS #123 which permitted us to account for share-based payments to employees using APB #25’s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. We also provided pro forma disclosures for our net income and earnings per share as if we had adopted the fair value accounting method for stock based compensation.

We maintain performance-based compensation plans that includes a long-term incentive plan that permits the issuance of equity based compensation awards, including stock options. At the present time, we do not anticipate utilizing stock option grants in the future, thus the only expense related to stock options would be associated with the issuance (if any) of new stock options associated with the “reload” feature of existing outstanding stock options. All stock options outstanding at December 31, 2005 were fully vested and there were no new stock option grants during the three month period ended March 31, 2006.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (continued)
(unaudited)

Prior to January 1, 2006 we granted options to our non-employee directors as well as certain officers. Options that were granted had vesting periods of up to one year, a price equal to the fair market value of the common stock on the date of grant, and expire not more than ten years after the date of grant. The per share weighted-average fair value of stock options was obtained using the Black-Scholes options pricing model. The following table summarizes the assumptions used and values obtained for the three months ended March 31, 2005:

The following table summarizes the impact on our net income had compensation cost included the fair value of options at the grant date for the three months end March 31, 2005:

A summary of outstanding stock option grants and transactions for the three month period ended March 31, 2006 follows:

The aggregate intrinsic value and weighted-average remaining contractual term of outstanding options at March 31, 2006 were $11.7 million and 7.0 years, respectively.

(unaudited)

Common shares issued upon exercise of stock options come from currently authorized but unissued shares. The following summarizes certain information regarding options exercised during the three month periods ending March 31:

9. In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, “Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140,” (“SFAS #156”). This statement amends SFAS #140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities”, to permit entities to choose to either subsequently measure servicing rights at fair value and report changes in fair value in earnings, or amortize servicing rights in proportion to and over the estimated net servicing income or loss and assess the rights for impairment or the need for an increased obligation. In addition, this statement (1) clarifies when a servicer should separately recognize servicing assets and liabilities, (2) requires all separately recognized servicing assets and liabilities to be initially measured at fair value, (3) permits at the date of adoption, a one-time reclassification of available for sale (“AFS”) securities to trading securities without calling into question the treatment of other AFS securities under SFAS #115, “Accounting for Certain Investments in Debt and Equity Securities” and (4) requires additional disclosures for all separately recognized servicing assets and liabilities. This statement is effective as of the beginning of an entities first fiscal year that begins after September 15, 2006. Early adoption is permitted as of the beginning of an entities fiscal year, provided the entity has not yet issued financial statements for any interim period of that fiscal year. We expect to adopt SFAS #156 on January 1, 2007.

10. The results of operations for the three-month periods ended March 31, 2006, are not necessarily indicative of the results to be expected for the full year.

Item 2.

The following section presents additional information that may be necessary to assess our financial condition and results of operations. This section should be read in conjunction with our consolidated financial statements contained elsewhere in this report as well as our 2005 Annual Report on Form 10-K. The Form 10-K includes a list of risk factors that you should consider in connection with any decision to buy or sell our securities.

Summary Our total assets increased by $46.9 million during the first three months of 2006. Loans, excluding loans held for sale (“Portfolio Loans”), totaled $2.615 billion at March 31, 2006, an increase of $59.2 million from December 31, 2005. This was driven by increases in all categories of Portfolio Loans. (See “Portfolio Loans and asset quality.”)

Deposits totaled $2.691 billion at March 31, 2006, compared to $2.641 billion at December 31, 2005. The $49.9 million increase in total deposits during the period principally reflects an increase in savings and NOW accounts and time deposits partially offset by a decline in non-interest bearing deposits. Other borrowings totaled $170.2 million at March 31, 2006, a decrease of $56.9 million from December 31, 2005. This was primarily attributable to the payoff of maturing borrowings with federal funds purchased.

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

Securities available for sale declined during the first quarter of 2006 because loan growth supplanted the need for any significant purchases of new investment securities, and the flat yield curve has created a difficult environment for constructing investment security transactions that meet our profitability objectives. Generally we cannot earn the same interest-rate spread on

securities as we can on Portfolio Loans. As a result, purchases of securities will tend to erode some of our profitability measures, including our return on assets.

At March 31, 2006 and December 31, 2005, we had $14.8 million and $15.3 million, respectively, of asset-backed securities included in securities available for sale. All of our asset-backed securities are backed by mobile home loans and all are rated as investment grade (by the major rating agencies) except for one security with a book value of $2.0 million at March 31, 2006 that was down graded during 2004 to a below investment grade rating. We did not record any impairment charges on this security during the first quarter of 2006 but during the first quarter of 2005 we recorded an impairment charge of $0.2 million on this security due primarily to credit related deterioration on the underlying mobile home loan collateral. We continue to closely monitor this particular security as well as our entire mobile home loan asset-backed securities portfolio. We do not foresee, at the present time, any significant risk of loss (related to credit issues) with respect to any of our other asset-backed securities. We did not record impairment charges on any other investment securities during the first quarter of 2006 but during the first quarter of 2005 we recorded an additional $0.1 million impairment charge on Fannie Mae and Freddie Mac preferred securities. At March 31, 2006, we had a remaining book balance of $26.2 million in Fannie Mae and Freddie Mac preferred securities.

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

Portfolio Loans and asset quality We believe that our decentralized loan origination structure provides important advantages in serving the credit needs of our principal lending markets. In addition to the communities served by our bank branch networks, principal lending markets include nearby communities and metropolitan areas. Subject to established underwriting criteria, we also participate in commercial lending transactions with certain non-affiliated banks and may also purchase real estate mortgage loans from third-party originators.

Our 2003 acquisition of Mepco added the financing of insurance premiums for businesses and the provision of payment plans to purchase vehicle service contracts for consumers (warranty finance) to our lending activities. These are relatively new lines of business for us and expose us to new risks. Mepco conducts its lending activities across the United States. Mepco generally does not evaluate the creditworthiness of the individual customer but instead primarily relies on the loan/payment plan collateral (the unearned insurance premium or vehicle service contract) in the event of default. As a result, we have established and monitor counterparty concentration limits in order to manage our collateral exposure. The counterparty concentration limits are primarily based on the AM Best rating and statutory surplus level for an insurance company and on other factors, including financial evaluation and distribution of concentrations, for warranty

administrators and warranty sellers/dealers. The sudden failure of one of Mepco’s major counterparties (an insurance company or warranty administrator) could expose us to significant losses. In particular, at March 31, 2006 we have an exposure of approximately $2.4 million with one warranty administrator that was created due primarily to an increased level of cancellations on existing vehicle service contract payment plans and insufficient holdbacks on more recently funded vehicle service contract payment plans. We are carefully monitoring business with this warranty administrator and are establishing specific requirements to eliminate this exposure including increased holdbacks on new business and additional required monthly payments. While we currently do not anticipate incurring any loss related to our exposure with this warranty administrator, adverse future events such as a material decline in new business or higher cancellations of existing vehicle service contract payment plans could result in a loss.

Mepco also has established procedures for loan servicing and collections, including the timely cancellation of the insurance policy or vehicle service contract, in order to protect our collateral position in the event of default. Mepco also has established procedures to attempt to prevent and detect fraud since the loan/payment plan origination activities and initial customer contact is entirely done through unrelated third parties (primarily insurance agents and automobile warranty administrators or automobile dealerships). There can be no assurance that the aforementioned risk management policies and procedures will prevent us from the possibility of incurring significant credit or fraud related losses in this business segment.

Although the management and board of directors of each of our banks retain authority and responsibility for credit decisions, we have adopted uniform underwriting standards. Further, our loan committee structure as well as the centralization of commercial loan credit services and the loan review process, provides requisite controls and promotes compliance with such established underwriting standards. Such centralized functions also facilitate compliance with consumer protection laws and regulations. There can be no assurance that the aforementioned centralization of certain lending procedures and the use of uniform underwriting standards will prevent us from the possibility of incurring significant credit losses in our lending activities.

We generally retain loans that may be profitably funded within established risk parameters. (See “Asset/liability management.”) As a result, we may hold adjustable-rate and balloon real estate mortgage loans as Portfolio Loans, while 15- and 30-year, fixed-rate obligations are generally sold to mitigate exposure to changes in interest rates. (See “Non-interest income.”) During the first three months of 2006 our balance of real estate mortgage loans held in portfolio increased by $8.1 million.

The $10.1 million increase in commercial loans during the three months ended March 31, 2006, principally reflects our emphasis on lending opportunities within this category of loans and an increase in commercial lending staff. Loans secured by real estate comprise the majority of new commercial loans.

The $401.7 million of finance receivables at March 31, 2006 are comprised principally of loans to businesses to finance insurance premiums and payment plans offered to individuals to purchase vehicle service contracts. The growth in this category of loans is primarily due to the geographic expansion of Mepco’s lending activities and the addition of sales staff to call on insurance agencies and automobile warranty administrators. During the first quarter of 2006 we instituted pricing increases and certain funding changes in the warranty finance division of Mepco. In April 2006, Mepco experienced a number of changes in key personnel. Effective April 25, 2006, we appointed Raymond Biggs, who was previously the senior vice president of commercial

lending for Independent Bank East Michigan, president of Mepco. Unrelated to Mr. Biggs’ appointment, certain key employees in the warranty finance division resigned. While we have replaced those former employees with individuals in which we have the utmost confidence, it is possible that these changes in management, as well as recent pricing increases and funding changes in Mepco’s warranty finance division, could negatively impact Mepco’s operations. This, in turn, could have an adverse impact on our results of operations. We are aggressively taking action to mitigate the impact from these changes in management, including the close monitoring of our relationships with key counter parties in the warranty finance business.

Future growth of overall Portfolio Loans is dependent upon a number of competitive and economic factors. Declines in Portfolio Loans or competition leading to lower relative pricing on new Portfolio Loans could adversely impact our future operating results. We continue to view loan growth consistent with prevailing quality standards as a major short and long-term challenge.

The increase in the overall level of non-performing loans in the first quarter of 2006 is primarily due to an increase in non-performing commercial loans. Non-performing commercial loans increased to $9.0 million at March 31, 2006 from $5.2 million at December 31, 2005. This increase is due to the addition of two loans. One of these loans with a balance of $3.6 million is secured by a low/moderate income apartment complex. We have commenced collection of this credit through foreclosure and do not currently anticipate any significant loss. The other commercial real estate loan has a balance of $1.5 million and is secured by vacant land. A purchase offer is pending on the real estate securing this loan, which if consummated is expected to cure this default.

Other real estate and repossessed assets totaled $2.6 million and $2.1 million at March 31, 2006 and December 31, 2005, respectively. This increase is primarily a result of a rise in the level of residential homes acquired through foreclosure.

We will place a loan that is 90 days or more past due on non-accrual, unless we believe the loan is both well secured and in the process of collection. Accordingly, we have determined that the

collection of the accrued and unpaid interest on any loans that are 90 days or more past due and still accruing interest is probable.

The ratio of net loan charge-offs to average loans was 0.17% on an annualized basis in the first quarter of 2006 compared to 0.30% in the first quarter of 2005. First quarter 2005 net charge-offs included a $0.7 million charge-off (based on an updated collateral analysis) on a real estate mortgage and commercial loan relationship with one borrower who had declared bankruptcy.
At March 31, 2006, the allowance for loan losses totaled $23.5 million, or 0.90% of Portfolio Loans compared to $23.0 million, or 0.90% of Portfolio Loans at December 31, 2005.

Impaired loans totaled approximately $9.8 million and $15.3 million at March 31, 2006 and 2005, respectively. At those same dates, certain impaired loans with balances of approximately $8.1 million and $13.8 million, respectively had specific allocations of the allowance for loan losses, which totaled approximately $1.6 million and $4.0 million, respectively. Our average investment in impaired loans was approximately $8.2 million and $14.9 million for the three-month periods ended March 31, 2006 and 2005, respectively. Cash receipts on impaired loans on non-accrual status are generally applied to the principal balance. Interest income recognized on impaired loans during the first quarters of 2006 and 2005 was approximately $0.10 million and $0.14 million, respectively of which the majority of these amounts were recorded in cash.

In determining the allowance and the related provision for loan losses, we consider four principal elements: (i) specific allocations based upon probable losses identified during the review of the loan portfolio, (ii) allocations established for other adversely rated loans, (iii) allocations based principally on historical loan loss experience, and (iv) additional allowances based on subjective factors, including local and general economic business factors and trends, portfolio concentrations and changes in the size, mix and/or the general terms of the loan portfolios.

The first element reflects our estimate of probable losses based upon our systematic review of specific loans. These estimates are based upon a number of objective factors, such as payment history, financial condition of the borrower, and discounted collateral exposure.

The second element reflects the application of our loan rating system. This rating system is similar to those employed by state and federal banking regulators. Loans that are rated below a certain predetermined classification are assigned a loss allocation factor for each loan

classification category that is based upon a historical analysis of losses incurred. The lower the rating assigned to a loan or category, the greater the allocation percentage that is applied.

The third element is determined by assigning allocations based principally upon the ten-year average of loss experience for each type of loan. Recent years are weighted more heavily in this average. Average losses may be further adjusted based on the current delinquency rate. Loss analyses are conducted at least annually.

The fourth element is based on factors that cannot be associated with a specific credit or loan category and reflects our attempt to ensure that the overall allowance for loan losses appropriately reflects a margin for the imprecision necessarily inherent in the estimates of expected credit losses. We consider a number of subjective factors when determining the unallocated portion, including local and general economic business factors and trends, portfolio concentrations and changes in the size, mix and the general terms of the loan portfolios. (See “Provision for credit losses.”)

Mepco’s allowance for loan losses is determined in a similar manner as discussed above and takes into account delinquency levels, net charge-offs, unsecured exposure and other subjective factors deemed relevant to their lending activities.

Deposits and borrowings Our competitive position within many of the markets served by our bank branch networks limits the ability to materially increase deposits without adversely impacting the weighted-average cost of core deposits. Accordingly, we compete principally on the basis of convenience and personal service, while employing pricing tactics that are intended to enhance the value of core deposits.

To attract new core deposits, we have implemented a high-performance checking program that utilizes a combination of direct mail solicitations, in-branch merchandising, gifts for customers opening new checking accounts or referring business to our banks and branch staff sales training. This program has generated increases in customer relationships as well as deposit service charges. We believe that the new relationships that result from these marketing and sales efforts provide valuable opportunities to cross sell related financial products and services.

Over the past two to three years we have also expanded our treasury management products and services for commercial businesses and municipalities or other governmental units and have also increased our sales calling efforts in order to attract additional deposit relationships from these sectors. Despite these efforts our core deposit growth has not kept pace with the growth of our Portfolio Loans and we have primarily utilized brokered certificates of deposit (“Brokered CD’s”) to fund this Portfolio Loan growth. We view long-term core deposit growth as a significant challenge. Core deposits generally provide a more stable and lower cost source of funds than

alternate sources such as short-term borrowings. As a result, the continued funding of Portfolio Loan growth with alternative sources of funds (as opposed to core deposits) may erode certain of our profitability measures, such as return on assets, and may also adversely impact our liquidity. (See “Liquidity and capital resources.”)

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

Other borrowed funds, principally advances from the Federal Home Loan Bank (the “FHLB”) and securities sold under agreements to repurchase (“Repurchase Agreements”), totaled $170.2 million at March 31, 2006, compared to $227.0 million at December 31, 2005. The $56.9 million decrease in other borrowed funds principally reflects the payoff of maturing variable rate FHLB advances and Repurchase Agreements with proceeds from federal funds purchased.

Derivative financial instruments are employed to manage our exposure to changes in interest rates. (See “Asset/liability management.”) At March 31, 2006, we employed interest-rate swaps with an aggregate notional amount of $619.7 million and interest rate caps with an aggregate notional amount of $187.0 million. (See note #6 of Notes to Interim Consolidated Financial Statements.)

Liquidity and capital resources Liquidity risk is the risk of being unable to timely meet obligations as they come due at a reasonable funding cost or without incurring unacceptable losses. Our liquidity management involves the measurement and monitoring of a variety of sources and uses of funds. Our Consolidated Statements of Cash Flows categorize these sources and uses into operating, investing and financing activities. We primarily focus our liquidity management on developing access to a variety of borrowing sources to supplement our deposit gathering activities and provide funds for growing our investment and loan portfolios as well as to be able to respond to unforeseen liquidity needs.

Our sources of funds include a stable deposit base, secured advances from the Federal Home Loan Bank of Indianapolis, both secured and unsecured federal funds purchased borrowing

facilities with other commercial banks, an unsecured holding company credit facility and access to the capital markets (for trust preferred securities and Brokered CD’s).

At March 31, 2006 we had $897.5 million of time deposits that mature in the next twelve months. Historically, a majority of these maturing time deposits are renewed by our customers or are Brokered CD’s that we expect to replace. Additionally $1.164 billion of our deposits at March 31, 2006 were in account types from which the customer could withdraw the funds on demand. Changes in the balances of deposits that can be withdrawn upon demand are usually predictable and the total balances of these accounts have generally grown over time as a result of our marketing and promotional activities. There can be no assurance that historical patterns of renewing time deposits or overall growth in deposits will continue in the future.

We have developed contingency funding plans that stress tests our liquidity needs that may arise from certain events such as an adverse credit event, rapid loan growth or a disaster recovery situation. Our liquidity management also includes periodic monitoring of each bank that segregates assets between liquid and illiquid and classifies liabilities as core and non-core. This analysis compares our total level of illiquid assets to our core funding. It is our goal to have core funding sufficient to finance illiquid assets.

Over the past several years our Portfolio Loans have grown more rapidly than our core deposits. In addition much of this growth has been in loan categories that cannot generally be used as collateral for FHLB advances (such as commercial loans and finance receivables). As a result, we have become more dependent on wholesale funding sources (such as Brokered CD’s and Repurchase Agreements). In order to reduce this greater reliance on wholesale funding we intend to complete a securitization of finance receivables during the second quarter of 2006. It is likely that a securitization facility would have a higher total cost than our current wholesale funding sources, which would adversely impact our future net interest income. However, we believe that the improved liquidity will likely outweigh the adverse impact on our net interest income.

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

We also believe that a diversified portfolio of quality loans will provide superior risk-adjusted returns. Accordingly, we have implemented balance sheet management strategies that combine efforts to originate Portfolio Loans with disciplined funding strategies. Acquisitions have also been an integral component of our capital management strategies. (See “Acquisitions.”)

We have three special purpose entities that have issued $62.4 million of cumulative trust preferred securities outside of Independent Bank Corporation that currently qualifies as Tier 1 capital. These entities have also issued common securities and capital to Independent Bank Corporation. Independent Bank Corporation, in turn, issued subordinated debentures to these special purpose entities equal to the trust preferred securities, common securities and capital issued. The subordinated debentures represent the sole asset of the special purpose entities. The common securities, capital and subordinated debentures are included in our Consolidated Statements of Financial Condition at March 31, 2006, and December 31, 2005.

In March 2005, the Federal Reserve Board issued a final rule that retains trust preferred securities in the Tier 1 capital of bank holding companies. After a transition period ending March 31, 2009, the aggregate amount of trust preferred securities and certain other capital elements will be

limited to 25 percent of Tier 1 capital elements, net of goodwill (net of any associated deferred tax liability). The amount of trust preferred securities and certain other elements in excess of the limit could be included in the Tier 2 capital, subject to restrictions. Based upon our existing levels of Tier 1 capital, trust preferred securities and goodwill, this final Federal Reserve Board rule would have reduced our Tier 1 capital to average assets ratio by approximately 9 basis points at March 31, 2006, (this calculation assumes no transition period).

To supplement our balance sheet and capital management activities, we periodically repurchase our common stock. The level of share repurchases in a given year generally reflects changes in our need for capital associated with our balance sheet growth. We previously announced that our board of directors had authorized the repurchase of up to 750 thousand shares. This authorization expires on December 31, 2006. During the first quarter of 2006 we repurchased 342 thousand shares at a weighted average price of $27.00 per share.

Total shareholders’ equity at March 31, 2006 increased $0.5 million from December 31, 2005, due primarily to the retention of earnings and the issuance of common stock pursuant to certain compensation plans that was largely offset by share repurchases and cash dividends that we declared as well as a $0.3 million decrease in accumulated other comprehensive income. Shareholders’ equity totaled $248.8 million, equal to 7.31% of total assets at March 31, 2006. At December 31, 2005, shareholders’ equity totaled $248.3 million, which was equal to 7.40% of assets.

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

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

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

Summary Net income totaled $12.3 million during the three months ended March 31, 2006, compared to $11.3 million during the comparable period in 2005. 2006 results include $2.8 million of other income and $1.7 million of non-interest expense related to the settlement of litigation involving the former owners of Mepco. (See “Litigation Matters.”) Additionally, 2006 results also include $0.3 million in compensation and benefits expense for severance payments primarily associated with reduction in staff initiatives implemented in the first quarter and $0.1 million of legal and professional fees related to the aforementioned litigation settlement. Collectively, these items resulted in a net after-tax increase in net income of $1.5 million, or $0.07 per diluted share, in the first quarter of 2006. The first quarter of 2005 included a recovery of $0.6 million ($0.4 million after tax, or $0.02 per diluted share) of previously recorded impairment reserves on capitalized mortgage loan servicing rights.

We believe that our earnings per share growth rate over a long period of time (five years or longer) is the best single measure of our performance. We strive to achieve an average annual long term earnings per share growth rate of approximately 10% to 15%. Accordingly, our focus is on long-term results taking into consideration that certain components of our revenues are cyclical in nature (such as mortgage-banking) which can cause fluctuations in our earnings per share from one period to another. For the period from 2001 through 2005 our compound average annual earnings per share growth rate was approximately 17%. Our primary strategies for achieving long-term growth in earnings per share include: earning asset growth (both organic and through acquisitions), diversification of revenues (within the financial services industry), effective capital management (efficient use of our shareholders’ equity) and sound risk management (credit, interest rate, liquidity and regulatory risks). As we have grown in size, and also considering the relatively low economic growth rates in Michigan (our primary market for banking), we believe achieving a 10% to 15% growth rate in earnings per share will be challenging without future acquisitions.

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

Tax equivalent net interest income totaled $35.3 million during the first quarter of 2006, which represents an $0.2 million or 0.7% increase from the comparable quarter one year earlier. We review yields on certain asset categories and our net interest margin on a fully taxable equivalent basis. This presentation is not in accordance with generally accepted accounting principles (“GAAP”) but is customary in the banking industry. In this non-GAAP presentation, net interest income is adjusted to reflect tax-exempt interest income on an equivalent before-tax basis. This measure ensures comparability of net interest income arising from both taxable and tax-exempt sources. The adjustments to determine tax equivalent net interest income were $1.7 million and $1.5 million for the first quarters of 2006 and 2005, respectively, and were computed using a 35% tax rate.

The increase in tax equivalent net interest income primarily reflects a $231.4 million increase in the balance of average interest-earning assets that was largely offset by a 33 basis point decrease in our tax equivalent net interest income as a percent of average interest-earning assets (the “net interest margin”). The increase in average interest-earning assets is due primarily to growth in all categories of loans. The net interest margin was equal to 4.59% during the first quarter of 2006 compared to 4.92% in the first quarter of 2005. The tax equivalent yield on average interest-earning assets rose to 7.50% in the first quarter of 2006 from 6.92% in the first quarter of 2005. This increase primarily reflects the rise in short-term interest rates that has resulted in variable rate loans re-pricing and new loans being originated at higher rates. The increase in the tax equivalent yield on average interest-earning assets was more than offset by a 91 basis point rise in

our interest expense as a percentage of average interest-earning assets (the “cost of funds”) to 2.91% during the first quarter of 2006 from 2.00% during the first quarter of 2005. The increase in our cost of funds reflects the rise in short-term interest rates that has resulted in higher rates on certain short-term and variable rate borrowings and higher rates on deposits.